Financial Stability

Hey I'm not complaining 'cause I really need the work
Hittin' up my buddy's got me feeling like a jerk
Hundred dollar car note, two hundred rent
I get a check on Friday but it's already spent
--Huey Lewis & the News

Amity Shlaes quotes a snippet from Calvin Coolidge's 1923 State of Union message. Coping with uncertain environments greatly increases when your financial house is in order. This is true at the country, organization, and individual level.

"Our main problems are domestic problems..." Some lines for the State of the Union from...one CC (1923 Coolidge State of the Union equivalent) #coolidgeclub pic.twitter.com/A5XTkyTGrS

— Amity Shlaes (@AmityShlaes) January 24, 2019

We are far more capable of dealing with external threats from positions of financial strength. In fact, as Coolidge observes, it is from firm financial foundations that peace and prosperity advance.

Conversely, weak financial arrangements predicated on borrowing and debt are sources of conflict and squalor.

Caution...Or Not?

Ever had that feeling
Almost broke in two 
Said that you were leaving
Like you do, like you do
--ABC

Although major stock indexes are running toward new highs this am, hard to see them capturing the flag without participation by the banks.

Following a lift when it needed to a couple of weeks back, the bank index has once again flipped over and is marking new lows as it heads toward the bottom of the trading channel. Today's heaviness (see that inverted hammer in yellow?) in the midst of a broad lift in the tape is a signal that strength is being sold in this sector.

Because rhythm has largely left the markets, perhaps all of this means nothing anymore. In the 'old days,' however, weakness in the banking sector on a big up for the overall tape would constitute a significant caution signal.

Disclosure for Journalists

"I can think of three reasons why you wouldn't want to do that, judge."
--Billy Ray Valentine (Trading Places)

In the financial services sector it is common practice to have pundits, analysts, et al disclose any positions they have in the securities they discuss. By doing so, consumers of financial information are made more aware of potential biases in the people generating such information. Those biases might slant the information to be consumed in some way.

Why aren't similar practices adopted by the media--particularly those reporting on political issues? Isn't it reasonable to have journalists disclose their political affiliations and contributions so that readers are more aware of potential for bias and slant in the information that they consume?

Perhaps, but I can think of at least three reasons why such disclosure is unlikely. One is that it would quickly reveal just how tilted the entire profession is to the left. Although this tilt has been recognized by many for some time, there are still those who want to believe that their sources of information are objective. Overt political disclosure by those generating the information would destroy this fantasy.

Another is that customers are likely to be lost if journalists subsequently attempt to compensate for their biases by actually producing more balanced content. A large market for bias exists, and followers will defect if their preference for bias is not satisfied.

A third reason is that journalists might realize, per core tenets of signaling theory, that the only time that consumers of information will view their information as credible is when they report a) negatively about friendly political entities (as suggested by their political disclosure) or b) positively about political opponents.

That thought is most unpalatable to an interested media.

Risk and Reward

Hear the echoes and
Feel yourself starting to turn
Don't know why you should feel
That there's something to learn
It's just a game that you play
--Al Stewart

'Common wisdom' in mainstream financial advice is that stocks, while being riskier than other asset classes such as bonds, handily outperform over time. Thus, investors should buy and hold equities for the long term because the longer one holds stocks, the more likely they are to outperform bonds.

Anyone who understands the relationship between risk and reward should see problems with this thought process. Axiomatically, riskier asset classes present prospects of higher reward. After all, who in their right mind would invest in a high risk, low reward proposition? But risky investments also carry higher potential for loss. If they did not, then by definition these asset classes would be low risk and high reward and everyone would pile into them, driving prices higher and reducing reward (which would bring the risk:reward relationship back in line).

Of course, proposing stocks as low risk and high reward in the long run is likely to draw doubts from even gullible clients.

A more truthful statement is that risky asset classes like stocks have potential for high returns over time but also potential for high losses over that same time horizon. In other words, investors heavily into stocks should prepare themselves for the prospect that their portfolios could just as easily be down big after 30 years as they might be up big.

If that were not the case, then the risk:reward axiom would be wrong.   

Perfect Storm for Income-Producing Securities

"He's no saleman for sure. Unless he's peddlin'...dynamite!"
--Doc T.R. Velie, Jr (Bad Day at Black Rock)

Perhaps the greatest challenge noted by participants at this year's RISE conference was increasing difficulties finding income-producing securities at an attractive price. This search is being driven by interest rate suppression by central banks, which is driving investors out of 'risk-free' Treasuries toward other asset groups. In fact, there was broad bearishness in Treasuries. USTs were labeled by some as being 'return free' rather than 'risk-free,' and perceived by some as possessing more risk than stocks at current prices.

BlackRock reps noted that they are recommending, and their funds are investing in, dividend paying stocks, corporates (including 'high yield' or junk bonds), Asian sovereign debt, and even securitized bank loans as alternative income generators. A gentlemen from a firm in Chicago noted that he was recommending non-agency mortgage backed securities to his firm's investment committee.

So, investors are once again walking the risk plank, bidding up prices of riskier, less liquid instruments.

Policy makers are getting what they want--they are forcing people to take more risk.

The timing couldn't be worse. We are coming off a credit bust that, if left to its own devices, would surely be raising rates and rewarding savers to clear away the bubble that inflated over the past decade. Current policies, however, do the opposite.

Compounding the problem is that more and more Boomers are retiring, which elevates the number of people looking for income than in the past as they move from 'accumulation' to 'distribution' phases of their investment years.

As investors reach for yield, prices of income-producing securities are rising much higher than the free market rate.  Increasingly, fixed income investors are overpaying.

This sets up a near perfect storm for this asset class during the next time down.

position in SPX, USTs

Distributing Financial Services

"Now you can concentrate on the big-ticket retail!"
--Lynch (Wall Street)

The first RISE session I atteneded this morning, "Investment Life Cycle," was hosted by four people from BlackRock and one from UBS. BR is the largest asset manager in the world with about $3.7 under management. This is split between actively managed mutual fund type products and the rest being passive ETF products (BR owns the i-share series of ETFs).

Two of the BR people were strategist types advising their portfolio managers as well as about 75ish BR wholesaler/consultant types who essentially market BR products to firms managing money for clients. The UBS guy, a senior VP who oversees about $600 million regional client accounts for the firm, is an example of a 'customer' of the BR supply chain.

The BR wholesaler meets with the UBS guy ~quarterly to share new products/service and to understand client needs.

This sketch provides just one of a mindnumbingly large number of ways products and services are distributed in the industry. It adds to my quest to better understand (examples of previous lessons learned at RISE here, here) how the financial services industry is structured and how it operates.

RISE 2013

Go closer hold the land
Feel partly no more than grains of sand
--Yes

For the 3rd consecutive year, I am attending the RISE (Redefining Investment Strategy Education) conference at the University of Dayton. RISE is one of the largest student-centered conferences on investing. I would guess that there are about 3000 attendees this year.

The first day is always a 'macro' day at UD arena where industry leaders and pundits gather to discuss broad issues and trends. I missed the morning sessions, which included a panel discussion with two Fed bank presidents, Charles Evans (Chicago) and Dennis Lockhart (Atlanta). Apparently they signaled that the Fed intends to maintain its zero interest rate policy (ZIRP) for the next two years, which is really no news given recent FOMC statements.

An afternoon "Markets" panel featured Liz Ann Sonders of Schwab, Phil Orlando of Federated Investors, Stephanie Link of TheStreet, and Barry Knapp of Barclays. All were bullish; the only negative voice was the moderator, David Asman of Fox Business. I was reminded of a similar situation two years ago where a moderator from Bloomberg provided a lone cautionary voice.

Three of the four discussants were very bullish on stocks, citing the usual reasons (easy Fed, equities as the only game in town given interest rates, Fed model type valuations, stong corp balance sheets, skeptical retail investors, etc). Only Knapp voiced reservations about the near term, noting that various indicators were 'flashing warning signs' to him. If there was a correction, "I would buy it," he said.

None of the panel felt that low interest rates or massive bond buying by the Fed were significant issues. Rather, these are plusses for equities, in their view.

Perhaps the best question came from a sharp student, who asked whether he should be concerned that all panelists are clearly bullish. To which the panel essentially replied that not all people are bullish--just them (presumably they are the 'smart ones').

Data obtained from attendees suggested general bullishness among attendees, with the average forecast for the Dow at year end being between 15 and 16K.

The final panel of the day discussed the future of the financial services industry. While the content of the discussion was interesting, I was particularly impressed by panelist Roger Ferguson, a former Fed governor who is now CEO of TIAA-CREF. He certainly holds some views that I do not agree with, and he's been affiliated with institutions that have done big time damage. But I found his comments, particularly on questions coming from students, thoughtful and spirited.

Also notewothy: throughout the entire day, I heard not one mention of commodities.

position in SPX, Treasuries, commodities

Money Management and the Agency Problem

"Best defense, no be there."
--Myagi (Karate Kid)

The previous post describes an 'agency problem' (Alchian & Demsetz, 1972; Fama, 1980; Jensen & Meckling, 1976). Lacking either skill, motivation, or time, an investor (the principal) retains a professional money manager (the agent) to invest capital. Because it is difficult for the investor to understand precisely how the money manager is behaving, the possibility exists that the money manager may not be acting with the investor's best interests in mind.

Even if the money manager prefers to act in the client's interest, institutional pressures may drive alternative behavior. Institutional pressures arise to some degree in any social setting. Categorically, these pressures are of normative (widely held prescriptive rules that govern behavior), mimetic (copying what appears to be effective behavior), and coercive (do this lest you will be punished) nature.

The career risk that Grantham discusses is largely shaped by these institutional pressures. The 'iron cage' famously elaborated by DiMaggio and Powell (1983) suggests the difficulty that even well meaning money managing agents will encounter when trying to effectively serve their investing principals.

The best solutions to this agency problem are likely found outside of the institutional field of professional money management. Investors who 'do it themselves,' for example, are less prone to the herding that Grantham discusses. For example, individuals can make concentrated bets that fly in the face of standard portfolio theory. They can also radically alter asset allocations in short order to express a macro view of the world--a macro picture that may be subject to frequent revision in today's turbulent context.

Both of these actions are frowned upon in the professional investment community.

Most individuals will of course argue that they possess neither the time nor the skill to make investment decisions themselves. Thus, they need to retain a specialized professional.

Those that value superior investment returns, and understand the difficulty of achieving them in the institutional field of professional money management, may decide that self-management of their economic future is worth the effort.

References

Alchian, A.A. & Demsetz, H. 1972. Production, information costs, and economic organization. American Economic Review, 62: 777-795)

DiMaggio, P. & Powell, W. 1983. The iron cage revisited: Institutional isomorphism and collective rationality in institutional fields. American Sociological Review, 48: 147-160.

Fama, E.F. 1980. Agency problems and the theory of the firm. Journal of Political Economy, 88: 288-307.

Jensen, M.C. & Meckling, W. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3: 304-360.

Iron Cage of Professional Finance

"Ever wonder why fund managers can't beat the S&P 500? Because they're sheep, and sheep get slaughtered."
--Gordon Gekko (Wall Street)

During last week's RISE conference, it was hard not to conclude that consistent outperformance by finance industry professionals is difficult if not impossible. In their quest for alpha, professional money managers must cope with standard industry practices (getting stronger with the CFA craze), regs and compliance, and career risk concerns--all of which drive behavior toward central tendency.

Subtract the fee structure, and principals who invest capital thru professional agents seem likely to under perform indexes over time.

Given the current industry context, seems to me there are three primary ways to outperform:

1) Concentrated positions. Among professionals, portfolios of less than 30 positions are rare. As such, professionals are unlikely to consistently beat benchmarks by significant margins. Yet, successful investors who do not employ professional money managers nearly always operate concentrated portfolios.

2) Bold changes to asset allocations. In the industry, asset allocation changes are considered radical when they are adjusted by 5%. Ten percent swings are almost unheard of. As we have seen, however, instability in the current macro environment has been rewarding swift and large adjustments in asset allocation. For example, those who have been able to move out of risk assets such as stocks during deflationary downdrafts have been able to sidestep steep draw downs.

3) Hedging. Pairing long positions with short positions ensures some variety in portfolio correlation. Hedging may also enable longer holding periods for positions as it tempers the urge to sell favored positions by mitigating drawdowns.

In the investment industry, the only firms capable of such freedoms are hedge funds. However, even hedgies are under increased pressure to comply with institutional rules. Professional money managers in other segments are destined for the Iron Cage that constrains performance via institutional norms.

This situation also spells opportunity for individual investors.

position in SPX

Notable Quotables

Top three quotes from RISE:

3) "2012 will be the year of de-fearing."--Bob Doll, equity chief, BlackRock.

2) "We need millisecond resolution. The second you fall behind, you get smoked." High frequency options trader.

1) "We are financial social workers."--Financial advisor to high net worth clients.

On the RISE

There is freedom within
There is freedom without
Try to catch the deluge in a paper cup
--Crowded House

Am attending the RISE conference at UD for second year. Day One is panel day at the UD Arena. Missed the morning sessions on economy and US equities. Did catch tail end of morning keynote by Morgan Stanley chief strategist, David Durst. PM sessions included altervative investments, 2012 predictions from Robert Doll, chief equity strategist at BlackRock, and international markets.

Will reflect on some sessions separately, but did want to note here that the sentiment by the speakers was universally bullish. The basic thought is that institutions and investors are underinvested in stocks. They are holding lots of cash and low yielding sovereign debt. Thus, stocks represent the best house in the neighborhood--whether that neighborhood is good or bad.

Moreover, central banks are acting in synchronized fashion with easy money, which provides more wind at the back of equities.

Skepticism is in order. The general bullishness expressed last year on panel day was pretty much dead wrong.

position in SPX

NKU Endowment AA

The NKU Foundation manages the university's endowment. The definition of an endowment is a gift given by a donor that restricts what can be done with the resources. Usually, the principle is not to be touched.

At the recent RISE conference, I attended an interesting session on endowment management and learned some specifics about the Rutgers endowment and how its investment portfolio was allocated.

Similar info can be found for NKU's endowment, as the foundation produces a variety of reports for stakeholders.

The last annual report for the endowment was issued 6/30/10. In terms of financial securities (cash and investments, but not counting loans, land, and promised donations), the endowment manages about $65 million. That includes about $9 million that the Foundation manages for NKU at large, so the actual endowment part of the portfolio is more like $55-56 million.

The endowment breaks down its $55 investment portfolio (page 14), but that does not include the bulk of its $10.7 million in cash shown on the balance sheet. It appears that the reporting convention is that cash is not an investment class.

To get a feel for overall asset allocation, I added that cash to the investment portfolio. Here's how the asset allocation (cash plus investments) maths out (in $ thousands):

cash $10,754 (16.4%)
fixed income $11,264 (17.2%)
equities $28,313 (43.1%)
hedge funds $8,531 (13.0%)
alternative assets $6,015 (9.2%)
other $795 (1.2%)
total $65,672

Alternative assets are said to include private equity, venture capital, real estate, and real assets. Would guess 'other' includes these as well--and perhaps some credit instruments as well. If we add, hedge funds, alt investments, and other, we get a total of 23.4% allocated to broad 'alternative investments.'

At the end of 2010, the foundation issued this report that summarized overall investment fund performance on a percentage basis. It also reports annual portfolio performance for the past decade. Not surprisingly, the fund experienced some losses in 2008, 2009.

It also reports an allocation toward equites of about 68%--much higher than the 6/30/10 annual report. This suggests that either the investment managers increased commitment to stocks in late 2010, or something's getting lost in the translation.

Mojo RISER

Motel money, murder madness
Let's change the mood from glad to sadness
--The Doors

Am attending U of Dayton's RISE conference over the next coupla days. Missed the morning sessions but caught two interesting afternoon panels, one on risk management post credit crisis and the other on general economic outlook going forward.

Can't scribe much right now, but will note that none of the four professional risk mgrs (Nuveen, two hedge funds, Credit Suisse) on the first panel were able to steer their firms from major losses during the meltdown. The two hedge fund guys both admitted that without the bailouts, they would be not be around today. The lady from Nuveen was at WaMu during the meltdown and we know how that turned out.

On the economic outlook panel, the audience (maybe 2000 strong) were asked they thought that chances of recession were significant over next 12 months. Perhaps half dozen hands went up. All five panelists (JPM, MS, Fed Reserve, EU guy, Western Southern strategists/CIOs) were all very bullish. Only the moderator, an economist who does radio for Bloomberg, voiced bearish concerns.

It once again became clear to me during this discussion that the finanicial services industry is a license to print money for its participants with little downside for taking too much risk. Everyday people just do not understand how much wealth transfer is occurring with the system as currently structured. It is so far away from a free market that it is mind numbing.

position in SPX