Brace Yourself

KAL's Cartoon from the Aug 13th issue of the Economist sums up our current predicament. What we are facing today is not the prospect of a double-dip recession, it is the reality of a severe economic recession that was never properly addressed. Many of the culprits and conditions that bred the 2008 Subprime crisis continue today.

1. The developed world is experiencing an enormous debt overhang. Weaning off that debt, or de-leveraging, is a painful process. And contrary to what Republicans or Democrats would like us to think, it wasn't the other party's fault. It was the fault of both parties and there is plenty of blame to go around. Just take the Clinton administration for example, although he left us with a budget surplus, Glass-Steagall repeal also took place under his watch and that was a major contributor to the 2008 crisis, which in turn, required a huge bailout under Obama's administration. My only point here is that it took decades of mismanagement, political lobbying from financial firms and protected special interests to get us where we are today. That's just the tip of the iceberg. Frankly, the recent and unprecedented S&P of the US credit rating is a minor issue compared to the possibility of an actual default by any of the PIIGS. A Greek default could be absorbed by the EU, Spain possibly with alot more pain but Italy? That's a G7 nation.

2. So Greece has been bailed out and Italy will be rescued somehow. What does that solve? We've just kicked the can down the road a few years. These countries will never be solvent. A friend of mine was telling me how evading taxes in Italy was a national pastime. How will these countries ever run a surplus? The dependence on debt has become culturally entrenched in the Western world.

3. How much does the USA really owe? As a corporation the US would be a junk bond, the S&P's AA+ rating is rather kind. It owes $14.3 trillion and loses about $1.4 trillion every year. But this is where things get hairy, if we were to sum up long-term liabilities in present value, the US actually owes something close to $200 trillion, healthcare alone accounts for $80 trillion. The recent debt ceiling drama was purely political. The US has been bankrupt for quite some time.

4. USD is the world's reserve currency. A few days ago, I heard the perma-bulls over at CNBC argue that it matters not what the US owes because it is the world's reserve currency and can always find a lender or print it's way out of trouble. That's the kind of shoddy logic that has let us to this mess. Using debt to pay off debt or printing more money aren't permanent solutions. The first simply exacerbates the problem and the second, debases your currency.

5. The US government does not work. The brinkmanship, partisanship, irresponsibility or both parties in Congress should be evident to everyone by now.

6. It doesn't help that a large section of the country believes the government is the problem. Invoking Reagan, they remind us that "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help.'" I would argue that there are certain things the government is better at doing, such as providing public goods without a profit motive. Why must every thing generate a profit? Getting mad at Amtrak for losing money is like getting mad at the Marine Corps for not making money. But rather than searching for a better system, many have decided to work against any system.

7. Education or the lack of. The US spends more than anyone else in the world and is ranked 20th in the recent PISA rankings. Click here. While the US isn't anywhere near No.1 for Math, Science or even Verbal, at the very least it's No.1 in one category--self-esteem, justified or not. How can any leading nation maintain an edge with sub-par education? This has resulted in the anti-intellectualization of America, science and factual knowledge have been supplanted by emotional superstitions. Sure, America continues to have some of the leading institutions like the Ivy Leagues, MIT, Stanford and Caltech, but go take a look at the engineering departments and see where the students come from.

8. What leadership? "...when faced with the greatest economic crisis, the greatest levels of economic inequality, and the greatest levels of corporate influence on politics since the Depression, Barack Obama stared into the eyes of history and chose to avert his gaze. Instead of indicting the people whose recklessness wrecked the economy, he put them in charge of it..." The full article can be found here.

9. Widening income inequality. John Steinbeck wrote that 'socialism never took root in America because the poor see themselves not as an exploited proletariat but as temporarily embarrassed millionaires.' However, it still amazes me that we've been unable to raise taxes on the top 1% of the population. The economic agenda for the factory line wage earner is no different than a corporate jet owner, even in a day and age where income inequality is at an all-time high. Click here.

10. Entrenched Interests. When I look at American politics, I do not see the world's greatest democracy at work, I see competing lobby groups channel their influence through the various Senators and House Representatives. The Supreme Court's Citizen's United decision has granted the same rights of an individual to a corporation. Corporations are now free to spend unlimited amounts of money to buy political decisions. Click here.

As an equity investor, I am deeply bothered. A widely accepted school of investing says that "buying and holding" with a diversified portfolio of stocks, with a heavy bias towards the US and developed markets, is the way to financial prosperity in the long-run. I've always accepted that as being a reasonable view but that has been dented by Ed Easterling's research, appearing in the recent NYTimes article here. It is very possible to buy and hold for decades and still come out with real losses if you get the timing wrong, and we all know market timing is virtually impossible unless you were Steve Cohen over at SAC Capital.

Today, the developed markets look more fragile than ever before. It is evident that debt-fueled growth, entrenched welfare benefits, combined with lax regulations and ineffective government are the reality. What is most worrisome is the lack of a political will to bring about any revitalization. The economic trajectory of the developed world is clearly unsustainable. We are in the midst of a tipping point, where the West may no longer be the Best. The complex and disruptive forces of technology and globalization have truly converged to bring about a new global paradigm. I am hesitant to raise China's hand as the victor, but we are seeing a seismic shift in economic power, opportunity and output from West to East. To deny that, seems delusional to me.

More practically, I've decided to slaughter the sacred cow of "buy and hold". I am waiting for the right opportunity to exit the equity market altogether. My sense is that Obama will have to do something that amounts to a QE3, propping up the stock market as housing prices and other assets deflate. I will keep you posted as I develop an alternate plan to preserving my net worth.

It's all about Perspective

Happy New Year. There was no double-dip and 2010 turned out to be another great year for the stock market. In fact, you'd have to have gone out of your way to generate a return less than the S&P 500's 12.8%. And yet, many mutual and hedge funds managed to do just that but what else is new? I'll try and look surprised at least.

We can dig deeper and there is more to be surprised about. Once in awhile, I'll chance across an article that forces a complete overhaul of my investment perspective. A recent one can be found here. If you accept Crestmont Research's findings, you'll quickly realize that conventional investing wisdom has betrayed us yet again:

1)the stock market is actually much more volatile than we've been sold.
2) average returns are much much less than the annualized 7 to 10% we've been sold. The median 20-year return is actually 4.1% net of fees, average taxes and adjusted for inflation.
3) There are many 20-year periods where returns were actually negative. That's about 2.5 times longer than a real estate cycle.

While I've been highly critical about how active managers are over compensated for often underperforming their benchmarks, it appears that low-cost passive investing may not be the solution either--20 years is a long draught for anyone to ride out.

Only human

David Swensen wrote the playbook on institutional investing.

Half empty, Half full...the sell/buy side perspectives

Incentives drive perspectives and perspective is everything. I visited a fund manager with an associate recently and after 2 hours of sitting through the usual sales pitch, we wrapped up and debriefed outside the meeting.

The quick and dirty assessment was that he was "really smart because he had an MD/PhD and was very articulate". I take a different view, while you must possess a requisite level of intelligence to be a successful investor, there has been no proven correlation between super-intelligence and successful long-term investing. This was the first point of divergence.

However, the major point of contention came when we discussed the manager's background. His previous fund had "blown up", a common occurrence in the hedge fund world whereby a fund manager performs badly, receives redemption notices from investors and is then forced to liquidate positions, usually at a discount to what they are worth to generate liquidity. This is a downward and vicious spiral that usually results in the fund winding up and the manager going on "sabbatical" for 6 months before the next incarnation of his fund.

My counterpart's assessment was that it was a good sign because he "had been to hell and back". I take the 180 degree opposite view, to me, he is a poor manager of risk. A manager must factor in periods of extreme stress and avoid blow-ups, regardless of
market conditions. That's what fund managers get paid exhorbitant fees for.

We worked the same job but it appeared that we were both operating in bizarro parallel universes. I was stunned by how different our views were.

Later that day, I realized that it was simply a matter of incentives. He came from a fund a funds that was sales driven. I viewed the world as a fiduciary responsible for the welfare of my family. Heaven and earth stood between us and it became clear.

What are Institutional Hedge Funds?

Unable to understand why people continue to pay fund managers enormous fees to manage money for them poorly, I asked a colleague why they would continue to invest with a fund manager when he had clearly underperformed over 14 years.

The answer was that the was really "institutional". Officially, that means the fund has institutionalized investment and risk processes that a repeatable over a large scale, meaning that the fund would operate smoothly even if the fund manager were no longer involved in the running of the fund, or if the fund were manager large sums of money.

I don't know about you but if the fund were to run smoothly, and if all the operational processes were superior to the other funds out there, the fund should at the very least, outperform the stock market over the long run. If you do your homework you will find the vast majority do not. Many funds will hide behind the excuse of "risk-adjusted quality returns". However, I would take high returns over risk-adjusted returns in the long run, I cannot pay my bills saying, "I owe you $10 but will pay you only $7. My $7 should be worth more to you because it was generated with better risk-adjusted returns". Sadly, most landlords and Wal-Mart do not recognize this odd currency of risk-adjusted returns.

So what are "institutional" hedge funds then? They are like growth stocks--you only know what they are after they have become growth stocks. Similarly, institutional hedge funds are simply funds which have raised a lot of money from pensions, endowments, foundations and other "sticky money". LP investors take comfort in investing with other people like themselves and they often stampede into funds that have already raised money, irrespective of merit.

New Direction

I haven't written in awhile. I've put off writing as I awaited crucial developments and decisions that never materialized. If I just wait another week, I'll be able to write about that financial reform bill...In the face of the largest financial crisis since the Great Depression somehow healthcare reform topped the agenda. Two years and counting and I have nothing tangible to report.

I am a worrier by nature, I always worry that tomorrow is worse than today. But what I've seen in the past year worries me even more than usual. Here are some of my troubling observations:

- A breakdown in values going from the Protestant work ethic and frugality to one of narcissism and materialism. The nation continues to gorge on its credit addiction and the country has not galvanized in the face of adversity. Sacrifice is only mentioned in the context of what others have to do.

- Boston University Professor Laurence Kotlikoff estimates that the true value of US debt is around $202 Trillion. Unfunded liabilities, especially in the pension world, not the Madoff Fraud are proving to be the real scandals uncovered by the financial crisis.

- I'm paying more taxes than ever before and I have no tangible benefits. And I know I am not alone. Aside from funding the ongoing wars in the Middle-East what else am I getting? The potholes on the I-95 leading into Manhattan are still there.

- The way China swallowed up America's $700 billion fiscal stimulus package. What remains unchanged is the fact that sections of the US economy are simply uncompetitive. The Chinese have an edge in manufacturing. So when the fiscal package was unleashed, it went directly to Wall Street and to Chinese exporters. Buy American? How can you when Wal-mart doesn't even sell American anymore?

- The financial industry continues to be "untamed":

- The congressional inquiry into Goldman Sachs degenerated into a legalistic hairsplitting masterclass between to Harvard lawyers (Levin and Blankfein). It was clear that the people who were supposed to be in charge and now meant to make things better lacked basic financial knowledge, let alone the ability to legislate effective regulation over a complicated industry. The other realization was how well-versed the financial industry had become in pushing the boundaries of ethics while playing within the grey zone of legal boundaries. And on the rare occasions where big finance is taken to task, inconsequential fines are imposed at best. - Continued unregulation of the bond and derivatives market.

- Continued dilution of the Volcker rule as the financial reform bill is passed through both houses. Massachusetts Senator Scott Brown has been negotiating extensive comprises on this. Why do we have someone, whose main achievement prior to winning the senate seat was posing nude for cosmopolitan magazine, making such important decisions?

- The obstruction of Elizabeth Warren to head the newly formed consumer protection agency.

- Continued ethos that free markets function best if left to govern themselves.

- How excessive compensation continues to be unaddressed. Even broaching the topic could be interpreted by some as "Un-American".

What does this all mean? We will not have financial stability for a long time and the PIMCO case for a "new normal" economy characterized by high unemployment, low economic growth and deflation doesn't seem so far-fetched now. We are looking at a broken economic system. And what's bad for America, is bad for the world.

Politically, I am even more disturbed:

- The idea of two or more opposing factions coming out to passionately debate a position, ultimately arriving at an optimal solution is a fallacy. The only role of the opposition in America, is to undermine the incumbent, at any cost.

- America has one political party with two corporate wings. The thin margin of support that separates a Democrat or Republican administration means that both parties are beholden to special interest groups, vying for that additional faction will push them over the fence on election day. What separates a donkey from an elephant is who they take money from.

- America has been unresponsive and unable to react to big problems as it is politically paralyzed. If neither party is able to make painful but necessary decisions in the short term for longer term gain, who will? Don't tax you, don't tax me, tax the man behind the tree. The government cannot cut spending, nor can it raise taxes any further. Who will provide the magic needed to reduce the deficit then?

- The symbiotic relationship between big business and big government in America. In deciding 5-4 to uphold the continued practice of campaign finance, the US Supreme court has protected the right for any entity with sufficient resources to lobby (or buy) a political decision over at Washington. So the very people supposed to regulate oil, finance and healthcare companies continue to be heavily influenced by the very people they are meant to regulate.

- 25% of Americans think President Obama is a Muslim (up from 17% when he took office, hmmm, I wonder how that happened?). Less than 50% believe he is Christian. Do you think that has anything to do with the fact that he's Black? Let's not pretend that being a Muslim does not have negative connotations in America. If that were the case, why the controvery over building a Mosque close to the 9/11 site?

On the other side of the world, China continues to post sizzling growth numbers. Questionable numbers some may contend, but it is difficult to argue that the general trajectory of the country's success has been anything but up. Communist China, with its authoritarian regime and lack of human rights (noticed how socialist economy has been dropped from the list lately) has been doing more than "ok".

The powerful force of globalization has been work. My cousin reminded me that when he was young the exchange rate between the SGD and GBP was 8 to 1. Today GBP/SGD is 2.11. Everything made in the UK was branded and the best, everything made in Asia was low cost junk. Things have changed.

I'm not concerned with will be No. 1 in the world. Only time will tell. What is far more interesting is the alternative political and economic systems that China offers. Francis Fukuyama prematurely declared the end of history and the last man by predicting that the world would essentially converge in a liberal democracy as other forms of governments had failed.

Going forward, this will be the central focus. How will the world respond to a new system of "Capitalism with Chinese Characteristics"? And no, I have not abandoned my position as a Cedalion Investor--The single most important global development is the rise of the middle class in countries like China, India and Brazil. We are talking about hundreds of millions, potentially billions stepping out of abject poverty. The largest car market in the world today is China, just ask GM how important the China market is.

Let me leave you with an observation, the Chinese worker earns less than a tenth of what the American worker does, and there are five Chinese workers for every American. Yes, the US is in the self-congratulatory habit of broadcasting how the American worker is the best in the world. Just ask yourself how true and sustainable this is when virtually all manufactured goods are produced in China? I would also like to remind you that your iPod and computer you are typing on are made there, so it's not just lead-laced Barbie I'm referring to.

Financial Innovation

I've said it before and I'll say it again, we don't need more financial innovation! I'm glad both Pauls, Volcker and Krugman, are on the same page.

Ask a banker why he/she is entitled to a multi-million dollar bailout and the answer is this: its the only way to attract and retain talent in a dynamic industry like finance. And without talent, there would be no financial innovation.

So explain again how financial innovation has benefitted us (the general public)? Well, I am told that financial innovation has made the capital markets more efficient, price discovery has improved and risk has can be better managed by distributing them across different parties through the use of derivatives.

So let me ask you again, what has financial innovation done for society? Let's look at specifics, let's look at good and the bad:

The Good:
- ATM Machines: No more waiting in line at the bank teller.

The Bad:
- Subprime Mortgages: You get a giant loan to buy the house of your dreams and you don't even have to prove you can afford it! Oh wait, you think you can afford it because you've been lured in by teaser rates (adjustable rate mortgages) that go from 2% to 20% after the first two years.

- Alt-AA Mortgages: Same as the Subprime, it's a little harder to get because you have to make up a more a believable income when you fill in the forms. But don't worry, no one really checks on what your REAL income is.

- Asset Backed Securities (ABS): Package a bunch of these mortgages together, pretend they make money and sell them off a sucker (preferably a bank too big to fail)

- Collateralized Debt Obligations (CDO): Package a bunch of ABS's, take them off your company's balance sheets, complicate things by dumping them in a Special Purpose Vehicle (SPV), tell everyone that it's 100% safe because its bankrupcty remote, and just mint money!

- CDOs Squared: CDOs of CDOs. Now things have gotten so complicated, neither the buyer nor seller really understands what they own or are trying to sell. But does it really matter when money is made so easily?

- Naked Short Selling; Removal of the Uptick Rule: You get to drive a proper brick and mortar business into bankrupcty by continuously short selling and driving the price down. Bankers say its better for us because it makes pricing more efficient.

- Derivatives: It's a bet on whether the price of something else goes up or goes down. There are two ways you get to profit from it consistently, i) you can predict the future because you are God; ii) you have information that no one else has (don't ask me how he got it).

- Credit Default Swaps (CDS): Get insurance companies and treasury deparments to write banks a blank check. Hey, what's a $50 billion write-down when AIG, the Federal Board of Reserve, Bank of England and the Swiss National Bank will bail you out regardless? Wait, it gets even better, you get to write $50 billion off AND pay yourself a bonus.

Banks should be boring utility companies providing credit that greases the wheel of the economic engine, no different than a gas or water company providing us with things essential to the running of a modern day society. All other functions are unecessary, dare I say, even parasitic.