International Exposure: A Challenge for Investors

The level of exposure to international stocks is an important issue for investors.  One of our featured sites,  Abnormal Returns has a thoughtful analysis of this question.  A.R. writes:

The question is whether this surge in international investment is
simply a means of catching up to the commonly recommended 20-40% equity
allocation. Or is it simply another case in the long line of individual
investors chasing hot performance? We will not know the answer to that
question until we have a notable market break, but until then there are
plenty of issues to deal with on the international investing front.

Read the entire article, a thoughtful consideration that includes evidence from several sources.  There is an interesting question for individual investors:  Can you use ETF approaches to hedge your inherent exposure to world conditions?  It is innovative and interesting.

A Reaction

Our observations are just opinions — conclusions based upon experience without our normal collection of data specific to this question.  This is the kind of topic that we have on the writing agenda for further research, but the question is so timely that we cannot resist a preliminary comment.

  1. Is this performance chasing or a thoughtful rebalancing of assets?   We vote for the former!  Chasing performance is one of the big mistakes of the individual investor, and many financial consultants wind up doing the same thing.  Financial advisors, even though they know better, are forced into taking positions like this to show they are "with it" and match performance.
  2. Is there transparency?  We say "No!"  ETF’s are opaque, not transparent.  The investor delights in not having to think about individual stocks.  Investors are encouraged to trade on "feel."  They just want to get some exposure to BRIC.
  3. Investors have no real knowledge of the countries or industries in which they are investing.  We know that more people in the U.S. can name the Three Stooges than can name the three branches of government.  They know who is leading on American Idol, but can’t name their own Senator.  Investors do not know the leaders, population, rate of economic growth, or political issues facing the countries in which they invest, much less information about the companies in the ETF.
  4. Accounting issues.  Financial accounting in the U.S. is at a different standard from that of other countries.  What do we really know about these companies?

Our strategy has been to invest in U.S. companies like Caterpillar, Inc. (CAT) where there is as much as 50% foreign exposure, and accounting that we can trust.  So far, this has not worked as well as buying the ETF’s.  Only recently has the market begun to realize the strength of the multi-nationals with foreign sales.

Thanks again to Abnormal Returns for an excellent insight on an important question.  Our reactions are more of a research agenda than a conclusion, so comments are especially welcome.

Transocean, Inc. — A Case Study of Risk and Reward

The current issue of Barron’s has a feature story by Andrew Bary, Crude Calculations, that points investors to the group of offshore drillers, two of which, Transocean, Inc.(RIG) and GlobalSantaFe Corporation (GSF), we own both for individual clients and in our funds.  Let us look first to Bary’s observations.  We will then compare that to our own risk/reward analysis.  He writes:

These and similar stocks
trade for 7-to-11 times estimated 2007 earnings, and 6-to-7 times 2008
projections, among the lowest P/Es anywhere.

The drillers carry such low valuations because Wall
Street is concerned the current profit boom won’t last as a slew of new
rigs hits the market by 2010. The industry historically has had
volatile profits, reflecting wide swings in daily rig-leasing rates, or
"day" rates. The drillers operated at around breakeven as recently as

Uh-oh!!  That must look risky to many investors.  Is this danger or opportunity?  Let us digress to consider risk and reward — and time frames!

The Objective of the Game Determines Time Frame

CNBC’s stock contest has hundreds of thousands of entrants and gets hourly publicity on the station.  Each  program has a celebrity (full disclosure — the old guy doesn’t know all of these supposed heavyweights.  I need help from Ryan and Renae) that gets on and makes picks.  It seems like anyone watching should be able to understand a few key ideas:

  1. The celebrities do not know anything about stocks.
  2. The rules of the contest require that participants beat a million other folks in a short time period.
  3. The only way to do this is to take risk — big-time risk — and get lucky.
  4. No investment manager could pass the Series 7 without understanding all of this.

Does it surprise anyone that plenty of those in the audience are trying to follow the winners?  Not us?  As participants in plenty of cocktail party conversations we have learned that everyone wants a "hot tip".  No one has ever asked me for suggestions about risk-adjusted return!

Roll the Dice

Bill Luby at VIX and More  has been doing a nice job with one of his entries.  (He is an expert on sentiment, options, and many topics that take us back to our own CBOE days.  We have been following Bill’s blog and now add it to our list of recommended sites.)  Bill would not buy RIG or GSF for the contest, since there is not enough short-term potential.

The time frame of the investment is crucial, as we discussed here, and Bill also did here.

Bill was alarmed to discover that a reader was putting his IRA money into one of his high-beta "shots."  Maybe the reader was joking, and maybe he was not.  After all, more than 30% of the people cannot name the Vice-President.  Some County Treasurer in Michigan invested in a Nigerian scam.

Risk Control

At the other end of the risk spectrum is the wonderful job being done by David Merkel on his blog.  David carefully explained how investors that managed risk had better long-run performance than those who did not.  We would add that David’s investors also sleep well — very well.  The drillers probably do not fit David’s criteria very well either.

Why We Like RIG and GSF

When analyzing stocks on the fundamentals, we look for two things — an inefficient market and a catalyst.

Inefficiency.  The market is too focused on the past and the overall cyclical nature of the business.  Few have done the requisite homework.  These stocks have a solid earnings base of locked-in contracts for two years, with plenty of upside.  Do you think that oil prices are dropping below $35/barrel?  We don’t either.  More from the Bary article:

Some investors fear a drop in oil and gas
prices will send day rates plunging; they have weakened recently for
rigs that operate in the shallow waters of the Gulf of Mexico. But
Transocean CEO Bob Long downplayed worries in a November conference
call, saying "we’re pretty comfortable that…oil prices down to $40 a
barrel and maybe even down to $35 would have little or no impact on the
deepwater market."

A Catalyst.  This is always a problem.  The consistently-excellent Kirk Report recently discussed William F. Eng’s book (which we have not yet reviewed).  Charles summarized the rules and we were struck by #46 —  yes, we read the entire list.

46.  The smarter you are the longer it takes.

Put another way, deep insight requires patience.

Here is Bary’s suggestion for a catalyst.

One way the drillers could boost their
share prices is by paying higher dividends, as Ole Slorer, an
oil-services analyst at Morgan Stanley, advocates. Slorer figures their
shares could rise 50% if they adopt a policy of paying out most of
their earnings.

Back to the Risk/Reward

There are two ways of looking at risk in the offshore drillers — absolute risk and volatility.

Absolute Risk.  Since we do not believe that oil is going back to below $35/barrel, and we like the locked-in earnings.  We see the absolute risk as very low.

Volatility.  Drilling stocks are part of various energy ETF’s.  Many hedge funds, not schooled in the Chicago futures tradition, do not use futures in their trading.  Many financial consultants also make aggressive moves in these ETF’s since the transaction costs are low.  Stocks like RIG and GSF swing around based upon the front-month oil spot price, even though this has little to do with their long-term prospects.  In fact, the oil futures forward curve, the best read on market prices, shows little backwardation.  The stocks caught up in this thrashing about show unwarranted volatility, and this exaggerates traditional risk measures like the Sharpe ratio.

Reward.  The catalyst might require market recognition of the factors we cite.  In the case of GSF, there is also buyout speculation, although we never use this as a fundamental buying rule.  Bary notes this:

Investors also could benefit from takeover
activity or leveraged buyouts in the sector. Seadrill (SDRLF.PK), a
fast-growing Norwegian driller with the highest P/E ratio in the group,
is believed to be weighing acquisitions. In a recent note, Citigroup
analyst Geoff Kieburtz identified GlobalSantaFe and Noble as the most likely targets for Seadrill.

Conclusion and Full Disclosure

These offshore drillers are among our favorite positions.  The market is wrong on risk as well as reward.  We hold them in all accounts.  We bought RIG two years ago, so we have a near-double already, but the stock has languished recently.  While we make trades in them at the margin, the overall risk/reward balance is so favorable that it would take a massive repricing for us to sell the entire position.

When Fundamentals and Perceptions Collide

What action is right when market perceptions conflict with fundamental valuation methods?

Let us put aside whether our valuation or the market perception is correct, and turn to the interesting case where there is conflict between the two.

For Warren Buffett or other Benjamin Graham followers the question is easy.  They recommend buying businesses that are undervalued.  If Mr. Market comes to them with a lowball offer, they do not care.  With Mr. Buffett’s track record, there is no need to worry about adverse fluctuations in value, even if these persist for quite a long time.

For most fund managers this answer does not work.  One has a mixture of holdings reflecting different time frames.  If properly done, the expected edge must vary with how long one must wait.

Hypothetical Example

Let us suppose that one holds "Stock X", a company that is about to announce earnings.  Your valuation methods show that the stock is very under-valued.  Recent LBO’s provide some evidence that this example is not so far-fetched, even for major companies, as Paul Hickey explored in an excellent article on TickerSense.

Let us further suppose that you have listened to past conference calls from Company X.  You know that the management does not hype earnings prospects, and frankly discusses anything of concern.  Company X has, as a part of its business, exposure to housing construction.  You fully expect that management will mention "the H word" during the conference call.

While this has no significance for your long-term projection, you might choose to take a trading position reflecting the market expectations.  In a hedge fund, for example, one might choose to use options to hedge the positions, or lighten up holdings until after the call.

For the individual investor it is much more difficult.  Psychologically, the most difficult move is to re-establish the position if the stock actually moves higher after the call.  Your hedging decision was wrong.  The manager must think in different time frames and trade accordingly.  This is more difficult for individuals.

Market Example

Let us next apply this thinking to a perspective on the overall market.  Regular readers of "A Dash" know that our long-term view on the market is quite bullish, and that we also take tactical short positions in accounts geared to trading.  Others, like Doug Kass and Barry Ritholtz, have an overall bearish view, but make astute trading calls to take long positions.  Using the time frame effectively can work if one is willing to trade against the overall outlook.  Some recent criticisms of bearish pundits strike us as unfair, since none of them trade exclusively based upon a long-term market viewpoint.  This may be difficult for their readers to follow, but those observing them carefully should be able to note their bullish counter-moves.

To get to specifics, many market participants have (among many concerns) two that stand out as major market threats.  As we often do, we look to Barry Ritholtz to identify these concerns.  Since we have occasionally (!) disagreed with Barry, let us look to two recent observations where we are in complete agreement.

  • The Fed.  Barry really nailed this story.  He analyzed the news and interpretation of the recent Fed statement and minutes in a series of posts.  We agree that the Fed is not about to cut rates, and suspect that another hike may be in the future.  This is because the Fed (correctly in our view) sees strength in the economy and is pursuing a policy of planned slowing to quash inflation expectations.  It is quite clear that the market, which has little respect for the Fed, has a fixation about the need to lower interest rates.  This poses a problem for trades or investments using a longer time frame.
  • Rhetoric — particularly about "stagflation."  In a strong post today Barry added some analysis to a great story from Caroline Baum of Bloomberg.  We have discussed the power of symbolic language, and the freely-used stagflation term catches the attention of many.  This may be particularly true of individual investors or, as Baum suggests, younger fund managers.  This is also a problem of positions in two time frames.  While we do not fear a stagflation scenario, we do expect that various (lagging–see CXO Advisory) economic indicators, like unemployment and inflation readings, may get worse before they get better.  With each report, even though the moves may be small, the stagflation scenario might seem more real.

At some point the market psychology will change.  Identifying the catalyst for this change is a thorny problem.

We will try to pursue this with the analysis of some specific stocks.

Good Games and Time Frames

A young person recently asked me for some career advice.  In my academic days I advised many students, of course, so the question was a familiar one.  This person wanted to enter the trading world.  The most important aspect of my advice was as follows:

Be sure to find a good game.

She asked, of course, "What does that mean?"

My definition of a good game is one where your theoretical edge will show up within sufficient time.  This may mean before your trading account runs out, you lose your clients, or you lose your sponsors.

In a good game you get into "the long run" fairly quickly, and use money management to make sure that risk is controlled.  We emphasize that investing (or trading) is not gambling, but the mathematics of the gambling literature is quite applicable to trading.  Casinos have a good game, since they have a known edge and can get into the long run quite quickly.  Despite this, short-term results (and earnings) are influenced by the performance of "whales", the big bettors who take big chances.

Ken Uston’s excellent book, Million Dollar Blackjack (now featured on our reading list), describes both his system and the implementation in team play.  Card-counting nerds would signal "the Big Player" who would seem to flit from table to table, cocktail in hand and a woman on both arms.  The team used the Kelly Criterion, treated extensively in William Poundstone’s book, Fortunes Formula which we discussed in this post.

As a result of this team method (no longer effective given casino counter-measures), Uston played exclusively in situations where he had an edge of about 5%.  Despite this advantage, he describes a period of time where they had a losing streak lasting more than a month!  Please note that this includes thousands of hands played.

Most gamblers, and probably many traders, make the mistake of over betting their bankroll, not realizing the devastating effect of a losing streak that should be entirely predictable.  Effective money management cannot turn a losing system into a winner.  Ineffective money management can doom even the best system.

What is a Good Game for Trading?

Dr. Brett Steenbarger’s recent post, "What We Can Learn from Trading and Poker," provides focus on this issue.  Time frame is important.

Here are the key time frames:

  • Intra-day.  Technical setups occur frequently.  If one has a good system, the long run can occur very quickly and a modest edge can yield big profits.  Many trading firms now use software that identifies small advantages and makes quick moves through automation.  This is the competition for the intra-day trader.
  • Short term.  I define this as trades lasting a period measured in days.  We employ an excellent system for short-term trading.  It is over-simplifying to call it "mean reversion" but that is the basic concept.  Vince, our modeling guru, identified key concepts and measured them in a unique fashion, drawing upon advanced mathematics.  Even with such an advantage, one must expect losing streaks that can last for weeks.
  • Intermediate term.  This is a period that is projected in weeks, often based upon technical indicators.  Vince has developed an excellent trend-following method, once again using his own special methods.  It is this model that we employ in our weekly responses to the Ticker Sense blogger sentiment poll.  For the  moment, we have made these calls public in the poll.  The  method can lead to gyrations at market turning points.  In the last few weeks it has steered us to be long, neutral, and short (currently long).  Such a system has the advantage of getting on the right side of the market for major moves and avoiding major losses.
  • Long term.  This is the realm of valuation, and macro analysis of fundamental trends. It describes much of what we write about on "A Dash."  The problem with long-term market calls is that the scenario might take a lot of time to play out.  The debate between bearish analysts and those seeing great value in the market is now in (at least) the third year, with few viewpoints changing.  The extended period of Fed rate hikes and the debate over the economy has prolonged the issue.  While we see it as a period of undue negativity (with evidence here), others continue to see an imminent recession.

Key Lessons

There are two main lessons.

First, the edge one needs must increase with the time period.  A good game requires getting into the long run.  The long run is not measured in time.  It is measured in the number of independent opportunities to make a "bet."  One should not invest or trade on a long-run call without the expectation of substantial edge.  Having made such a decision, patience is required.  One holds on until victory is achieved or the evidence changes.

Second,  it is important to choose a trading or investing strategy that is geared to the expected edge.  This means careful attention to position size.

This is a framework for analysis, and a key concept for traders and investors — or poker players!

Reality Check: Productivity

Should one look at the forest or the trees?

We are bombarded with data on every topic related to the economy.  An important one is productivity, which is subject to many influences.  It is important because economic growth — and ultimately earnings growth — can show gains through productivity increases.

The secular decline in manufacturing jobs, more than offset by an increase in service jobs, is partly a function of improved machinery.  The output for each manufacturing worker has increased, and continues to do so each year.

Last year, before my father’s death, I had the opportunity to go to Dearborn with him and tour the Ford Rouge plant.  Sometimes one just needs the sweep of a long period of time to understand that things are different.  The Rouge plant was Dad’s first assignment after the war.  It did not even resemble what he remembered.  Many street pundits seem detached from the yearly improvements in output/worker.

While this varies from year to year, partly based upon wage gains, the overall trend is quite clear.

In the service sector it is just as dramatic.  There is a tendency for us to think that service jobs are all low-paying and menial.  In fact, most of those reading this are engaged in high-paying service work.

So let’s do a reality check.  Here is a little,  homely anecdote that got me thinking about the subject.  Our bowling league changed sites.  (This happened because the land for the former site became so much more valuable that the owners finally sold out.)  I needed to know how to get to the new site for our match.  I typed in the name of the lanes and the city in Google.  A map popped up, showing the location.  I clicked on directions and my home address was available as a starting  point.  I printed this out and had an accurate answer to my problem in less than one minute.

Multiply this by the hundreds of small tasks you do each day.  We all check scores of market commentaries in a short time with RSS readers.  News is there instantly.  I checked my flight today with Google SMS, and also scouted O’Hare parking.  I downloaded quotes and ran our sophisticated models to plan tomorrow’s trades in a few minutes.  When we have a new model, backtesting it takes hours rather than weeks.

There is also video conferencing, online sharing, and many other more sophisticated applications.

Many of these developments have taken place during the last five years.  In my operation, I think that it would take a staff of at least double our size to do what we do today.  Personally, I do three times the work that I did a few years ago.  What is your experience?  (I understand that some time is not productively spent, so you can allow for that.  Some fun is allowed, and encouraged at the top firms).

It is easy to get caught up in statistics and ignore the obvious. 

Be skeptical.  When someone suggests that economic growth is not "organic", but only a function of some sort of "stimulus", it may be time to ask questions. Do you really believe that a fully-employed work force, using better tools, has not improved since the last time that "peak earnings" were achieved?

Recession Expectations: An Important Anomaly

Where does one look for economic forecasting?  At "A Dash" we take the role of the educated consumer of forecasts.  We like to find the best information from the most reliable sources.

During the last week we learned the recession expectations of distinctly different groups.


The Blue Chip Economic Indicators panel reduced the consensus forecast for U.S. economic growth for 2007 from 2.5% (last month) to 2.3%.  The 2008 forecast dropped 0.1% to a prediction of 2.9%.  These results do not provide for the analysis of individual forecasts without a subscription.

Our take:  The forecast is consistent with the planned Fed slowing of the economy to address inflationary expectations.  It is what should be expected if we are accomplishing what some call a "soft landing" and we call the Glide Path — a better term when one expects to keep flying!

The Wall Street Journal poll of economists forecasts GDP growth for the first two quarters of 2007 to be 2.2% and the remainder of the year to be 2.9%.  62% of those polled expressed confidence that the result would be within 0.5% of their estimate.

Consistent with this confidence level was the statement that the chance of a recession in the next twelve months was only 26%.  Keeping in mind that recessions occur with some regularity, one needs to understand that "normal" expectations are about a 20% chance.  Something can always go wrong.

The economists were asked what might upset their predictions.  20 of 54 respondents said slower CapEx spending and only 11 cited the housing market.

Our take:  Once again, the overall results are consistent with the Fed’s expectation for growth that is slightly below the long-term trend expectation of about 3%.  There is not much worry about recession, and the forecasters are pretty confident of their views.

Regarding the biggest worry, one must realize that the question asked them to name something!  The respondents did not attach a probability to CapEx or Housing.  They merely answered that this was what to watch.

Despite this rather obvious inference one would get from actually looking at the questions and answers, the headline of the story in the WSJ was:

Economy Enemy No.1:
Soft Capital Spending

An alternative might have been:  Economists see recession as unlikely.  What to watch?  CapEx.  A notable feature of this poll is that the highly trumpeted housing factor is the big threat for fewer than 20% of respondents.

Prominent bloggers like Barry Ritholtz at The Big Picture also highlighted the CapEx concern.

Read it here first: Slow CapEx Spending Worries Economists

This emphasis on a "forced response" does not capture the overall sense of the survey.

The People

The Bloomberg/LA Times poll asks the people what they think about economic prospects.  The Bloomberg Story had this headline:

Most Americans See Recession in the Next 12 Months

Their survey showed that 60% of respondents expected a recession, and they compared this to 64% who had similar expectations in December of 2000, "three months before the last decline."

This seems to imply some prescience on the part of the average American to anticipate recessions.  Buried in the article is another interesting result.

Sixty-four percent of those polled said their own finances
are very or fairly secure compared with 35 percent who described
them as shaky.         

“People tend to be pretty optimistic about their own
situation, but when it comes to the larger economy they’re much
more pessimistic,” said Karlyn Bowman, a polling expert at the
American Enterprise Institute in Washington. “The public’s just
in a very sour mood because Iraq continues to cast a pall over


Our take:  The public perception is not surprising given the media spin on the economy.  It is not that economic reporters are intentionally biased; potential problems are more newsworthy than bland forecasts.

We are also reminded of the ongoing poll results about how people feel about Congress (always scoring high negatives as an institution) and their own House Member (usually scoring positives).  It is an interesting irony which does not lend itself to a solution in the voting booth.


At "A Dash" we have stressed the importance of finding the real experts on any topic.  Does the average citizen have a better sense of the probability of recession than a panel of economists?

There is a general sense on Wall Street and in the blogosphere that since economists did not forecast the last recession their opinions are no good.  It is a wonderful, democratizing conclusion, allowing each pundit or writer or citizen to feel they are just as good as those who trained to do this, and spend their professional lives on the problem.

We disagree.  This is not American Idol.

This is an important theme, especially with the election season starting, so we plan to pursue it further.  Meanwhile, readers with a serious interest in recession chances could pursue our past posts on this topic.

Quantifying the Impact of Housing Problems — An Update

Recently we objected to a Doug Kass prediction that demand for new housing would fall by 50%.  Doug used an approach that identified potential foreclosures and eliminated entire classes of buyers.  He also cited secondary effects.

Our Objection

We suggested that the economy does not work this way.  A potential buyer may qualify for a lower mortgage, even if standards tighten.  New buyers emerge.  Existing loans get restructured.  Prices move lower, of course, until a market-clearing point is reached.  Briefly put, supply and demand are not absolutes, but intersecting curves that shift until the market-clearing price is reached.

Already there is substantial support for our viewpoint.  In a typically excellent summary of Dallas Fed President Fisher’s speech today, Gary D. Smith points out (among other things – read the whole post) that Fisher sees the market, the Fed, and lenders working to resolve the problem.  Fisher sees the damage as "contained."  (Here is the Bloomberg summary, and here is the entire speech.)

Meanwhile, news stories like this one (Lenders willing to help struggling homeowners) cite a rather obvious point.  Lenders prefer to work with existing owners rather than to foreclose.

Anecdotal Evidence

This weekend I heard of a young couple that waited for a price reduction on a home in Madison, Wisconsin and can now qualify for a suitable mortgage.

My home construction contacts in the Chicago suburbs continue to find new work.

My real estate contact in Minneapolis reports a brisk business in the 300K to 700K range, with prices down 5 to 10 percent from last year.

While we like to use macro-level quantification, sometimes the individual cases help to see the economy at work.


Taken together, this is all evidence that the doom-and-gloom scenario for mortgages and housing is overstated.

Expensive Misconception: Economic Growth was Fueled by Debt

Individual investors must watch out for the latest piece of nonsense from those preaching doom and gloom.

The statement is that the U.S. economic growth, particularly that of the last five years, has been artificially induced by debt.  The implication is that the economy will collapse like a house of cards when the debt must be repaid.  Those making these statements call this "incontrovertible fact", culminating with an issue of Time Magazine that will be the most expensive copy you every buy, if you read and believe this article.

At "A Dash" we have a key mission of helping individual investors.  Part of this work involves trying to develop some guidelines about how and where to find the right information.  We look for various sources on a topic and try to find the real expert.  Let us see how an astute individual investor might analyze this current proposition.

  • Look at people’s credentials!  When everyone is on one of those televised "debates" it may seem like they are all equal.  Sometimes those in the know are a bit less eloquent or glib than those who lack the relevant expertise.  This is especially true when the format emphasizes sound bites.  Our review of those focusing on debt-based growth is that they are usually non-economists–often journalists, bloggers, traders, or "global strategists".  They usually have a special agenda — promoting a book, or a web site, or their own trading positions.  Since they never did the formal work required to understand economics, they disparage those who have real expertise, claiming that it is irrelevant, or even a disadvantage!
  • See if the author knows the basics about the topic. With respect to debt, these writers choose to look at only half of the balance sheet.  They ignore assets!  Many of my smartest and wealthiest friends have elected to increase debt because of the attractiveness of various investments.  Corporate CFO’s learn to compare financing from debt and equity.  Is it surprising that in an era of low interest rates, many astute people have chosen to buy homes and to consolidate high-interest consumer debt into low-interest home equity loans?
  • Do a reality check.  Does the argument make sense?  Do we really believe that three years of double-digit growth in corporate earnings was achieved through stupid decisions by all of the leading corporate CFO’s?  Are the journalists and bloggers smarter and more knowledgeable than those running these businesses?
  • Compare the types of evidence.  Those making the debt argument paint a world where consumers are "spent up" and debt-laden.  They make anecdotal arguments about people who are the marginal borrowers, and act as if this is evidence of the mainstream.  They lack accurate quantitative analysis, often making outrageous projections using "black or white" estimates instead of using economic basics about supply and demand.

Considering the Facts

The household balance sheet is excellent, and has never been better.  David Malpass, an excellent economist with a great record, wrote as follows in December:

The multi-decade accumulation in U.S. household assets, not
reflected in the personal savings rate which excludes gains, is a key factor in the economy’s sturdiness and strong long-term prospects.
The U.S. household sector is showing rapid growth in most types of savings. At $27.5 trillion,  U.S. households have more net
financial assets than the rest of the world combined. By this measure, IMF data shows
Japan with $9.5 trillion, the UK 
$4.3 trillion, Germany $3.2
trillion, and   France
$2.6 trillion. Having added $1.5 trillion over the last four quarters,  U.S.   households probably also added
more to financial savings than the rest of the world combined.  This measure includes mortgages and credit cards in debt but
excludes houses in assets, so broader definitions would be even more favorable to the U.S. In the third quarter, household
net worth rose $776 billion to $54.1 trillion. Financial net worth increased
$479 billion to $27.5 trillion. Household liabilities rose $268 billion to $13.0

Briefly put, household balance sheets are very strong and getting stronger.  If one were to add gains in home values for the last several years, the picture would be even better.  Please note that the gains in household net worth dwarf the alleged impacts from housing declines and sub-prime mortgages.  Do yourself a favor and bookmark this page.  The next time you see one of the doom and gloom articles, please check back here and compare the (exaggerated) numbers from anecdotes with the overall household strength.

Malpass concludes, both in this piece and in various others, that household net worth or home equity withdrawals are not key drivers of consumption.  He cites the low unemployment rate and the "rapidly rising personal income."

Anyone who has been paying attention to how personal savings and debt are measured understands the flaws in the highly-publicized reports.  The government clarified this years ago, pointing out the shortcomings.  Readers of James Altucher on’s RealMoney site learned this through his excellent analysis of these measures.

(Part of the "debt fuel" argument is about the U.S. national debt.  More on that in our next post.)

Reaching the right investment conclusions often starts with figuring out where to get the evidence and knowing how to find those who are expert.  Our guidelines will help with this.

Painting the Tape

Any trader or investor must consider the use of stop loss orders.  Since circumstances may arise that suggest the original decision was wrong, one must be willing to exit the trade at some point or to face major losses.  This is an element of trading discipline.

Placing a standing order risks a situation, especially in futures trading, where locals "run the stops."  If trading is slow, active floor traders may probe for and find the stops.  Everyone is looking at the same charts, and the placement of stops in a logical fashion may make one a victim of a small run, followed by a bounce back to normal levels.

Placing a "mental stop" can work if one is always watching.  Even then there is the problem of painting the tape.  The recent controversy over Jim Cramer’s comments, well documented by Trader Mike, have called attention to the dilemma.  Cramer talked about the potential for hedge fund manipulation of individual stocks and even the entire market, through aggressive selling, put buying, and influencing key media figures.

While we have no opinion on the Cramer controversy, it is timely to take note of a broader and similar question related to exchange rules, ETF’s, and selling on downticks.

Scott Rothbort wrote an excellent piece on this topic, now available on his blog, one of our featured sources.  The article may seem long and detailed, but that is because it is carefully written and covers all of the bases.  At "A Dash" we hope that exchange rulemakers will act to protect individual investors.  The markets carry a message, but we should hope that the rules make that message clear.

We hope that Scott’s views, reflecting his broad experience and wisdom, attract attention.

Quantifying the Economic Impact of Housing Declines

Everyone wants to know about housing and the economy.  Is the sub-prime lending issue something that will extend to other mortgage classes?  How much might home prices fall?  Will the impacts lead to reduced consumer spending and an even greater economic effect?

Doug Kass, the popular hedge fund manager noted for his skill in short selling, has been one of the leading voices on this topic.  His view is that this is a major economic problem and one that will affect the home prices and portfolios of individual investors. 

Writing today in Street Insight, the valuable premium service of, Doug does a "back-of-the-envelope" calculation of the likely housing effects.  At "A Dash" we are big fans of such an approach.  Trying to think about quantities and actual impacts is essential.  Market participants often have knee-jerk reactions to news, mostly because they cannot estimate the real effect.

To get Doug’s entire argument, you need to be a member at, but they might republish it later for the general public.  Since he is such a frequent and popular TV guest, you will also see it soon on CNBC.  I am quoting just one section, the place where he quantifies the likely impact of what we all read about every day:

Quantifying the Impact of Tightening Credit
I would conservatively
estimate that about 55% of the subprime borrowers, 25% of the Alt-A borrowers
and 15% of the prime mortgage lending borrowers will no longer be able to secure
financing for new homes because of tightened conditions. (This will produce
about a 25% drop in housing demand). Speculators and investors – who were
responsible for nearly 20% of all home purchases in 2004-06 – will also find it
more difficult to secure borrowings and it is likely that this buying category
will revert back close to their historical demand role of about five percent of
all homes. (This will result in another 10%-15% drop in housing demand).
Finally, end of economic cycle conditions (lower consumer confidence, slowing
economic growth and moderating job growth) should contribute to another 10% drop
in housing demand – as it has done historically. In total (adding the above
three influences), new home demand should fall off by almost 50% (vs. the
rolling 12- month average showing a 17% drop off in 2007) – even before the
effect of a market inundated by record foreclosures is considered.

What is Wrong?

This estimate will sound frightening and persuasive to most who hear it.  For students of economics, the problem leaps out.

A statement like "a 25% drop in housing demand" has no economic meaning.

Non-economists speak in terms like Doug.  Someone is either in the housing market or he/she is not.  A home is either on the market or it is not.  Completely lost is the concept that a buyer may not qualify for a loan of one size, but will qualify for a smaller loan.  Homes for sale at one price are withdrawn from the market if the price is lower.

The century-old concept  is shown in the supply-demand curve that one sees the first day of Econ 101.


As price declines, the quantity demanded increases.  As price increases, the quantity supplied increases.  The actual exchange price clears the market at the  quantity where the curves intersect.

When one wishes to describe underlying changes in either supply or demand, these are characterized as "shifts" in the curve.  Reduced demand, for example, shifts the downward-sloping blue curve to the left, meaning that there are fewer sales at a lower price.  Reducing prices shifts the supply curve to the right, increasing the quantity.

Is this News for Doug Kass?

Readers should understand that Doug Kass knows everything we have written here.  He has an MBA from Wharton and he certainly studied economics.  He knows full well that one cannot describe supply and demand as a binary function — either in or out.  One of the first things you learn in economics is that shifting the curve has a much smaller price effect than one would think at first.  So why is he writing this?


We wish we could provide a good answer about the impact of housing and mortgages on price and quantity, but we cannot.  To do that, one would need some data about the shape of both curves, at least enough to make an estimate.

We can say with confidence, however, that the Doug Kass scenario is extremely unlikely  The relevant curves would need unusual shapes and make massive shifts to have the impact that he forecasts.