Throwing in the Towel (on the Blog Agenda)

There comes a time to admit defeat.

When I was a grad student I reached a point where I had taken all of the required classes.  I now needed to pass preliminary exams (prelims) in various subjects.  If I passed the prelims, I was an ABD (all but dissertation), and could proceed to propose and execute a major research project.

Since the prelims were conducted by panels of professors, it was important to know the work from their courses.  The problem was that some of them were new, and the courses changed with time.  Some of my peers thought that they needed to "audit" classes they had already taken, to catch up on new material.

My approach was different.  I made a list of all of the things I needed to review, re-read (or perhaps read for the first time!) in preparation for the exam.  When I finished a work, I crossed it off of the list.  When I read something that pointed to some other seminal work in the field, I added it.

As I prepared for the examinations, a clear trend developed.  I ignored the trend, scheduled the exams, and moved on to the dissertation stage at an enviable pace.  What did I notice?

The length of the list of absolutely necessary readings was at its longest on the day I took the exam.

Anyone who is a serious scholar knows this.  The more you study, the more intellectual hooks you find.  They all seem important.

My Current Agenda

I have reached a similar decision point in my blog agenda.  I have so many ideas, so many potential book reviews, so many great readers questions  —- and so little time.  I try to highlight what I think is important, but others do not share my lens on the key issues or on the markets.

So I am throwing in the towel — not on the blog, but on the agenda.  I am going to do some short hits on certain ideas, with my plans in mind.  I will try to respond to feedback on what is important and useful.  I also ask current readers to remember that I am reaching out to an audience that is currently not reading — the individual investor who may be struggling with conflicting information.

The Current List

Here are a number of topics.  In each case, I am going to state a viewpoint.  Unlike prior articles from me, it will be a conclusion with a hint of reasoning.  In all cases I am prepared to make a more detailed case.  It is not a lack of analysis, just a lack of time to write it up.  The list includes must do items, things that I "star" from other comments, and good reader questions.  It is not comprehensive.  I have scores of items; these are the most pressing.  In no particular order, please consider the following:

  • Reader "Yo" asks, apparently in response to my article on how many are analyzing Fed policy in the future instead of the market, whether the people who "called the real estate bubble and were wrong for years" were stupid.  My answer is a resounding "No!"  I was one of the earliest in identifying outlandish real estate prices.  I advised clients (prematurely as it turned out) to be wary of excessive real estate investments in 2004, pre-dating this blog.  It is not "wrong" to see a potential problem, but it is better to see the time frames, and invest accordingly.  I also avoid disparaging any large group by characterizing their prediction.  Members of the group all have different reasoning and methods.   I really hate arguments that go "these are the guys that got us into this, why trust them now."  The subject deserves more careful consideration.
  • Bob McTeer (a favorite source) takes off on this theme.  Why don't more people pay attention to this sources?  He has outstanding credentials, a free-market attitude, and a practical bent to his work.  He explains why this broad-brush approach is wrong for banks.
  • Reader Mike C continues to ask many excellent questions.  I have decided to do an article each week related to choosing stocks.  I started this last week, and I'll try to keep it up.  Other astute comments have echoed this theme.  I'll next turn to methods for finding specific ideas.
  • Several readers have inquired about our "penalty box" and why we do not buy the highest-rated sectors from our TCA-ETF model.  The simple answer is to think of this in terms of a stop loss, commonly used by nearly every trader.  Our modeling guru, Vince Castelli, has analyzed thousands of situations with risk/reward and hot money in mind.  His conclusion helps us to find faster exits and to avoid trades with high danger in our three-week time frame.  While I cannot reveal all of the elements of his method, I have conducted many tests.  The penalty box is a good short-term indicator, but may not be relevant for investors taking a longer view.
  • Market strategist Ramsey King writes as follows:   "Once again, just like in July, August & September, Benito juiced the system during expiry week."  I have an immediate negative reaction to those who believe that using some spiffy name for the Fed Chair proves their point.  If King wants to make his point, why not look to the data, as I have done in the past.  We have many years of official Fed transcripts available.  If he wants to do real research, why not find evidence for the conspiracy in actual data from prior meetings.  These meetings include about 60 people, many of whom have now moved on to other jobs.  If there is real evidence of juicing the market, plunge protection, or whatever, let us see some evidence.  Otherwise, this is just another opinion piece masquerading as investment advice.
  • Market strategist John Mauldin thinks that the economy will no longer even "muddle through," his long-held viewpoint.  For evidence he cites one economist on the topic of the economic multiplier, an obscure issue that most will not understand.  I am disappointed with John's approach to being a gatekeeper and an explainer of economics.  He should, at the very minimum, state this viewpoint (from a widely-cited source) is not the only one, and represents an extreme.  There is a debate among macro-economists.  The impact of economic stimulus is important and deserves careful analysis.  He footnotes a page in a $200 book that most people cannot verify, and does not provide even a quote.  The conclusion seems at odds with other published material from the same source.  Whatever we might conclude, his article does not provide a complete and balanced picture.  If he wants to cite various sources and explain why he picked this one, that would be stronger and more persuasive.  Mauldin is important because he has a much wider readership than any blog.  It is reasonable to expect a high standard of scholarship and balance.
  • The BLS estimate of job creation has broken down.  Unlike most of their critics, they look at the results when actually available from state data.  I need to write a more comprehensive piece on this, with special emphasis on where we are now.  Hint:  Our own more bearish estimates, published monthly, have been closer to the truth on employment.  I think that there are many people trying to assess the employment problem.  I have often stated that we should not view the honest efforts of the BLS as the official answer, but rather one measure among many.
  • Brad DeLong highlights a question on my plate:  How to deal with seasonal adjustments when there is a dramatic change in trend.  Good question, tough to answer.  I actually have some cooperating experts working on this question.
  • My "summer quiz" has a winner.  I need to reveal him, review the answers and award the prize.  The point of the quiz was to get people thinking on the right track, and I hope that many did so.

This is only a start.  There are many other interesting topics.

Tonight is my anniversary (number 30) and I am getting some static, although we have a nice weekend planned.  I do not know whether this approach has shortened my list of work, or made it longer.  I have barely scratched the surface on the points I try to highlight:

  • Finding true experts.  I am not an expert on everything, but I am good at finding them.
  • Analyzing data.  This is my sweet spot.  I taught the classes on this, and I can spot the impostors.
  • Putting together risk and reward.  There are always opportunities.  I see two big mistakes — polar opposites.  Some are trying to "get it all back" with a big play on a risky stock.  Others are frozen out like a deer in the headlights.  Most of my public recommendations have done well — CAT was today's example — but many think they have missed out, looking backward instead of ahead.

Earnings Season

For my long-term investors there is nothing more important than corporate earnings, especially when compared to alternative investments.

Here are some key issues that I follow:

Forward or  Backward?

I read hundreds of analyst reports and earnings call transcripts.  Everyone is focused on future prospects in the analysis of specific stocks.  In the market of stocks, everyone looks to the future.  Somehow, when people try to evaluate the stock market, they prefer to look at the past.  Why?  It is pretty simple:

You can have solid, certain data that is not forward looking, or you can engage in forecasting.  If your perspective is past earnings, ten-year earnings, past peak earnings, or whatever,  you are rooted in what happened last year.  By definition, you will miss what is happening right now.

Earnings Quality

The concept of earnings quality is important, mostly relating to the sustainability of apparent strength.  While there are many challenges to quality, the 2009-era challenges relate to revenue.  The idea is that corporations slashed costs and thereby exceeded earnings forecasts.  From this viewpoint, earnings growth is not sustainable, since costs can only be cut so far.  Without top-line growth, the earnings rebound will falter.

Defining Good News

This widespread challenge has everyone looking for a perfect earnings report:  an earnings beat, revenue growth, and a positive outlook.

Will we see any of these?  How many?

I did not expect much this quarter, since most companies are looking at the same data as the rest of us.  Their corporate economists, if they even have one, are reviewing the modeling of other economists and reading the Wall Street Journal.  Most importantly, in the post Sarbannes-Oxley environment there is a penalty for companies and accounting firms that engage in undue puffery.  In fact, many companies no longer provide guidance.

Actual Data

There is an interesting historical pattern where most companies beat earnings expectations.  Some critics take an interesting position, arguing both of the following:

  • Forward earnings expectations are unduly inflated by optimistic companies and foolish analysts whose job is to sell stocks, and
  • Companies beat expectations which have been driven down to a level that is easy to beat.

For both of these to be true, corporations must spin a positive picture a year out and then violently reduce estimates.  This has not been happening.  Forward earnings estimates have been growing at a solid pace.

The reports from this earnings season have been spectacular.  Take a look at this informative chart from the fine team at Bespoke Investment Group.

Bespoke Net Earnings Guidance 

If this does not grab your attention, you just do not care about data!

The BIG team provides helpful data and charts every day — for free.  If you sign up as a member, you get even more.  For a helpful glimpse, check out this Charles Kirk live chat with the BIG team.

The Right Perspective

Much of today's pundit conversation was focused on the Fed.  Many bearish market observers have taken the following path of analysis:

  1. Expecting an economic collapse since the Fed had no options;
  2. Criticizing the various innovative Fed strategies as unwise and predicting failure (first prediction wrong);
  3. Denying economic progress under the Fed regime (second prediction wrong);
  4. Renewing criticism of Bernanke and team as clueless and repeating mistakes;
  5. Predicting some future failure, stagnation, or stagflation.

Whether these predictions prove to be correct on some multi-year time frame is an open question.  Meanwhile, the immediate impact is hard to deny.

Personally, I look at a one-month time-frame in our TCA-ETF trading, where I update our position each week.  For the average investor, I think a six-month to one-year perspective is more appropriate.  When I look at data, I see continuing, gradual improvement in the economy and, more importantly in corporate earnings — all in the face of a skeptical market.  My initial target is the pre-Lehman levels (both individual names and the market), where we need to take another look.

I outlined today's article during the day, but the Apple Computer, Inc. (AAPL) and Texas Instruments (TXN) reports (after the close) underscore the Bespoke findings.

[Full disclosure:  Regular readers know that my accounts are long AAPL and I have frequently recommended the stock for those needing a growth component.]

The Bias in Reporting Job Losses

Each day’s news brings more stories about layoffs at major companies. The stories get a big play in mainstream media. The leading bloggers also cite the stories and encourage readers to keep a summation of job losses.

This is quite misleading. Job losses occur in highly visible chunks, as we can readily see. New jobs are created a few at a time, both in existing businesses and in new businesses. Even sophisticated observers do not recognize the ongoing job creation from the invisible hand of the market.

Try This Headline

Suppose that the New York Times or the Wall Street Journal had a headline:

100,000 New Jobs Created Today.

Actually, they could run that headline every business day, even during the recession, and it would be accurate.

How do we know? As usual, we start with data. The best illustration available is from the last recession, so let us look back to 2001.

The 2001 Example

The data presented here are drawn from the Business Dynamics series from the BLS. The data are not from surveys. The evidence is from state employment data. Since no one reports employment, and pays taxes, on phantom jobs, these are data that we should believe. Here is the evidence.

2001 Net Jobs

Source: Bureau of Labor Statistics seasonally adjusted data. (Unadjusted data show the same result for the year).

As one can readily see, over 35 million jobs were lost during the year. That is what you would get if you added up all of the layoff announcements and also included job cuts that did not make the newspaper. What most people do not realize is that over 32 million jobs were added. This development is not publicized.

By focusing on gross job losses we get a false impression of the problem. The net losses are bad enough; there is no reason to exaggerate.

Conclusion

There are three important conclusions:

  1. About 90% of announced job losses were offset during the same month by job gains. We should be taking a 90% haircut to those newspaper articles.
  2. There was substantial creation of new jobs in opening establishments, a total of over 7 million for the year. That is something to remember the next time someone scoffs at the idea of business births during a recession.
  3. President Obama dropped the tax credit for new jobs, and that is a good thing. There is no way to separate the new jobs from the credit from those that would have occurred anyway. If the credit were paid for gross new jobs, the money would be gone in a couple of months.

Most importantly, this shows that we should remember that net job change is the key economic concept. That should also be our policy target.

What Went Wrong

There are plenty of “Year in Review” articles in mainstream media and on the Web. Here at “A Dash” we try to add value, so we are not going to tread the same ground. Instead, let us offer a few ideas that seem to have been neglected.

Looking for Causation

Investors looking forward, as they should, need to understand what happened in 2008. The easy explanation, which has plenty of truth, is that there was too much leverage, too much greed, a poor job by rating agencies, and a system that sold homes with teaser rates to many who could not afford adjusted payments.

Having made this bow to the obvious, the story is a bit more complicated. Understanding what happened is important. Why? How else can one know if there is a real solution?

What Went Wrong

Our analysis of problems, as noted, is not intended as comprehensive. It is an addition to what readers have already seen.

There was a real problem in excessive leverage at some Wall Street firms, excessive lending to home buyers, packaging of securities in complex derivatives, and rating agency failures in certifying these securities as AAA. This partly reflected the conflict of public policy – trying to help an aspiring class of homeowners – with the reality of sound lending practices. It was also a manifestation of greed on the part of many participants in the process. Government was slow to address the housing issue. It came at the worst possible time, when we had a President whose strength was limited by an unpopular war. Government agencies did not, and perhaps could not, react with sufficient speed. Few realize that problems must gain widespread perception before they can be addressed. Despite many innovative efforts, government agencies were playing catch up.

There were many who were celebrating this failure. Some hedge funds took advantage of the unregulated credit default swap market to undermine confidence in financial institutions. They “bid up” prices in this thin market, betting on the failure of certain firms. They bought put options, which would pay off if the firms failed. The failures cascaded since mark-to-market accounting rules forced other institutions to write down their holdings, even those that were performing assets. This created an environment that was much worse than the original problem. We were sucking assets out of our lending institutions at WARP speed. There was agreement that leverage was excessive, but no agreement on what level was appropriate, nor how to get from point A to point B. There is an appropriate level of leverage, not zero, and not 40-1.

Because of the general bias against “bailouts” the government chose to allow the failure of Lehman Brothers. This led to an environment where no financial institution believed in the viability of any other. Normal lending – not the leveraged stuff or the national debt – came to a halt. This meant that companies that relied on borrowing to finance inventory through commercial paper could not operate normally. It was a full-fledged credit crisis.

The Bush Administration reacted by going to Congress for a massive plan, hurriedly created and with little detail or oversight. President Bush should be congratulated for action, but there was little time. Congress balked, resulting in a better and more flexible approach. This new TARP plan quickly morphed into a generalized program of preventing the failure of financial institutions through direct investment. Others can and have criticized this action, but there was really little choice. Treasury Secretary Paulson was acting to prevent the dominoes from falling. The Lehman example made the risk obvious to all.

The result is now a holding action, where one administration is fighting to prevent things from getting worse, while we wait for a new one to take power.

What to Watch

As we evaluate the proposals from the Obama Administration, it is important to look for actions that address root causes. Some of these are already in place, including stimulating inter-bank lending and reducing mortgage rates.

The missing pieces are those directed to the dysfunctional reaction of financial markets. It is important to prevent attacks on specific firms via the thinly traded credit default swap market. It is important to break the cycle of forced write-downs of performing assets. It is important to address – quite directly – the housing market, helping new buyers and existing owners alike.

These are all death spirals. Stopping them is the key to limiting the recession effects.

 

ETF Update: Strength in Coal? Really?

An important strength of a trading system is that it forces you to think.  Humans form opinions and stick to them.  The blinders of selective perception and confirmation bias lead everyone's fundamental analysis to conclusions that are difficult to budge.

We find that a regular review of the market, sector by sector, helps to avoid these biases.  Our own approach looks at Trend, sector Cycles, and adds a touch of Anticipation.   Since we do this with a universe of 57 ETF's representing a range of sectors, we call it the TCA-ETF model.  (For new readers, there is a more complete description of our methods and ratings at the end of the article.)

This week's ETF update provides two good illustrations.

The Market

The S&P 500 gained almost 1% for the week.  That is a great return, but to most it does not feel that way.  Why not?  Extreme volatility makes a 1% gain seem trivial.  The market was up almost 5% on Tuesday, and declined the rest of the week.  Most of the media and punditry are completely focused on bearish economic news.

The system rankings force us to keep an open mind.  Fifty of the 57 ETF's have positive ratings.  Since three members of the universe are inverse funds, we can never achieve more than 54 in the "buy" range.  In addition, most of the ratings are quite strong, indicating better than average stock performance over the next month.

The market action, captured by the model, suggests that we look past the bearish fundamental news.

Strength in Coal

This week's featured sector is the Market Vectors Coal ETF  (KOL).  The ETF is based upon the Stowe Coal Index, which is down over 56% YTD.  40% of the exposure is outside the US.  The top five holdings make up nearly half of the fund.  The P/E ratio is under 11 and the price-to-book is just under 4.

During the last week, KOL made a big move in our rankings, from #12 in last week's report to #2 this week.   We added the position on December 12th.  Let us take a look at the price and volume history as shown in the chart below.

KOL

Our model is like a wise advisor, providing recommendations and ratings without commentary.  From experience, we know that a basing pattern like this is a positive factor.

We are pretty much alone in spotting the KOL potential.  Charles Kirk, who misses very little, noted the ETF as a big mover without further comment.  Tom Lydon did a feature last week on clean coal and coal gasification, mentioning KOL.

Coal Fundamentals

We are surprised at the KOL forecast from the model.  We have three concerns:

  1. Oil prices have been falling despite OPEC production cuts.  There is always some ability to substitute one form of energy for another, so this is a negative for coal;
  2. Chinese imports have been lower, with the Baltic Dry Freight Index hovering near historic lows; and
  3. Obama energy policy does not favor coal.  In fact, it is pretty much the opposite of the Tom Lydon position.  At our sister site, ElectionStocks.com, we continue to monitor the impact of the Presidential transition on specific stocks and sectors.  There is a good article on Obama's plan for auctioning emission rights and also breaking news on his science advisory appointments, the clean team.

Our Conclusion?

Trading has different time frames.  While we expect the Obama energy policy to be relevant in the long run, we respect the market signal on coal.  Our best guess is that there is something positive with Chinese demand.  Meanwhile, we follow our system.

Weekly TCA-ETF Rankings

The
ratings reflect prices and signals as of Thursday night, December 18th.
In
our daily trading program (for accredited and institutional investors)
we buy the top eight sectors. In our weekly program for individual
investors (free report available upon request) we stick with the top
six sectors.
There
was not much turnover at the top.  One of the new additions, RSX, did not perform well.  While we were up about 2% on the week, this was the major limiting factor.

Based upon the current ratings, we continued our bullish stance in the Ticker Sense Blogger Sentiment poll.

121908 

Note for New Readers

Our weekly ETF Update is designed to assist both investors and
traders interested in ETF's and Sector Rotation.  Before turning to the
current rankings, let us undertake a review for readers new to this
series.

Our Method.  In this past article,
we described our basic methodology and why we believe the rankings are
useful for fundamental traders and technical traders alike.  While we
urge readers to check out the entire article, the key point is that
ETF's pose challenges and opportunities different from investment in
individual stocks.  The fundamentals may be more difficult to assess. 
Even with a good grasp on fundamental trends, there is a lot of
technically-based trading in ETF's.  This means that those trading with a fundamental approach (and we do this as well) want to monitor the "hot money" moves.  Here is an article on that point.

The system synopsis.
We look at Trending sectors, Cyclical Sectors, and build in an element
of Anticipation for both entry and exit — thus the name of the model,
TCA-ETF.  While we do not reveal the exact methodology for spotting
trends and cycles, the system is not a "black box."  The basic elements
are used by many, and widely reported.  We even discuss the need for human analysis as opposed to black box trading.

We
do not buy a sector that is in the "penalty box." One can think of
this as similar to a trading stop. It means that trading in the ETF has
violated certain technical criteria. To assist readers in following
this, we have added a field showing which sectors are in the penalty
box. The overall number of sectors in the penalty box is also an
important read on the overall market, influencing our overall posture.

We report the rankings
each week, now on the weekend with a one-day delay, using the Thursday
output from the model.  We monitor and trade this daily, and offer a
free report (request via the email address on the top left of the site)
for those interested in our weekly trading program.

Reviewing Economic Data

One of the benefits of writing a blog is the feedback from readers.  Here at “A Dash” we certainly do not have a “boo-yah” society.  Readers feel free to swing freely and offer arguments and links.  Great!  And thanks!

Sometimes we write an article with a mission related to our book, one geared to individual investors and including a chapter on Internet traps.  Yesterday we tried a somewhat whimsical approach and it seems like we missed the mark.  It is often difficult in print.  Sports Illustrated, in April, 1985, wrote about a rookie pitcher, Sidd Finch.  This was quite a find for the Mets, since he had a 168 MPH fastball.  Many readers did not understand the April Fool’s joke.

And this was a fairly obvious situation, not like what we do in blogs.

There are only so many ways to escape from a pedantic mode.  Since we do not embrace the colorful language of other sites, we occasionally try for humor in other ways, hoping that some appreciate.

Revisiting Economic Data

Taking the cue from our excellent reader comments, let us merely state a few observations, as follows:

  • Intelligent people can look at the same data and reach different conclusions.  If you think that yesterday’s data had a clear-cut message, you missed the point.  Take a step back and look again.
  • Those with a mission use inconsistent rules for interpreting data.  Do we really care about revisions to data from eight months ago?  Market pundits on a mission usually dismiss such information.  It is relevant only to the academic and historical question of when the recession began.
  • Those with a mission pick the adjustment that fits the viewpoint.  Sometimes it is inventories, which can be viewed in different ways.  Astute businesses build up inventories in anticipation of sales.  Or inventory build-up can be involuntary.  It is subject to spin.  That was the point.
  • New and creative methods. This is the realm of inflation adjustments.  Those who prefer to reject the official data have dredged up (yet another) method of objecting.  There are various methods of adjusting price changes, each geared to the particular economic problem.  The recessionistas did not get the negative GDP number they wanted, so they object to the methodology.

Just think about this.  Would it not be nice for those debating the economic issues to agree on the measures — in advance, before they come out.  Instead, we find data that supports a particular viewpoint is readily endorsed, while any contradictory information gets the hatchet job.

Our Take

Please note that none of the above reflects any argument that we have a strong economy or some perma-bull philosophy.  Regular readers of “A Dash” know that we have been quite flexible in our approach to the market.

Having said this, we try to warn the average investor about those who are determined to find the worst in any economic report, especially those pundits who have done so for many consecutive years. 

Temptation and Greed: Lessons from Sports

Last year we reviewed Dr. Brett Steenbarger's Enhancing Trading Performance, one of our recommended readings.  We made the observation that the book should be read by competitors in all fields, not just trading.

It works both ways.  Many of the lessons from sports can be applied to trading.

Playing within Yourself

Athletes often mention the idea of playing within yourself.  It means not over-swinging at golf, as Harry Vardon, for whom the PGA scoring average trophy is named, always did.  Golfers and traders should both check out the quotation on Jon Leland's excellent golf blog.

Harold Reynolds, a great base-stealer and fielder, writes about how he learned to play effectively.  He looked at the giants of the game at his position, second base, and came to the following conclusion:

When I was able to reduce them from the giants they were in my head, to
the same size of the man I saw in the mirror, the vision came alive.
They all had a special skill that stood out amongst the group, but once
I set that skill aside, it cleared my vision and I realized not only
were we similar in physical stature, but we basically all had a similar
style of play — catch the ball, hit for good average and don't make
mistakes. After assessing the competition, I concluded that if I could
play within myself, which meant catching the ball, putting it in play
and stealing bases, why couldn't I be an All-Star too?

We could find examples from other sports as well.

Why Players "Reach"

Frustration and lack of success are driving forces.  Players who are striving to recover make unsound decisions.

Poker Superstar Daniel Negreanu cites this important lesson:

Bad decisions are born from a lack of focus combined with a lack of
confidence. In order to be at your best, you have to separate the past
from the present, and devote 100 percent of your attention to the here
and now.

Bringing this back to trading, Dr. Brett's blog has an excellent series on frustration and trading.  The following quotation is from the first part, but readers will benefit from reviewing all three parts.

When a trader emotionally accepts losing as part of the business, loss is not so threatening.
With proper money management, it can be contained and need not pose
more than an annoyance. But if a trader *needs* to make money–perhaps
because of perfectionism, or perhaps because of dire financial
circumstance–then normal loss might be experienced as unusual
frustration. It's the overriding *need* to make money that sets the
trader up for acute frustration.

The Result?  A Typical Investor Mistake

David Merkel has a first-rate analysis of an investment scam.  He takes a stock that is a likely pump-and-dump candidate and carefully shows how an investor can be taken in by touts.  Every individual investor should read this article carefully and be prepared to ask similar questions.

The only thing we might add to David's article is a comment about "why".  We know that these schemes work, if only because companies are paid to circulate this "research."  People listen because they are trying to hit home runs or drive the ball 300 yards.

The Investor Lesson

Our own education on this subject came about ten years ago.  One of our most valued investors asked us to design a program to complement our sector rotation strategy.  This caused us to review our methods and record over the prior ten years.  While we had done well, there was a major opportunity for improvement.  We discovered these two key things:

  • Many clients wanted instant winners and home runs.  We obliged with our best shots.  These speculative plays, as one might expect, had highly variable results with some big losses.
  • The "basic strategy" of finding strong themes and more modest valuation advantages actually performed better, and with much less risk.

The request from the investor led to the development of our most successful program.  An important element is the definition of the goal — a double in three years.  This is a compound growth rate of 24%.  It is an aggressive target, but not the stuff of the heady 1999-2000 era.

Do we achieve the target?  Of course not, but we get nearly half of it.  Reaching for more actually generates a lower return.  It is an important lesson.

Investors swinging for the fences should expect plenty of strikeouts!

Reviewing Three Characteristic Business Decisions

Successful trading and investing requires finding an edge. At "A Dash" we look for broad themes that most are getting wrong. Since there are many very intelligent, very savvy people who work in the investment world, it may be difficult to find corners of knowledge that are under-represented.

We have suggested that one such opportunity is the very poor understanding of government and the policy-making process. Few seem to remember their role, be it analyst, fund manager, or investor. Instead they react as a voter, using their personal opinions about the merits of the policy.

Take our recent discussion of housing problems as an example. For many observers it is important for them to express their personal feelings about the merits of the legislation — whether it will be effective, whether it is fair to those not affected, how much it will cost, and the possible message to future borrowers and businesses.

These are all excellent questions, if one is a Member of Congress deciding how to vote on the bill. They have little or nothing to do with the impact of the legislation on the housing market, the economy, or the stock market.

The Business Comparison

We know from many years of teaching and interaction with investors that most people have a strong personal bias. In a broad sense, they believe that government is error prone and dysfunctional while business is efficient and effective. In fact, the decision-making processes of large organizations in the public and private sector are quite similar. The classes in MBA and MPA programs are more similar than different.

We are going to take a harder look at this bias, starting with a better understanding of organizational decision making. Readers who spend a few minutes with us on this summary will be getting the most relevant portions of classes ordinarily requiring many months of study.

Revisiting the Business Examples

Some time ago we provided three examples of business decisions. These were all actual case studies of widely-known businesses in actual situations. To appreciate fully our point, please take a few minutes to review the prior article. Make your own guess about the situations involved. The actual companies are identified at the end of this article.

Decision-Making Types

Organizational decision making can be usefully classified as one of
three quite different types. While there is an extensive literature in organization theory on this problem, our analysis is chiefly inspired by one work, Essence of Decision: Explaining the Cuban Missile Crisis, by Graham Allison (now added to our recommended reading list). The Wikipedia article notes the seminal nature of this work, which they identify as the "founding study of the John F. Kennedy School of Government.

Allison identifies three models–the rational, the incremental, and the bureaucratic.

In the
“rational” model, the organization analyzes problems and creates general
solutions. Decisions resulting from the rational model are often similar to
those of a single human actor. This does
not mean that the decisions are the most effective, just that they exhibit a
certain consistency of method and planning.

Some organizational decisions are more like piecemeal reactions than
general solutions. Decisions may be
reached to try a number of simultaneous approaches not all of which are
consistent. This method, which can be
called the incremental approach, results in policies that address part of a
problem. Ideas that work get
expanded. Those that do not often die
out.

A third broad type of decision making is bureaucratic in
nature. Any large organization – private
or public – has different departments or parts. Each department has its own interest in control over a project, expanded responsibility for members, and veto of anything that does not fit. It is highly rule-based.

Returning to the Three Business Decisions

The first example, Company A, was The Coca-Cola Company (KO). After taste-testing comparisons, they abandoned the original recipe for their leading beverage and launched New Coke. The failure of this initiative led to some fast footwork, including the resumption of Classic Coke.

The second example, Company B, is Google, Inc. (GOOG). Google innovates by encouraging employees to develop ideas, allowing everyone time for that brainstorming function. The myriad of Google search applications is a result of this approach. Some, like Google Maps, get expanded. Others, like Google Answers, may end after testing. It is a modern success story illustrating the incremental method.

The third example, Company C, is a major auto company that we will not name here. The company considered a plan almost identical to the current initiative by Chrysler. The Chrysler plan, well-known to anyone seeing their current advertising, has successfully drawn new customers to the showrooms by offering fuel price protection to the average buyer. Chrysler realizes that there is a need for a transition to more fuel-efficient vehicles. The price protection approach helps them to succeed in making that transition. Chrysler was able, through a new leadership team, to overcome entrenched departmental bureaucracy.

Application to Public Policy

The takeaway for investors is realizing when government agencies are following a successful process. Too often the market pundits will criticize a policy as being too small and not comprehensive. Recent examples include the various Fed initiatives to address liquidity in credit markets and the assortment of actions directed at the housing market.

We will review each of these decision processes in more detail. For now, investors can gain by taking a more open-minded approach to government actions that do not seem, at first glance, to go far enough.

A preview: Most pundits make the initial student mistake of thinking of government strictly through the rational model.

Economics IQ Answers

Last week we presented a small true/false quiz with a number of economics statements.  Some of the statements are true, but possibly misleading.  The quiz is repeated below with answers following each question.

The Quiz

  1. Home prices are now deflating at a 32% annual rate, versus 8% six months ago.  [True, but misleading.  You get this result by taking the rate for a single month and multiplying by 12.  Taking two specific points like this is often misleading.  Why not the rate last month? Or a year ago?
  2. Inflation, as measured by the CPI, shows housing costs to be increasing according to the "imputed rent" formula. [True.  Despite the decline in housing prices, the impact of housing on the CPI is +2.6% year over year for about 24% of the consumer basket.]
  3. Planned corporate layoffs rose 68% in April to a total of over 90,000. [True]
  4. As long as the largest asset on household — and bank — balance
    sheets continues to deflate, the credit and consumption hits will keep
    coming.  [Marginally true, but aggressively stated.  See #10]
  5. The US economy created about 2.5 million new non-farm payroll jobs last month.  [True, but potentially misleading unless one understands that about 2.5 million jobs are also lost each month.  The point is to show the dynamic nature of employment changes.
  6. The TED spread is now at 86 bp's, down from 204 in mid-March. [True]
  7. The Baltic Dry Freight Index has plummeted, showing global economic weakness. [False.  It is back to the former highs.]
  8. The Fed has devoted about half of its balance sheet to "unusual" liquidity efforts. [True, although many believe that the "balance sheet" approach does not reflect a real limitation on Fed power.]
  9. The BLS Birth/Death adjustment has reduced past predictive
    performance, as measured by actual state employment counts when the
    data became available (months later). [False.  The Birth/Death adjustment has improved results throughout its history.]
  10. Household liquid assets at $21.9 T and net worth at $31 T are about
    1% below the all-time records as of the most recent published data. [True.]

The best scores among those who submitted answers had eight correct answers.  We realize that some may disagree with the interpretation on a couple of the questions, but each raises a point of some interest.

TCA-ETF Update

Jeff is on the road again.  Below is the weekly TCA-ETF Update.  He will comment more if he gets the chance.

    ~Renae

Etf_sector_report_031208