Friday, May 4, 2007

Posting On Comments

After my May Day request, some readers suggested that I comment on: a) value investing, b) the soundness of ETF sponsors and c) "where it is all going". Let me first thank you for taking the time to make these suggestions - please keep them coming.

Value investing

Made popular by such luminaries as Graham, Buffett, Templeton, Neff and others, it is a time-tested approach. However, it is not at all easy to identify "value"; apart from mechanical low p/e and p/bv approaches, it requires much slogging through financials, the understanding of the business involved and at least some sense of timing. One must also be very careful to distinguish between what may appear as "value" vs. a fundamental, permanent change in the economic worth of the enterprise due to a shift in technology, consumer tastes, etc. (eg buggy whips vs. steering wheels). In other words, a company's price may be low because its business is in permanent decline. Also, with powerful information technology now at everyone's fingertips, finding real diamonds in the rough has become extremely difficult.

Probably the best way to identify value is through your own daily experience. Keep your antennae up and try to find companies or sectors you are familiar with that are coming up with new or better products and services. My best personal example is of a friend who was a telecoms engineer years ago - he saw that a small, little-known company had come up with a very good product that his own company was buying in big numbers. So he bought shares in it. The small company was CISCO and the year was 1992.

Apart from the above, my other approach is to try to fathom fundamental macro shifts in the economy, identify the sectors that will benefit or suffer, find and analyze the appropriate sector leaders and invest accordingly (long or short). This is more of a cyclical approach to value, one that tries to take advantage of the ups and downs in the value perceptions of the investing public. For example, right now I believe the financial sector is overvalued, from a macro perspective.

ETF Sponsors

I must confess I am not crazy about ETF's and all other types of "packaged" or "indexed" products. They promote a passive style of investment I find personally not to my liking. Oh, they certainly have their uses in cases where individual share picking may be difficult or even impossible (eg country funds), but I prefer a more hands-on approach.

But the question was about the funds' sponsors... As long as they are large, reputable firms I don't really see much of a problem, unless there is a major blow-up. Naturally, one must always be wary of the annual fees and charges involved - they can be quite sizeable.

It's The End Of The World As We Know It (??)

A reader suggested that my comments frequently reach the edge of the precipice, but never go over it to proclaim the coming of a major financial crisis or meltdown. This is because I combine a data-driven economic analysis ("just the facts, ma'm") with a search for signs of psychological/emotional excess in markets ("fear and greed"). In the rare cases where both match, I look deeper and then act. For example, the copper madness of several months ago: prices had zoomed out of control but housing in the US was fast slowing down and people were getting electrocuted trying to steal high-voltage transmission wires: fundamental data plus people's folly pointed to shorting copper.

Right now the financial system in the US shows both kinds of negative signals: the economic data is coming in weak-ish and there is a party going on in Wall Street, albeit low-intensity (the drunken revelry is in Shanghai). But the individual investor is laying low in the US and Europe, having left the field to hedge and private equity funds who are maintaining the party through steady infusions of borrowed cash. They have a massive vested interest in keeping the party going, so it is difficult to say WHEN the party will be over and - most crucially - HOW it will end.

Usually, "smart" money takes a market to within 75-80% of the ultimate top and then unloads to the unsuspecting multitudes by creating a get-rich-quick euphoria that gooses the market the rest of the way. They typically unload after the crest, too, when individuals see the weakness as a "buying opportunity" and foolishly "double-down". We have not seen any of this yet in the US and Europe (though I strongly believe it is unfolding in China). What's more, I suspect we may not see this scenario play out in this market cycle: this time it may become a game just for the big boys, something straight out of the 19th century Gilded Age clashes between Morgan, Vanderbilt, "Diamond Jim" Burke, Jay Gould, et al. Certainly, the socio-economic climate is similar: monstrous gains for a few hundred "financiers" (some are making over a billion dollars a year) while the public is in huge debt, stockmarket takeover clashes are producing enormous bids, asset wealth is swamping income generation and so much more...

During the Gilded Age we got regular economic and market "panics" even though the public had very little participation in the bond and stock markets. They culminated in the Great Panic of 1893, which was the most serious to that point, with bank failures and very high unemployment.

So, in answer to your question, I suspect the current cycle will end with a 19th century-style panic after the "smartest" operators unload their paper on the "smart" ones. After all, there are now tens of thousands of hedge funds, private equity funds, asset managers, etc - and they can't ALL be "smartest". I bet 90% of them will end up holding the bag.

ADDENDUM: Of course, the wider public is already in this market through their pension funds - 30% of all investments in hedge funds are currently held by pension funds. That's 30% of $1.6 trillion, so we're talking serious money here. Individuals are in it, allright, they just don't know it.


  1. How can there be a panic and bank runs with fiat currency? Won't the fed print their way out of bank problems, creating a Weimar Republic situation?

    Jason B

  2. Hi Hellasious,

    I recently search the Internet and read upon nineteenth century panics. Found it attractive intellectual proposition.

    Like your proposal to equate the current hedge funds with the tycoons, barons and other financiers.


  3. Before I answer the basic question about the Fed, let me say that "money" is already being very rapidly "printed" in the form of debt. Credit expansion is running at over 10%/yr in the US and EU and 100% (!) in China. So, in a sense, we are already on the way to "Weimarizing" (over-inflating) the global financial system.

    On to your question:

    Banks aren't the weak link right now and the various regulators saying "the banking system is sounder than ever", misses the point entirely. Banks no longer intermediate between depositors and borrowers, but arrange loans to sell them to the public via securitizations. Mortgages, LBO loans, credit cards...everything is securitized now. Even premiums for catastrophy insurance.

    That's where the weak link is: all those garbage securities that have been sold to the gullible. The securities cannot be "bailed out", no matter how many dollars are printed. If the borrower cannot repay his/her (frequently adjustable) loan the bond defaults - period. And each bond is spread out amongst thousands of owners, not conveniently tucked away within one single bank, as loans were previously. There is a structural problem with this kind of debt.

    Let's take a "for instance": instead of a 1890-style bank run we get a 200X CDO run. Who will buy the stuff? At first it will be opportunistic funds and banks, looking for a "bargain", like we are getting right now with sub-prime mortgages. But if the run persists? Wealth will be destroyed - the Fed can't be the last-resort buyer of all private debt instruments at par.

    And let's keep in mind that Weimar's problem was high government obligations from punitive war reparations, not a private debt mountain such as we have now.


  4. Hellasious,

    "And let's keep in mind that Weimar's problem was high government obligations from punitive war reparations, not a private debt mountain such as we have now."

    Should all those securities fail massively, it looks like we are going to deflation, aren't we?

    From inflation to deflation in a row, this is a chilling scenario.


  5. Dear Francois,

    How about this: in the past years we have had low goods inflation (thks to China) and high asset inflation (thanks to debt). We could simply go into reverse mode, if China decides to consume instead of exporting and debt gets harder to get and/or gets destroyed.

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