Tag: davidson

I had several folks wonder what this was when it was first discussed here

“Davidson” submits:

One of the most difficult tasks one can have is to find a proper method of valuing the marketplace as so many competing methods are offered. I have looked to basics and once I learned of Knut Wicksell, much became clear.

My view which has developed over the years is that capital returns follow the Wicksell Rate which was first authored in 1898 by Knut Wicksell. This rate is the US Real GDP Trend + the trimmed core PCE (core inflation rate as run by the Dallas Fed). Written as the formula:

Real US GDP(long term trend) + 12mo trimmed mean PCE(Personal Consumption Expenditure per Dallas Fed) = Wicksell Rate

All long term returns arbitrage about this rate but with considerable deviation due to market psychology (Chart Below) and earnings swings. Long term this should be about 5% if inflation is kept between 1.5%-2% and equates to a 20 P/E on the SP500. The emergence of inflation can substantially depress P/E’s regardless of the strength or breadth of earnings and represents the greatest risk to undiversified portfolios. The Dallas Fed has information on Wicksell.

Coming to terms with periods of economic distress and the associated market declines can in my view be greatly fortified by looking at some of our economic and market history.

US Real GDP (Chart Below) shows just how resilient the US economic system has been over nearly 80yrs. There have been seemingly catastrophic events, i.e. Herbert Hoover followed by FDR, WWII, Kennedy’s assassination, rampant inflation, Richard Nixon followed by Jimmy Carter, “Death of Equities”-1982, Crash of 1987, Crash of Long Term Capital, Crash of the Russian and Asian currencies, Crash of the Internet Bubble and more yet we have ALWAYS snapped back. Note that in the early 30’s with 4 weak years we had 4 quite strong years so that the avg. US Real GDP trend has been in fact a fairly smooth procession from a smallish economy of ~3.9% to the one we have now of ~3.2%. I think you can rely on the fact that our society’s productivity has had resiliency that is basic to our system of government. I do not think that we have destroyed US productivity in our current situation. In fact the evidence suggests that productivity has improved. I for one trust that we will return to the normal trend in a couple of years including a few years better than 3.2% to reestablish the long term trend.

Turning to the SP500 chart(Below) note the earnings trend of ~6.1%. I observe that Greenspan’s tenure has resulted in higher than normal earnings volatility vs. Paul Volcker. Although I did not draw it on this chart, my previous trend had been slightly below 6% before I recently added on the last 5yrs of earnings. It would appear that as technology has entered our economy’s various nooks and crannies we have been more productive and our earnings from our existing capital has risen some what.

I view the earnings in 1974, 1982, 1987, 1990 and 2002 as low points. We are close to comparable low earnings levels today. The market psychology today is comparable with similar media headlines of crisis and fear of Depression. However, we have avoided Depressions since the 1940’s due to the Federal Reserve acting as a financial shock absorber thus giving our society and economy financial breathing space to adjust to new conditions. This is why the US Real GDP has had decidedly much less volatility over the years as the Fed has exercised its financial cushioning actions. I estimate the current Standard Deviation at +/- 2.4%. This is well below what we had experienced in the ‘30’s of +/- 14%.

Yes, we may see lower earnings than we have seen, but historically most of the damage is done in my opinion. The Fed has loosened the purse strings forcibly and in multiple modes. So that, even though the media argues in the same fashion as in the past that the Fed either has not done enough or not done it the “Right” way, the end result is that the Fed has acted forcibly and our economy remains free to sort out the process of recovery. I have sent you several studies that indicate the early stages of recovery are with us.

The advice I provide is also based on that proffered by some of the greatest investment minds of the last 50yrs, i.e. Warren Buffett, Bruce Berkowitz and many more too numerous to list. A continuous process is in use in my office to assess the current insight of the most astute investors which I believe to be extraordinarily helpful

The advice to add REITs( see 5th Chart), Nat. Res and EmgMkts as part of a balanced portfolio is based upon the longer term observations of US economic strength and history as well as other observations as noted above. The use of the Wicksell Rate and the 5yr MovAvg Return/Risk analysis( 4th Chart) is helpful to determine when asset classes evolve to carrying higher levels of risk than is appropriate. Today this means to avoid Treasuries. Berkshire’s (BRK.A) Warren Buffett just called Treasuries a “Bubble” in his latest Chairman’s Letter. A comparison of Treasuries with the current 5.4% Wicksell Rate confirms this view.

The reason for being in most available asset classes(but for Treasuries) today is simple. They all appear relatively cheap. To try to focus on one or another using an expected return is difficult. You can be right on the earnings trend, but if the market cares more about another area you will not be rewarded with expected gains. Psychology plays a huge role in all markets as most market players are trend followers. In my opinion they are “Players” not “Investors”.

Disclosure (“none” means no position):none

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Davidson has a very thoughtful pieces on markets, the government’s roles, investors and traders vs value investors.

Under the Bush Administration it would appear that “Fair Markets” which was the theme of Securities Act of 1934 and other responses to the events that produced the Great Depression became “Free Markets”. Free Markets which have little restraint become dominated by the avarice of the marginal investors who are bright enough to skirt all the laws then enforced to take undo advantage of all other investors who being responsible and in the view of these few operate within the doctrine of “Fairness”. The “Free Market” syndrome simply missed the fact that there are always individuals who will “game” the system and because they have greater resources manipulate markets for their own advantage knowing that most will follow a sense of “Fairness”. These few are not stupid people. They are very bright. Bright enough to understand the system, see its flaws and acquire the means by which to enrich themselves at the expense of others who believe in the concept of “Fairness” as originally conceived.

It would appear the April 28, 2004 SEC regulatory meeting much discussed today at which investment banks were freed to lever up to 40-50X was simply part of a general belief that “Free Markets” self-correct and self-monitor. Unfortunately what was missed is that this is only possible in a medium of complete and utter transparency. In fact, while we gradually forced Warren Buffett to expose his holdings thus taking away some of his freedom to move about the market place, we gave HF’s invisibility. We also gave these folks invisibility as to the new securities contracts they created with the incredibly wrong belief that they would self-monitor. Many including Alan Greenspan supported this construct.

“Free Markets” will never be completely transparent as individuals will always find a means to game the system dishonestly. This is why rules are necessary to make markets “Fair Markets” to all with the individual investors who are the fundamental base of all investing through their daily effort, their labor and creativity, to produce GDP. We lose sight that our economy and the stock and bond markets rest on the efforts of people earning a living. We lose sight of the fact that the investment markets are not a world unto themselves that can be mathematically analyzed and thrown in to formulas by which to create wealth. The investment markets are simply a representation of the productivity of our society. I like to think of the markets as a console full of dials. It simply measures the results of all the inputs to society as it pertains to our productivity. The markets reflect our hopes, our generosity, our legal system and our political system. The markets reflect our entire value system and how we organize our efforts to self improve.

Markets need to be “Fair” not “Free”. Transparency of every contract, every levered position, every trade and every association of one contract holder with another should be paramount. If there is an ability of one investor to gain advantage over another with secrecy, then there should be rules that forces this into the light of day so that we can determine if it is “Fair to Individual Investors”.

There should also be a “Recourse Rule”. If you buy a house today it is non-recourse to the buyer. It is up to the bank to have performed the underwriting to the level that assures safety of principle and interest. This lets single buyers own multiple homes to speculate without personal risk. We are all suffering today from the fallout of housing speculators who have walked away from recent transactions leaving our financial institutions with the losses. All obligations should carry some form of recourse to the parties involved. It would add personal risk to speculation and reduce the risk to us all. How this can be done regarding investment contracts and investment firms can be left up to them to develop a fair solution. The concept is that there should be some recourse to the individual who created the contract till the contract has terminated.

“Fairness” should be the rule-personal responsibility of behavior should be the goal. “Free Markets” leads to avoidance of responsibility. I liked Pres. Bush, but he simply got it wrong. This mess will be his legacy.

We have Traders and Value Investors. The former believes that price accounts for all information, Efficient Mkt Hypothesis. The latter believe in understanding a business and buy with cash flow, Owner’s Earnings and etc.

First, the Traders support Mark-to-Market while the Value Investors scream that it is a bogus benchmark. The Traders sell stock and if it goes down they say, “See!! If it goes down, it was meant to go down to find its real “value”!!” It is an amazing set of mental gymnastics that Traders use to convince themselves that “emotional pricing” of securities represents a valid method of “fair value accounting” for which Mark-to-Market was designed to effect.

Second, there are many, many more Traders with their simplistic approach and strong self belief/confidence than there are true Value Investors. It is easy to see that Value Investors do not by their selling create tops nor by their buying create bottoms. It appears to be more a factor that Traders simply exhausted their fire power. Where this level is I do not know. Unfortunately, “Mark-to-Market” is a destructive feed-back device. It supports erroneous contention reinforcing it’s own effect. It goes in the wrong direction till you reach such a silly level that eventually some percentage of Traders see the folly and an apparent “Value” becomes obvious. The snap back becomes very sharp.

I don’t know where that level is. Obviously this past week was not that level.

Disclosure (“none” means no position):

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There is a growing chorus that feels the current situation will be resolved with a “V” recovery in which upside is a violent as the downside has been. To wit:

Here is the theory:

“Davidson” submits:

Wesbury has had this stance for some time. One way I would explain this is that this was not a consumer lead economic slow down. Consumers were actually still in good shape re: credit scores and could have continued to buy cars and houses if the lending institutions were lending. BUT, the lending institutions stopped lending and consumer sales hit a wall. Consumers do not stop dead this way, especially after nearly 3yrs of slow down that began at the beginning of 2006 in housing and autos. This whole slow down is an institutional/governmental heart attack on top of a normal slow down that began with the effect of Mark-to-Market on Lehman, AIG, Bear Stearns and then was kicked over the cliff with SEC Cox’ ban on short selling.

This has been such a misunderstood economic panic that was caused by first cheap money, then encouraged by political avarice, fostered by poor regulation and the incredibly stupid belief in the “Free Markets Self Correct” syndrome and then topped off by incredibly inane elimination of the “Up-Tick Rule”, the passive approach to naked short selling, the political decision to let Lehman fail so that Republicans could display some “Character?” during the Presidential election and the rest is history. The consumer was in fact OK till the credit markets and importantly the Money Markets seized with now bankrupt Lehman commercial paper.

Politicians and regulators just do not see that it is they who are the problem, it is they who have failed to act in accordance with the regulations that they passed. Politicians and regulators are looking for some one else to blame because they are so thick in the middle of causing this mess that I really don’t think they even have a clue as to what they have done. And they think that they are the solution to the problem??

The market is healing on its own. That this is occurring you can see from the rise in Treasury rates as funds flow into various market channels looking for opportunity. I watch with fascination the activities of Warren Buffett and numerous savvy investors buying up discounted assets especially real estate. The signs are there for all to see.

I am all in and have been since January ’09.

Could it be? Consider the following chart from Howard Lindzon

It shows, far from being an abnormality, “V” recoveries in equity markets are the norm. Now, the question we need to answer is “Are we at the bottom of the “V” or are we going down to a point between where we are now and the bottom of the 1931 “V”?”

The optimists will say we are at the bottom while the pessimist will say we will pass 1931. I lay not in either camp. My take is that we fall further then shoot up. How much further, who knows, and anyone who tells you they do is lying, they are guessing. My take is that based on the news flow and economics trends, which are still negative in the aggregate, more downside is in store. I know recent numbers have been encouraging but a month does not a trend make (nor does two).

In that vein, Henry Blodget writes:

Prof Shiller’s work (above chart) shows clearly that stock values are mean-reverting. The only trouble is the time they take to mean-revert. If things go badly over the next few years, stocks could bounce along the bottom for another decade or more.

For example, Jeremy Grantham, whose shop (GMO) produced the forecasts above, reminds us what happened in the 1970s:

“Today all equities are moderately – one might say, boringly – cheap. The forecast for the S&P has been jumping around +6% to +7% real, with other global equities slightly higher. 

To put that in perspective, a 1-year forecast done on the same basis we use today that started in December 1974 would have predicted a 14% return (which, by the way, it did not deliver since the market stayed so cheap). For August 1982, the forecast would have been shockingly high – over 20% real! So do not think for a second that this is as low as markets can get. “

(It’s worth noting, though, that 1982 was the start of the great bull market. Jeremy also warns of the possibility of another sucker’s rally, so don’t get too comfortable waiting for the bottom:

“Now, I admit that Greenspan and 9/11 tax cuts caused the “greatest sucker rally in history” from 2002-07. We therefore cannot rule out another aberrant phase in which extreme stimulus causes the market to rally once again to an overpriced level for a few more years, thus postponing the opportunity to make excellent long-term investments yet again. But I think it’s unlikely. “

One thing seems certain: Stocks are cheaper now than they have been at any time in the past two decades. That’s encouraging for those with another couple of decades to invest and–increasingly rare these days–cash to put to work.

We’ll see….I think we have a bit deeper on the “V” to go..

Disclosure (“none” means no position):

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Seeing the Blankfein piece in the FT against Mark-to-Market vs. Wesbury is the dichotomy of the market place. Those who believe in Efficient Market Hypothesis believe that price trend represent all the information available for a particular security. Mark-to-Market is valid in all environments for traders, technical and momentum investors. Efficient Market players have investment horizons from minutes to months. If they hold longer than a year, it is only due to a series of short term technical signals that reinforced holding.

The “Value Investors” on the other hand look for mispricing vs. fundamentals, i.e. discount to Book Value, Cash Flow or some other value parameter that is measurable and quantifiable. Warren Buffett is the prime example of Value Investing, the best known, but there are numerous others. However, the number of true “Value Investors” is far less than all other investors. Value investors investigate, analyze and parse a target company’s business till they are comfortable with the decision to commit funds at a level at which they feel an anticipated rate of return is likely to be had over a multi year period. It is not unknown for Value investors to hire investigators and analysts to look at each business site of a company’s operation, individual tax filings, competitors and vendor information in an effort to sleuth the locations of all values within a company. Value investors have an investment horizon that is typically greater than 5yrs.

Mark-to-Market accounting during down markets provides opportunities for Value investors. Their records are well known. There are no traders famous for their investment judgment over the same period of any well known value player.

Importantly, mixing Value investors and Efficient Market players (calling them investors is an abomination of the word) in the same room is like watching two vastly different cultures trying to communicate. They can’t. They are so culturally different that the terms, “value”, “return”, “analysis” which stand for defining action and criteria for one have no equal meaning in the other. What is even more bazaar is that in most instances they do not understand why they don’t understand each other as they each believe they are perfectly correct in their views of assessing investment opportunities.

I am a Value investor. There are truly very few of us vs. other investors. My guess is less than 2%.

Mark-to-Market accounting is an abomination of reasoning during periods of market disruption such as we just experienced when the SEC banned short selling. Unfortunately, there are more of them than us, but fortunately the market will and is currently righting itself even with the mistakes we have made and continue to make. Philosophically we need the majority of investors to not get it right so that us few can take advantage of the deep discounts not produced in any other way.

All will be well even if the current stimulus package is passed. It may just take longer.

Disclosure (“none” means no position):

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Berkshire Hathaway (BRK.A) has purchased $300m of Harley Davidson’s (HOG) debt. The real news is he is getting 15%, so much for credit “loosening up”.

Disclosure (“none” means no position):Long HOG

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