Day: December 13, 2007

The Nature of a Nervous Bull

The Nature of a Nervous Bull

Cast your bread upon the waters,
For you will find it after many days.
2 Give a serving to seven, and also to eight,
For you do not know what evil will be on the earth.
3 If the clouds are full of rain,
They empty themselves upon the earth;
And if a tree falls to the south or the north,
In the place where the tree falls, there it shall lie.
4 He who observes the wind will not sow,
And he who regards the clouds will not reap.
5 As you do not know what is the way of the wind,[a]
Or how the bones grow in the womb of her who is with child,
So you do not know the works of God who makes everything.
6 In the morning sow your seed,
And in the evening do not withhold your hand;
For you do not know which will prosper,
Either this or that,
Or whether both alike will be good. [Eccelesiates 11:1-6, NKJV, copyright Thomas Nelson]

The point of Ecclesiastes 11:1-6 is that the farmer in Spring, much as he might be hungry, and want to eat his seed corn, instead has to cast his seed into the muddy soil, perhaps planting 7 or 8 crops, because he doesn?t know what the future may bring. If he looks at the sky, wondering if it will rain enough, or whether the winds might ruin the crops, he will never get a crop in Summer or Fall.

That?s the way that I view investing. You always have to have something going on. You can?t leave the market entirely, because it?s really tough to tell what the market might give you. Typically, across my entire set of investments I run with about 70% equity investments, and the rest cash, bonds, and the little hovel that I live in. Private equity is a modest chunk of my equity holdings, so public equities are about 60% of what I own. Domestic public equities are about 45%.

I don?t think of that as particularly bullish or bearish. Even with public equities trading at high price-to-sales ratios, my portfolio doesn?t trade at high ratios of sales, cash flow, earnings, or book value. Together with industry selection, modest valuations provide some support against bear markets.

My tendency will be if the market moves lower from here to layer in slowly using my rebalancing discipline. That?s what I did in my worst period 6/2002-9/2002, and the stocks that I held at the end were ideally positioned for the turn in the market.

So, I never get very bullish, or bearish. I see the troubles in the markets, and I avoid most problem areas, such as in housing-related areas, but I continue to plug along, doing what I do best — trying to pick good stocks and industries (and occasionally, countries.)

Should the FOMC Statement have been a Surprise?

Should the FOMC Statement have been a Surprise?

Here?s the quick answer: no.? The Fed Statement was what I expected.? Read Dr. Jeff?s pieces on the reaction to the Statement; he hits the nail on the head.? No one should have been surprised at 25 bps, no differential change in the discount rate, and an evenhanded statement.? Real GDP is still growing, unemployment is low, and inflation is low also (pardon any differences on measurement issues).

There are too many people who are little better than cheerleaders for the equity markets, and think that the Fed should cater its policy for the good of public equity shareholders.? Forget what you think the FOMC should do.? I gave that up seven years ago, and it was amazing how much better my FOMC forecasting became.

The Fed only has three functions:

  • Keep inflation low (as they measure it)
  • Keep labor unemployment low (as they measure it)
  • Protect the security of the depositary financial system, particularly that which is affiliated with the Federal Reserve.

Three functions the Fed does not have:

  • The exchange value of the dollar, except as it affects inflation
  • Affecting the value of the bond market (though they occasionally mess around there trying to affect the shape of the yield curve)
  • Preserving the value of the stock market.

At some level of fall in the stock market, the Fed does care, but only because it affects soundness of the banking system and labor unemployment.? While the stock market is within 10% of record highs, it does not figure into the calculations of the FOMC.? Maybe at a decline of 30% it does matter to them.

Now, this doesn?t mean that the FOMC isn?t going to eventually lower the Fed funds rate to 3% at some point in 2008.? I believe they will still do that, largely because of the effect that falling housing prices will have on the credit of the residential mortgage market, and not just Subprime, but Alt-A, and Prime loans as well.

The thing is, the FOMC is off on a fool?s errand.? The cheap credit that they inject will overstimulate healthy assets, perhaps encouraging healthy US firms to level up using short-term finance, and buy back stock.? It?s one of the few areas of strength left.? What else could absorb the incremental credit?? The US government?? Maybe.

Cheap credit can?t reflate a sector in fundamental oversupply, like residential housing, unless the FOMC were willing to let inflation rip, perhaps leading the value of residential housing to rise, as it did in the ?70s.? More likely though, is that commodities that are in short supply globally would rise, like coal, steel, oil, gold, rare minerals, etc., and only after a while, would housing prices rise, as nominal incomes become large enough, and household formation great enough for the excess supply to disappear.

But inflation would lead mortgage rates to rise, which would cut against the ability to afford housing.? So, let this be a takeaway.? The FOMC is using their powers for other than there stated purposes, but grudgingly.? Their actions may preserve some marginal lenders, but will be inadequate to reflate housing, particularly in the short run.

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Now, I wrote the above while on a plane heading from LA to Baltimore, so I only found out about the Fed’s announcement about their term loan facility when I got home this evening.? Not to be a perpetual pessimist, but I think this idea is more show than substance.? The Fed can discontinue this program after two months.? The Fed has not done a permanent injection of liquidity since May 3rd, and growth in the monetary base is anemic.? All of the growth in broader monetary aggregates is coming from the banks stretching their balance sheets.

This may work in the short run to lower the TED spread, but unless the Fed makes a commitment that they will keep doing this until the market sees things their way, it will not have a major effect on the markets.? I don’t care how many different types of collateral they might take; if they won’t guarantee to take that collateral on favorable terms for a long time, it will amount to nothing by mid-2008.? For a clue to the market’s view, watch the change in 1-month LIBOR versus 12-month LIBOR.? True credibility will be measured by the change in the yield on 12-month LIBOR.

Book Review: The Dick Davis Dividend

Book Review: The Dick Davis Dividend

I must confess that I had merely heard of Dick Davis, but did not know much about him until reading his book. I enjoyed his book, and think it is useful to new investors, and investors that have been unsuccessful in actively managing their own portfolios. I have read the whole book; this is not a review that comes from bullet points suggested by the publisher or author (sent to me and others, I have ignored them). I do have a minor criticism of the book; more on that later.

The Book

The first thing to appreciate about the book is its structure. After learning about the long career of the author, the book begins with a small amount of basic ideas per chapter, moves to progressively larger numbers of ideas per chapter that are less basic, and then returns the way it came, ending with progressively fewer ideas per chapter, but more basic ones.

The second thing to appreciate is the humility of Mr. Davis. His first answer to most investment questions is ?I don?t know,? followed by reasons for and against the proposed course of action, after which he would indicate an opinion if he has one, and then say that he could be wrong, and that it would be good to do further study.

What does the book emphasize?

  • Passive investing (ETFs and index funds)
  • Careful selection of active managers.
  • Imitating those carefully selected active managers if one decides to invest in common stocks directly.
  • Avoiding too much trading, because the average investor tends to panic at bottoms, and get greedy at tops. Buying and selling have to be properly timed, because the average investor tends to do worse than the buy-and-hold investor.
  • Be careful with costs on mutual funds. Most aren?t worthy of the fees, and with bond funds, cost advantages are the most durable.
  • Invest for the long haul, realizing there will be bumps along the way, and keep enough excess liquidity on hand.
  • There is no one right person or opinion. Things shift in the market, and trends often last longer than expected.
  • Be wary of news flow; get a thick skin toward the multitude of opinions presented.
  • Asset allocation is the key discipline to risk control; diversify broadly by asset class, country, style, etc.
  • You can?t win every time, but you can tilt the odds in your favor.
  • Use stop losses to limit losses. (I disagree. Use loss points to review your thesis, and if it is wrong, sell. Get a second opinion also. Otherwise, buy more.)
  • Rising dividends beat high dividends
  • Many strategies can work in the market; it?s more a question of when and how you apply them.
  • Macro forecasting rarely works.
  • Buying and holding the equity market tends to work over the long run, so have a core investment in the equity markets.
  • Humility is a core character attribute of good investors. (Be more like Charles Kirk, and less like Jim Cramer… he spends several pages on this.)

Beyond that, Mr. Davis gives lists of good investment books, good investment blogs (I?m not on his list, so it goes), quotations, and active managers. I thought his favorite active managers to be a very good list for those looking for active mutual funds. The investment books were generally classics, though some are too new to tell. As for the blogs, well, we are here today and gone tomorrow. We are only as good as the last few things we publish, so good financial blogging is not something that a book can capture. We vary too much.

Now for my one criticism. The book has one long chapter on index fund portfolios that takes up 20% of the book, and gives 28 models (with sub-models) for ?set it and forget it portfolios.? There are a couple of problems here: first, there are too many strategies here, and many don?t differ enough to deserve separate inclusion. Second, it would be better to spend more time on the factors behind why someone might choose one approach rather then another. What goes into creating a good asset allocation? How much should I have in bonds? Foreign bonds? Foreign equities? Cash? Obscure asset classes? I?m not asking for detailed math, but rules of thumb for average investors to follow, so that they could find a passive strategy that is among those strategies that would be more likely to meet their needs.

But with that one cavil, I can recommend this book to investors, particularly those that have not done well with active management. This book won?t teach you what to do, as much as how to think and discipline yourself. Most investors should limit their options in investing because their emotions and abilities aren?t suited to the violence of the markets.

For investors that do well with active management, you don?t need this book, but you might like it for the stories that he tells, or as a gift for relatives who need to follow a more passive style of investment management.

Full disclosure: I get a modest amount of money if you buy the book through the link above.

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