There have been a lot of articles written recently about a high average correlation level in the stock market.  I want to take a stab at explaining what it means and implies.

A few notes before I start.  First, remember that cash doesn’t enter or leave the market when we buy or sell.  Cash enters the market when new stocks, bonds, etc., get issued in exchange for cash.  Cash exits the market when stocks, bonds, etc., get retired in exchange for cash through buyouts, maturities, etc.  Second, when we buy or sell, the price changes based on whether buyers are sellers are more motivated to buy/sell the asset and sell/buy cash.  In the short run, even the amount of cash doesn’t change, aside from what the brokers and market-makers scrape off.

Note that this applies to ETFs as well.  Even as they grow, they suck in more of the stocks/bonds that they index, but after fees (more scrape) they are just shells, holding vehicles for assets.

Third, there are two reasons why assets can be highly correlated.  The first reason is that the business performance is geared to the same driver, for example, the expansion of credit.  The second reason is that the current and future ownership has similar motives for each asset, and trade each similarly.  The first is Ben Graham’s weighing machine, while the second is the voting machine.  The second reason is more relevant for what we are experiencing today.

Fourth, remember that correlation is not the same as beta.  Stock A always moves half as much as stock B.  The correlation is 1, but the beta versus B is 0.5.  Just because correlations are high does not mean every stock is moving the same amount.  It does mean that they are almost all moving in the same direction at mostly consistent relative amplitudes.

The preliminaries are done.  The most important aspect of my preliminaries is that we are likely dealing with Ben Graham’s voting machine as the causative factor for the high valuations.

Okay, now think of stocks and other assets as dependent on the time horizons of their investors.    If the time horizons of investors are predominantly long, correlations on assets should be low in the short-run, because investors don’t make decisions to trade off of short-term macro factors.  But when a large part of the investor base is skittish and is always running to or from the latest bit/byte/bite of data – that leads to high correlations.

ETFs aren’t necessary for high correlations, but they seem to help the process by creating easy ways for people to implement decisions that are a simple idea.   “I want financials, I don’t want energy, buy the long bond, sell gold.”

Thus high short-term correlations indicate a momentum mindset in the investor base.  Momentum investors are the “weak hands” of ownership.  They don’t have much of a balance sheet, and so their decisions are quick and correlated with short term price action.  The strong hands have balance sheets, or are long-term minded, and can “buy and hold” or “sell and sit on cash.”  That takes a lot of fortitude, particularly in the present environment.

In an era of high correlations, I have two things to say:

1)      When the voting machine is running hot, pay more attention to the weighing machine – the fundamental values that drive long-run investing.  Pretend you are Seth Klarman, Warren Buffett, or if you can’t imagine that, pretend you are me, and aim for the best over the next three years.

2)      In general, markets are near short-term peaks when the level of momentum investing is high.   Volatility tends to be high as well.  Volatility is inversely proportional to time horizon. (I.e., the longer you aim for in investing, the less you care about short-term volatility.)

Thus my conclusion is this: now is a time to pay attention to fundamental values.  Ignore the noise and protect your capital.  I know this sounds too simple, but when correlations get too high, act against the direction of the market.

PS — still don’t have power back from Irene.  Pray for us.  I get my work done at a backup site.

Even Hayek said something to the effect that there are no good solutions in the bust phase of the market.  Opportunities to avoid the bust come in the bull phase of the market.  How?

  • Fiscal authorities could lessen the advantages of financing with debt, leading to a decrease in debt employed.
  • Monetary authorities could keep monetary policy tight for longer, allowing bad debts to fail, rather than refinancing them with lower interest rates.  Let recessions do their real work of eliminating marginal economic concepts.

The Fed is supposed to take away the punch bowl when the party is getting too wild.  Greenspan (and to a lesser extent Bernanke, because he inherited Greenspan’s profligacy) did the opposite.

Instead of letting markets find their own level in a panic, they aided in the refinance of dud assets.  This led to a buildup of personal debts, particularly those financing housing.

But let’s consider the individual situations.  Start with 1987.  Alan Greenspan, new Fed Chairman reacts to the crash in October by promising loans to back up the market.  Wrong.  Let some market players fail, revealing the bad risks they had taken.  But no, this is the beginning of the Greenspan Put, and all of the malarkey that allowed risk-taking to extend  to every market because it seemed the Fed would rescue every crisis.

The stock market should not be an interest of monetary policy.  Focus on banks, and have them cut their links to the stock market.  Bonds are fine, that is lending.  Banks should not engage in speculation, if their deposits are guaranteed by the FDIC.

Then we come to the Commercial real estate crisis of the early 90s.  More projects needed to fail, but the Fed lowered rates to what were then unprecented levels, and enough marginal projects that should have failed survived.  The recession should have gone longer, and reduced overall debt levels.  But no, we end up with more debt and a reduced marginal productivity of capital.

In 1994, the residential mortgage market imploded because of perverse bets on the volatility of residential mortgage prices.  The rout led to a self reinforcing rise in interest rates, and then the Fed loosened too soon, once again.

By this time aggregate debt levels had risen dramatically since 1984.  With lower interest rates, the interest burden was lower, but the principal burden was higher, because people refinanced, and began to take money out.

Also in 1994, speculators on Mexican Cetes were partially rescued by the US Government through a set of loans to the Mexican Government.  This led to a greater sense that the US Government would back up speculators if they were big enough group.

In 1998, the Fed could have let investment banks sweat over Long Term Capital Management and Russia, but no, they forced them to cooperate while injecting a lot more liquidity into the system.

As a result, bad loans persisted and the marginal efficiency of capital fell, as companies and people refinanced.

In 2000, the Fed had its last chance to right the system in the midst of the tech bubble.  Instead of leaving rates high, because the general economy was not under that much threat, the Fed loosened down to unimaginable levels, mainly to force a bubble in US Housing, which would lead the economy out of the recession, which it did and then some.

In doing so, the Fed pushed debt levels relative to GDP far higher than they were during the Great Depression.  Because overall debt levels create depressions, I sometimes wonder that the supposed scholar Bernanke, and the toady Greenspan did not consider that they were setting up the seeds of destruction.

By 2007, the situation is too far gone, as the Fed tightens, it reveals systemic weaknesses as debt is too high relative to GDP, and we find ourselves in a structural depression, as opposed to a cyclical recession.

In 2008, if the Fed had not loosened, maybe things would have been worse in the short-to-intermediate run.  I expect that if deposits were protected, and losses of senior unsecured capped at 25%, the system would have survived.

But no, the Fed acted to increase leverage more, again.  In this new era, since 1984, that’s all it can do.

When does the day of reckoning come?  I trust the masses more than the elites.  Where is the bailout for the masses?  The elites got more than their share recently.  Is the helicopter of happiness going to fly over the homes of average people anytime soon?

If Bernanke ever believed in Milton Friedman’s view of the economy, it does not show here.  There is no increase in inflation, at least in the assets that need it.  There is only inflation in the prices of assets that are healthy, and little in those that are sick.

There should be no surprise here; it is impossible to reinflate a dud asset, except at high cost.

My point is this: who pushed for greater austerity when it would not have hurt our republic?  Few.

Instead, the debt grew exponentially as the Fed created the Great Moderation, which in other terms would be eventually be called a liquidity trap.

Though the US government is guilty for its deficits, and fostering a culture favoring debt over equity, the Fed is more guilty for not keeping interest rates higher, letting moderate recessions do their good work of eliminating malinvestment.  That might have prevented this current crisis.

There are no good solutions now.  Bail out this, bail out that.

Eventually there will be a fail of some sort.  I just don’t know what, when or how.

This book review is different.  It was written back in 1963, and has not been reprinted.  If you want to buy it, you will have to buy it used.  My copy used to be a part of the Newport, Rhode Island Public Library.  It is a short recounting of the economic history of the Pilgrims.  The total pages allocated to the main text are less than 60 pages.

But a good 60 pages they are.  Michael Milken once self-servingly said, “America was built on Junk Bonds.”  If we were talking about the Pilgrims some might say their effort was financed by loan sharks, but really, it would be fairer to say that they were financed by venture capitalists, which occasionally worked on an equity basis, and also on a debt basis.

The author does not dwell on the religious views of the Pilgrims, aside from the effects it had on the financing of the colony.  Given that this was written in 1963 that is not a weakness, because writers in that era had better historical knowledge than most in the present era, in my opinion.

Though the book has only two chapters, it breaks down into 5 phases:

  1. The decision to emigrate from Leyden (in Holland) to the New World, obtaining an initial patent, gaining financial backers who were less than reliable, to the formation of a Joint Stock company.
  2. Leaving England and arriving at Plymouth, Massachusetts which was not their intended destination.   Disaster happens with their Winter arrival, with many dying.  The initial ability to service the debt is poor, which leads to squabbles among the financiers.  The joint-stock company breaks up, and the Pilgrims agree to buy out the financiers at a price that gives the financiers a profit, but leaves the leaders of the colony in debt to a new set of financiers.
  3. Socialistic policies lead to disaster, until residents get their own land to till, leading to relative local prosperity.  In order to pay down debts the Pilgrims enter the fur trade, though with difficulties.
  4. They get a new patent, and find that their agent, Isaac Allerton, was not fully trustworthy.  Disputes over accounting embroil the Pilgrims and their financiers, probably to the detriment of the Pilgrims.
  5. Their financiers quarrel among themselves, after which an agreement is struck, where the amounts of goods that the Pilgrims delivered are adequate to pay off the debt.

The book doesn’t deal with the aftermath.  Anyone that has read Bradford’s writings on Plymouth Plantation would recognize that at the end, Bradford was dispirited, because almost all of those who came and survived, had moved further west to get more and better lands.  The religious motives of the colony were sufficient for its founding, but proved inadequate for its continuation.  After 25 years, the debts were paid, but for the most part, the colony had evaporated.

The collective financiers earned a handsome return, between 20-40%/year, maybe.  We don’t have enough details to be certain.  All I know is that the heavenly reward of the Pilgrims was far greater than their earthly toils to pay back their financiers.


The book could have dealt a little more closely with the motivations of the pilgrims, and their willingness to take deals that were against their interests.  Yes, the pilgrims were not as financially savvy as those that financed them, but they weren’t stupid either.  They were desperate to get out of the Netherlands and Britain.  That desperation drove some of the bad deals they took, and made them look like a bad risk, which narrowed down who would deal with them.  Leaving that aside, financing for most colonial ventures was stiff.

Who would benefit from this book: If you want to understand the economic struggles that the Pilgrims undertook, you will like this book.  If you want to, you can try to buy it here: Debts Hopeful and Desperate: Financing the Plymouth Colony.

Full disclosure: I bought the book with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.


T+1 will raise volatility.  Often increases in the technical efficiency of information or trading systems increase volatility, because people can act precipitously on information, all at the same time.

There was an effort in the early 2000s to make almost all securities settle as a rule in one day.  Three days was the rule for most markets then, as it is now.  Government bonds settle differently, and some other securities as well.  The effort to settle transactions more quickly failed, and we still settle trades in three days.

I was glad when the move to T+1 failed.  There were efforts to move to T+0 behind it.  Not that I had many trades that I needed to break as a bond manager (I had one, the phone call to do so made me ill), but I knew there were settlement failures even at T+3, and the stress on the back office would be considerable.  Better to go slower, and have fewer failures.

I prefer stability over efficiency.  Efficient systems tend to require high attention.  Stable systems have redundancy.  Not everything has to go right for the system to work.  In my example above, T+1 required a lot more accuracy, and T+0 would be unimaginable.  We would need angels to clear trades.

That’s one reason why I am not crazy about market efficiency.  Yes, efficiency is a good thing as far as it goes, but when it begins to impact stability I part ways with efficiency.


It is inefficient to have a balance sheet.  All of the slack capital that you don’t need all of the time.  Far better to be a trader with no significant balance sheet, the profits will be greater.

I disagree.  Though this is an extreme example, look at Buffett with his purchase of Bank of America preferred stock with warrants.  In a single stroke, he protected the downside, and allowed for the participation in the upside.  He probably understands that his credibility can move markets.  The preferred stock can be stuffed inside an insurance entity with little capital cost, while the warrants can be held at the holding company.

Bank of America entered into expensive financing with Buffett who had cash at a critical moment.  Give the Buffster props for his cleverness in the tub — he understood their need of capital, and gave it to them in away where they could deny the need for new capital.  Brilliance.

Brilliance, so long as the losses never reach down into the preferred equity portion of their balance sheet.


Having a balance sheet allows for modest losses to occur and the system does not fail.  But it means that some capital is not deployed; it is there in reserve for disasters.

That is why financial systems with excess capital survive better.  Yes, it is inefficient to carry capital that does not earn much, but it is more inefficient to fail.  Think of the Baumol model, where there is an economic order quantity.  The same can be applied to finance, where the is a level of efficiency below which we should not go, because of ordinary volatility.

Volatile markets require intermediaries, or at least, systems that slow settlement.   Slack in the system is not wasted, but is there to protect against catastrophes.  That is a benefit to all, even those that seek to make markets more efficient.

There has been a boatload of articles arguing how the US is going the way of Japan.  I know, I have added to the crowd.  Tonight’s piece is meant to nuance my views, because there are similarities and differences between the US and Japan (20 years ago).


  • High private debt levels leading to high government debt levels, as the government “rescues” selected areas of the private sector
  • Asset bubble deflating
  • Desire for security drives government interest rates lower
  • Intractable government deficits
  • Both have warped monetary policy to try to deal with the problem.
  • Slow to fix banking problems; reluctance to take big banks under.
  • An unwillingness to note that the problems are structural, not cyclical.
  • Failure to recognize that growth is not a birthright.  Proper policies must be maintained.
  • Slow response from legislators.
  • Low growth is anticipated, because of high private debt levels.


  • Japan’s deficit is self-funded for now.
  • Demographics in the US are far more favorable.
  • US Economy more open to global competition.
  • No Tohoku tsunami in the US.
  • Japanese politics don’t care as much about their problems.
  • Japan’s debts were debts of over-production, rather than over-consumption.

Michael Pettis argues that increases in productive capacity will be more harshly treated than over-consumption.  Quoting his most recent piece:

These – with the possible exception of the debt – are not the problems from which the US or Europe are suffering. They suffer from a typical debt-fueled overconsumption boom, whereas Japan suffered from a typical debt-fueled over-investment boom, and Japan’s period of over-investment was much, much more extreme (centralized investment booms can last much longer and go much further than decentralized consumption booms). This is why I think the Japanese experience tells us almost nothing about what Europe and the US will go through.

On the other hand, it might tell us a lot about what China will go through. In fact we can make a more general point. Command economies (Japan, the USSR, Brazil and many others during their “miracle” periods) tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments. Capitalist democracies are more prone to consumption-driven booms, which aren’t as extreme and don’t last as long, and their adjustments tend to be brutal but relatively quick.

This is a great generalization, of course, and every specific country departs from the generalization in very specific ways.

I think the right answer to the question of whether the US is going the route of Japan is no, but there are similarities, and significant differences.  In Japan, they entered their troubles with corporations and banks overly indebted, whereas in the US it was consumers and banks. A lot depends on how much US consumers reduce debt, making them more capable of buying goods and services in the future.

With a over-production there is no guarantee that the world will ever get up to the level where they demand all the capacity that was developed.  With over-consumption, many debts will get compromised, lenders may be in a funk for a time, but there should be cleaner ways of clearing away and paying off the overindebtedness.

In the Great Depression, the US was in the position of being the over-producer.  Other nations indebted to the US came through the experience better.  Japan was the over-producer of the 1980s.  This time, the US will probably come through the crisis better than China and other creditors of the US.  No guarantees, but foolish lenders eventually get their comeuppance.  We’ve seen that recently… if somewhat short-circuited by the government/Fed.

I was too bold in my prior statements on Hurricane Irene.  Though ordinarily forecast errors persist, as of early Thursday, the errors have straightened out and the path of the storm is clear.  That said, I think the risk of large insured losses are still not high.  The picture above is for 39+ mph winds over the next five days.  That won’t do much to most of the east coast.  Here, look at a graph of Hurricane force winds:

Not so much, huh?  There are a lot of insurers and reinsurers worth buying in this environment.

I invest in a lot of insurance companies.  It is the industry I know best.  When I worked for a hedge fund as an insurance analyst, they called me the weatherman.  I subscribed to a wide variety of services on hurricanes, but I eventually concluded that the forecasts of major hurricane analysts have a bias, and the best thing to do is to look at the error versus the forecasts, because when the error goes to the left, it tends to go further to the left, and vice-versa for the right.  In this case, the storm Irene is rightward biased versus the forecasts.

That’s why I said this two days ago.  It’s easy to panic over hurricanes, but harder to analyze the situation and suggest that the estimate are wrong.

At worst, I think Hurricane Irene will clip the easternmost point of North Carolina at worst, and very possibly miss the US entirely.  Little risk to the insurance industry.

This book was surprisingly good, and ambitious.  It takes on the short-term nature of our business culture in many areas:

  1. The nature of the problem is that the owners no longer work for the corporations, and so managers run companies for shorter term objectives.  Owners would care more about the survival and long run profitability of the firm.
  2. Much of the financial crisis stemmed from managing for the short-term, as financial institutions moved from a originate-to-hold to an originate-to-sell model.
  3. Corporations focused on meeting quarterly earnings estimates, possibly to the exclusion of longer-term profitability improvements.
  4. Investment managers manage for the short run as they try to beat indexes in the short run rather than over the long term.  Investors pulling money in the short term influences that.

The book then takes on these problems, and proposes solutions:

  1. Create the proper long-term incentives for all parties: Executives, Line managers, and Employees.  I think he gets it right.  Make them long-term, and relative to a proper market index.  Or do it on a book basis, but make the hurdles reflect the cost of capital.
  2. Communicate to the external world that you are no longer going to play the short-term game, like Berkshire Hathaway.  No more earnings guidance, and no more pseudo-earnings guidance where the analysts get enough to publish their estimates.
  3. Most boldly: adopt new accounting principles that revolve around free cash flow, not earnings.  Make balance sheets probabilistic.  (even as an actuary, I don’t think we are ready for that, good as it would be)
  4. Incent investment managers properly.  This is probably the weakest part of the book, because the problem of incenting investment managers properly is probably impossible.
  5. Finally, how to make money.  Concentrate your investments, and if you are a good investor, you will make money over the index.

Now, some of these insights are truisms: sure concentrate your investments, and if you have good insights, you will do well.  Duh.  Most professional managers don’t have good insights, but they aren’t dropping out, and their investors are sticky enough.  That will be hard to change.

But creating longer term incentives for managers and realizable goals for workers are significant ideas.  I have argued for these for some time.  At my fellowship admissions course for the Society of Actuaries, I remember arguing with a consultant over these ideas, where she told me that longer-term incentives were unrealistic.

In a similar vein much of the book argues that you should think like a life actuary (my words, not the author’s).  Discount over the long term, taking into account interest rates and likelihood of the cash flows occurring.  I can heartily back that idea, though I wonder how well the average professional would deal with the concept.  Imagine a new income statement that has a pessimistic, realistic, and optimistic scenarios, and has ranges for accrual items off of that.  I would enjoy that, but the average investor would blanch at the complexity.

Average professionals, much less investors, don’t do well with probability  They want a point estimate and that is human nature.  Are we trying to create the NEW CAPITALIST MAN here?

Maybe, and I actually like the effort, though I think it won’t amount to much. Eliminating self-interest is very difficult; channeling it is another matter.


The book uses the exact same quote from Peter Bernstein on pages 54 & 130… come on, you can do better than that.  Where is the editor?

Beyond that, if you are going to rework the income statement, then differentiate between investment capital expenditures, and maintenance capital expenditures.

I think the proposed excess return versus shortfall ratio is flawed.  Under your definition, a manager who beats once by a lot, and loses often by a little, but loses versus the index overall would look good.  I think it is better to just look at long term returns versus the index, and consider Buffett’s dictum, “I would rather have a noisy 15% than a smooth 12%.”

Who would benefit from this book: Those who want to see a better capitalist economy built could benefit from this book.  If you want to, you can buy it here: Saving Capitalism From Short-Termism: How to Build Long-Term Value and Take Back Our Financial Future.

Full disclosure: The publisher sent me a copy of the book for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

A reader sent me the following question:

Hi David, this is shall be link to your impossible dream part 2 question.

You mention in the article date May13 that we are probably at #4 part of cycle (looking back great called) Where are we in the part of the cycle? ( I would assume we are in #5) if that is the cast..why you added large 5 of your cash in this sell off? (for trading or for investing) Hope I am not asking too much since I am not a client, only long time reader whom respect your opinion.

Here’s the article he was referencing.  There is a tension between my equity management and the switching strategy I proposed in the first Impossible Dream question.  If we are in a market where we should be allocating asset to safe areas, why am I buying more equities here?

It’s a question of time horizon.  The switch model tells you what will do well for the next month.  I am playing for longer horizons.  That’s why I have my seventh portfolio rule:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

My best purchases occur in bear markets.  I buy things that are safe but way out of favor, and they rocket back when the market finally turns.  That adds a lot to my alpha, which is more than the advantage of switching, historically.  That’s why I average down in bear markets, if the thesis behind the investments is still valid.

As for what phase we are in, I would say 5 or 6. Cycles aren’t neat.  In this case, we don’t have a lot of defaults, but we do have a lot of negative momentum in equities. In four months we have moved from top momentum, top valuation, to bottom momentum middling valu1ation.  That is pretty deep in the don’t buy stocks region, but it often offers the best opportunities to long only investors, if one is buying for three years, rather than one-to-six months.

So I continue to buy equities that are attractive, even in a market where bonds might be favored in the short run.  As for my clients, it is a question of investment horizon.  Short-term: bond strategy.  Long-term: equity strategy.

In general, I aim for the long term.