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In January 2009, the S&P500 index lost 8.6%, the worst January in its history. In February 2009, the S&P500 index lost 11%, the second-worst on record following the 18.4% decline in 1933. On March 1, 2009, the S&P500 lost 4.66%, the worst first day of March in its history. We know it feels like a century ago, but it was just in December 2008, Bloomberg surveyed market strategists for their 2009 S&P 500 price targets. Collectively, strategists were looking for a gain of 21.8% from the index's level then, or for the S&P500 to end 2009 at a price range of 975 to 1300. Call them stupid, but didn’t we all kind of enter 2009 a bit concerned of missing a market rally? After all, the S&P500 climbed 20% to end 2008 at 903.25 from its November 2008 low of 752.44. Although we knew 2009 was going to be a very challenging year, we believed a recovery would happen sooner rather than later.Obama stimulus package.
What has happened? There was certainly very bad news such as steadily rising unemployment, a disheartening GDP decrease of 6.2% in Q4 2008, the fastest pace since 1982, rising foreclosures, falling home sales and prices, rising credit card defaults, and continuing banking troubles. While all that news was bad, it was hardly surprising. The market had been waiting for the government to unveil a logical plan to deal with banks, given the build up for our new Treasury Secretary, and had hoped for a restoration of some fiscal discipline of the federal government. Those hopes turned out to be short lived. Starting with Geithner laying an egg during his first major address to the nation about the banking crisis, things only got worse as the month progressed.
Here are the various plans and proposals from the federal government that have been passed, or will likely be passed in the near future, which are largely responsible for the market slide, in our opinion. Obama stimulus package.
1. (2/13/2009) The “Un” Stimulus package passed. The $787 billion stimulus package was pieced together in 4 weeks and quickly passed in the Senate and House, with the final bill not read by a single House member before its passing. Rather than serving the purpose of stimulating the economy, a big portion of the government spending, which accounts for 2/3 of the bill, is to significantly expand federal power, promising to give billions of dollars in grants to local schools, to replace lost state aid, and to increase the federal share of Medicaid payments. While it is very questionable whether this package creates any sustainable stimulus, the bill represents 2.5% of two years’ US GDP, dwarfing Franklin Roosevelt's New Deal which never increased the deficit by more than 1.5% of the nation's GDP even during its biggest-spending year of 1934.
2. (2/18/2009) The Irresponsible Homeowner Affordability and Stability Plan. This plan aims to provide several forms of assistance to as many as 7-9 million home owners who may be at risk of defaulting on their mortgages. By investing in failure, we worry this will fundamentally change the average American’s views on self reliance and financial responsibility. In addition, because this plan is focused on reducing mortgage rates, and investors/lenders will be forced to cover a portion of the mortgage rate reduction, it will deter private sector investment from entering the mortgage market in the future. In addition to the overall concept, from a capital market perspective there are also some particularly troubling provisions in the bill.
A) To provide an extra incentive for borrowers to keep paying on time, the initiative will provide a monthly balance reduction payment that goes straight towards reducing the principal balance of the mortgage loan. As long as a borrower stays current on his/her loan, he/she can get up to $1,000 each year for five years.
B) It encourages the enactment of legislation allowing bankruptcy judges to alter the terms of certain mortgage loans, a practice that to date has been prohibited by federal law.
C) The program applies for loans made on Jan.1, 2009 or earlier and mortgages for single-family properties that are worth up to $729,750.
The formal endorsement by the President of a bankruptcy provision that allows judges to alter the terms of certain mortgages significantly increases the risk to lenders of all mortgages, which will keep many investors on the sidelines and result in higher risk adjusted returns. We believe this will lead lenders to require additional compensation for making loans, through either larger down payments or higher interest rates, which will deter potential borrowers with good and excellent credit from owning a house. By allowing certain principal reductions through a government subsidy, the plan allows the irresponsible to enjoy the potential upside of property value appreciation in addition to the favorable mortgage rates responsible homeowners cannot obtain. This bailout’s loan origination cut-off date is also deeply troubling. If someone bought a house in 2008, as the real estate slump was widely known and in full force, and is now close to default, we believe the borrower should take the sole responsibility for his/her poor decision and cannot possibly blame anyone or anything else for their troubles.
Lastly but most importantly, the long-term moral hazard issues of rewarding irresponsibility and recklessness by having the 93% of the American people pay for the 7%’s mortgages is really disturbing for a society that has long thrived and relied on common sense and self-reliance. It is true that declining house values negatively affect the 93% and obviously we don’t want to see that continue. However, it is not obvious that keeping people in homes they cannot afford is a good solution to getting the housing market back to a sustainable equilibrium. As Rick Santelli captured on a live on air rant, it seems Americans do not want to pay for our failing neighbors’ mortgages to possibly inflate our house values.
3. (2/26/2009) President Obama’s Ambitious Budget. President Obama unveiled a $3.6 trillion budget for fiscal 2010 (ending Sep 2010), making a major down payment on his priorities and marking a historic shift toward greater government involvement in health care, energy and education, while raising taxes on the wealthiest Americans. The budget was a declaration of hostility toward capitalists across the economy. Every voluntary risk-taker and investor now knows that another tax increase will slam the economy in 2011, even if the current crisis subsides in the year ahead. Based on this budget plan, the projected federal deficit will be $1.75 trillion for 2009, or 12.3% of the GDP, a level not seen since 1942 as the U.S. plunged into World War II. The projected federal deficit will be $1.17 billion or 8% of the projected GDP for 2010. While the projected federal spending that is sending the country towards a nanny state is disturbing, the means the federal government will utilize to achieve this goal, mainly via tax increases, are damaging.
A) Based on the announced budget proposal, taxes will rise for singles earning $200,000 and couples earning $250,000, beginning in 2011, for a total windfall of $656 billion over 10 years. Income tax hikes would raise $339 billion alone. Limits on personal exemptions and itemized deductions would bring in another $180 billion. Higher capital gains rates would bring in $118 billion. The estate tax scheduled to be repealed next year would be preserved, with the value of estates over $3.5 million or $7 million for couple, taxed at 45%.
B) The budget is to reap $210 billion over the next decade by limiting the ability of U.S. based multinational companies to shield overseas profits from taxation. Another $24 billion would come from hedge fund and private equity managers, whose income would be taxed at income tax rates, instead of capital gains rates. Oil and gas companies would suffer most, with the repeal of multiple tax credits and deductions.
C) It also plans to cap the emissions of greenhouse gases, forcing polluters to purchase permits for emissions that would be brought down. The sale of those permits, beginning in 2012, would reap $646 billion through 2019.
We are very leery of the tax revenue assumptions on which this budget is based. When President Reagan cut taxes, the fear was that government revenues would plunge, as a result of static projection models. These models tend to work as follows: If taxes today are 70% and income is $100, the government collects $70. If tax rates are cut to 28%, such models project the government will only collect $28. However, the reality during that time showed that as workers and entrepreneurs were given greater incentives to work and take risks, the economy flourished, and revenues to the government actually increased during the Reagan era. We fear that this new budget raises the price of making investments and taking risk, which will be a long-term losing proposition. As people adjust to new tax realities, they will scale back their work and investment activities, with the result being that real revenues to the government fall short of existing projections, as the economy slows more than expected and fewer Americans secure attractive jobs, or lose them as a result of a slower and smaller economy. The stories we have heard in the past weeks include dentists, doctors, accountants, lawyers, who are ready to work less by laying off clients and workers so they make just $249,999 a year.
Over time we have learned that the hard work of individuals is not enough, if government policies are not set to maximize individual growth potential through a rewarding mechanism. A brick layer will not achieve greater prosperity if his employer doesn’t seek to expand his business. An office worker will not receive raises if his company does not grow and become more profitable. Scientists will not create new inventions if investors don’t supply capital to fund their research and development. As taxes on capital and income increase, the barriers to grow a business will likewise increase, resulting in less business for everyone and less wealth to share around. This works to dampen the lives of all people that are not already wealthy. No one would think of adding weights to Kobe Bryant’s or Lebron James’s ankles before they play a game so the talent disparity with other players on the court can be lessened.
The “rich” are not thieves or robbers. While some may have gotten lucky or been born to the “right” family, most of them have worked their butts off, enduring long hours of study, work, uncomfortable risk, and multiple failures before they get to where they are. The “rich” are not the enemies of average folks. The “rich” create jobs for both themselves and the average folks.
Somehow, in the name of reducing income inequality, it has become fashionable to handicap the deployment of capital and application of labor. While income inequality makes for great headlines and is an easy target to advance wealth redistribution policies, it misses the key focus of a good policy – maximizing the wellbeing and life quality for the average citizen. China had perfect income equality between 1950 and 1980 when the country’s economy was in a slump. It is now the world’s 3rd largest economy, despite a rapidly expanding “wealthy few”.
History has shown wealth is best achieved by implementing policies that promote long-term sustainable growth and innovation in the economy. Ultimately that means working to lower barriers to investing capital and supplying labor. The current policies advanced in the new budget do not meet those ends. More alarming, the attitude taken by the new administration seems to echo the recent history of California, where a ravenous government has created an unrealistic budget problem, and has driven highly skilled individuals out of the state.
It is interesting that these new policies are not at all well defined or agreed or proved effective, but will likely be implemented to a system that has worked amazingly well based on different sets of principles. But here is something to consider when evaluating the risk/return of even small changes to our existing political and economic system. Over a century, the difference between an economy that grows at a 3.5% annual real rate of return versus one that grows at a 1.5% real rate of return is 7-fold. An economy worth $1 that grows at 3.5% over a century is worth $31, while the economy that grows at 1.5% is only worth $4.4. That 7-fold increase in the wealth of the economy translates into a greater living standard for all citizens versus the slower growth alternative. While faster growth will likely lead to greater income disparity, few people would willingly belong to the slower growing, more homogeneous economy.
Let’s end the letter quoting what Buffett wrote in Berkshire Hathaway’s 2008 annual report:
Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.
Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.
We want to emphasize, however, that Americans do not possess a special strand of DNA, or unique wiring or have morphed into a new species. We have overcome all of those obstacles and made the US the most prosperous nation the world has seen through the ages because, and only because, our political and economic system has placed the individuals above the government, and has allowed individuals to freely pursue their dreams, and fulfill their potential. The price of our freedom and prosperity has been the dual taxes of self-responsibility and self-reliance. This country will have better days, but the question is when, and how much pain has to be endured before the right policies are in place to get the US economy’s mighty growth engine roaring again.
1. Focus investments and don't spend to preserve
Each government needs to draw up a priority list during these times of scarcity and decide where it has the best shot at a competitive advantage for the next century in the global economy. Resources are scarce in this day and age so we must focus those resources and investments. The future economy is like a start up. It needs extreme focus to engender success. We also need to be like venture capitalists and kill the ideas that are not working.
How can we focus the resources? We should pour lots of money and offer incentives up and down the stack in that chosen industry from universities to businesses to worker training in order to create a critical mass cluster in those areas. In my own country, Israel, I would argue we need to invest massively in Digital Innovation (broadband), Water, Biotechnology and probably Energy or Agriculture. How can we do this?
Let's take digital innovation as an example. The Israeli government must invest to upgrade the broadband infrastructure with more underwater cables, bandwidth to the home etc. Like Korea, 100 MBPS should be the near term target. This will enable Israelis to work at home for companies across the globe and not be limited to job creation and demand for skills in tiny Israel.
With increased bandwidth, the government should provide micro-loans and tax incentives to people who work independently from home in the digital economy. We should provide tax incentives to these workers since they are saving money on gasoline, road upkeep, traffic accidents, to encourage them to work at home and hire others. We should incentivize profitable IT companies to hire and retrain more of our workers with tax rebates per worker trained. The government should shower university labs with money for post-docs and basic research into innovation that will drive the 21st century economy and to keep our brains in Israel and bring back those that have left. The same can be done in agriculture where Israel is a world leader and has critical mass and in Water where we need to get much better and already have an advantage. This type of investment must be done at all levels in order for it to work and truly drive innovation.
2. Do not be afraid of virtual companies and local production
I alluded to this in #1 above. I have had two experiences with startups that have most, if not all, of their workers working remotely. It has its challenges but is incredibly cost effective and efficient when you learn to manage it.
Think of the time saved not driving to work. That is extra responsiveness and productivity. It forces a great spirit of collaboration and removes a lot of office politics.
A corollary of this is local production. I referred above to agriculture. The 20th century saw a dramatic move to centralized agriculture (read this excellent NYT article). It turns out that industrial agriculture has a lot of unwanted side effects from transportation costs to fuel consumption to abuse of the land. That is a model that can be rethought. In fact it is already happening. CSAs and local farms are gaining steam (for a good summary see my favorite agricultural site www.localharvest.com). These are local businesses run by fellow members of my community who are improving both the health of our diets and the environment as well as creating local jobs and living symbiotically with our natural resources.
3. Invest in retraining
We keep stimulating businesses and preserving jobs at these companies but the companies keep laying off folks and taking more stimulus money. That should tell us something about the shrinking need both for those businesses and the skills of its laborers. Let's rethink how we take care of the workers. In fact, we need to take care of the employees but not necessarily the businesses. Morally and socially, society owes workers respect, decency and a shot at earning a good living. It is not their fault that technology advances and changing economics has eroded their employer's business.
While at a macro level, we cannot provide for everyone, that should be our goal nonetheless. You will notice that even in my example of digital innovation above, there are jobs for technology savvy people and blue collar workers as well. Israel is today reeling from the potential impending closure of a vegetable packing plant and a chicken packing plant. The plants have been losing money. I do not know if it is from poor management or a bad business model. However, they will not be the first or last factories to close as production and packaging seeks cheaper global alternatives.
We need to invest in retraining these people in local agriculture, in laying fiber optic cables and other elements of 21st century economies when Israel will be less competitive in certain areas. We owe it to these workers to take care of them, not by pouring good money after bad to prop up failing factories but in exhilarating them to tackle a new career that they can certainly handle with the government's retraining help. We must invest in worker retraining in the focus areas the governments will lay out. The government, which has never been particularly adept at retraining, can offer tax rebates to successful businesses to retrain many of these workers. I believe it will not cost more than paying people unemployment and the societal costs of thousands of disgruntled former employees.
4. Reexamine business models.
I spoke in my previous post about the anomaly in the music industry of people paying 10X for a concert ticket what they pay for the same number of songs on iTunes. They also pay $1.99 for a ring tone when the song costs a buck. Go figure.
Lets use the music industry as an example of a business that can reexamine its business model. For years the music industry sold songs (it still does, just digitally) . Like newsprint, music is IP. It can move in bits and on physical media and today I can get it any way I like and often for free but I am still willing to pay lots of money to go to a concert. Why? The experience.
Here is an idea: Artists and music labels need to start turning music intro a consumable experience rather than a sale of songs. Here is just one idea among many: how about if the labels or artists sold you ten songs by an artist, 3 ringtones, special digital photos of the artist for your screen saver or social network profile, behind the scenes video of the song making (unseen footage!!), priority access to concert tickets (real or virtual) and membership in the artist's fan club for 10 bucks. You could let them post this all to their social networking profiles with a cool badge and label so they get digital reputation for having spent the dough and they market it to their friends. I bet this will be as profitable for the music industry as selling CDs for $10. Media costs are lower, ad costs are lower, there is zero distribution cost and I may not need to pay Apple (AAPL). Artists will need to reach out to their fans online as part of the fan club but they spend time on that anyway. It will be a good way to identify who and where your fans are so you can plan concerts and marketing properly. Sell the experience. Not the individual IP asset.
The same reexamination can be done in agriculture, water and any other industry. We just need new blood and new brains to think and invest deeply in the stack of innovation.
5. Market your expertise not your time and labor
I hosted a panel the other day at Israel's Internet Association annual conference. At the end of the panel I remarked to everyone in the audience that they needed to build their digital reputation and domain expertise because that will become their job of the future. Next thing I know, the next day the WSJ runs an article on the same topic entitled "Selling Expertise on the Internet for Extra Cash." Here is the well-put money quote
"It was the economy," she says of her move to take her skills online. "LivePerson is way more lucrative than my private practice." Ms. Estes had charged her private clients up to $75 an hour.
As the recession deepens, a small but growing number of people are taking their skills online, doling out expertise or performing specified tasks for a fee. Labor-at-the-keyboard sites are gaining popularity as people increasingly turn to the Web in search of work.
It is not just the layoffs but the structural change in the economy that makes it more lucrative to work from home and sell your expertise rather than your hours. In a knowledge economy, we should pay for knowledge and not time. Everyone is an expert at something and in many cases that expertise has economic value. When you think about the corporate cost equation above and the changing cost models required to compete in the 21st century, independently selling your expertise looks like an exciting model for many workers in the next century. It can be done remotely and globally and is not limited by local market size.
Governments should provide incentives for ongoing education and independent businesses owners that sell their expertise globally. This is the export economy of the 21st century. It is no longer crates shipped by boat and plane (although that will not go away) but keeping brains at home that will export their knowledge. Governments should stimulate this type of economic creativity. It will have meaningful societal and employment benefits as well.
As we continue thinking about stimulating the economy we need to encourage politicians to think about their children and our children. By increasing deficits and borrowing from tomorrow, we are mortgaging a big part of the future. By propping up failing businesses and business models we are bequeathing our slow adaptation to the 21st century to our children who will really not understand the 20th century that politicians think was built for them. Now is the time to invest for the future. It is a time to lay the roots of innovation rather than watering the decaying trees of the past.
We have arrived at a moment that defines leadership. Leadership requires hard and often unpopular decisions. It will take a remarkable group of political and business leaders who will be willing to stare down political pressure to spend on quick fixes in order to invest in stimulating innovation for the future. Let's hope they do it.
While the media’s master narrative is generally correct, an analysis of recent coverage reveals that it suffers from several problems. A major shortcoming is that the coverage tends to conflate all quantitative hedge funds and the investment strategies used by those funds and leaves the impression that it is the quantitative approach itself that is the problem. This becomes particularly apparent when one considers the discussion of “market-neutral” funds and strategies.
Recent coverage reports huge losses at market-neutral hedge funds and cites “non-quants” like ClearBridge Advisors’ Hersh Cohen in New York. Cohen denigrated market-neutral approaches in the WSJ and noted that “[he now realizes] that what sounded impressive was not much more than a thing we saw played out in 1987 and 1998.”
Or, one can consider the comments of oft-cited “Black Swan” pusher and former quant Nassim Nicholas Taleb, who tells the Washington Post that current-day quants are "very smart in front of a textbook but not smart enough to understand very elementary things in reality." In fact, “most” of the legions of PhDs toiling away on Wall Street, says Taleb, are merely “idiot savants brought to industrial proportion."
In an effort to explore the recent media criticism of market-neutral investing, we contacted ValuEngine View newsletter portfolio manager Eric Stokes to discuss his thoughts on the topic. Stokes, the author of “Market Neutral Investing” practices a hybrid form of the market neutral approach whereby he uses his own picks for the long side - which are based on his analysis of technicals as well as ValuEngine’s quantitative models, and ProShares S&P ETF (SH) for his shorts.
Stokes used the ValuEngine View portfolio results to illustrate the protection afforded by his preferred strategy. The portfolio, which is “long only” and rebalanced monthly, recently took a hit of 15.5% as the market gave up most of this year’s gains. However, if one had hedged the portfolio by investing an equal amount in Pro-Shares SH or any other similar ETF, the decline would have only been 3.2 %. That modest loss, notes Stokes “would have been far better than the S&P’s loss of 9%.”
Stokes cautioned investors to “remember not to throw the baby out with the bathwater.” He noted that “the problems of the supposedly market neutral large hedge funds were related to their reckless utilization of leverage to garner large returns as well as their inability to pick good shorts. With equity buyout firms buying up"dogs" based on attractive cash flow”- Stokes likes to use the Yellow Pages as a prime example of this phenomenon - ”it is tough to make sure that shorts really do"lose."”
The better coverage of the hedge fund meltdown notes that many of the big losers utilized strategies similar to their competitors along with huge multiples of leverage, and then, when faced with margin calls, liquidated their positions all at once. Thomson Financial claims that "many of the highly sophisticated quant funds employed similar investment approaches and held similar core holdings. This resulted in the funds selling similar long stocks and covering similar short positions." This factor, say the astute journalists, resulted in stock prices for long picks decreasing in value while the value of short picks increased.
But this role reversal between the long and short side did not effect all market- neutral investors. Consider the experience of ValuEngine client Forrest Warthman. Warthman uses ValuEngine Institutional software to trade and track several portfolios based on our quantitative models. Warthman’s tracking data for his VE Standard 20 Market-Neutral Strategy shows that the portfolio had a positive return of 2.82% for the period July18-August 10, 2007 while the S&P lost 9.02% for that timeframe. Warthman’s data for his VE Forecast 22 Market-Neutral Strategy demonstrates similar results with gains of 1.29%. For Warthman, the VE models’ short picks performed exactly as needed.
So, if one cannot condemn the market-neutral strategy or the use of quantitative models, what is to blame for the recent “unpleasantness?” One might start with an old standby, greed. It seems clear that many hedge-fund managers, mesmerized by the magic of leverage on their portfolios, resorted to ever increasing lines of credit in an effort to boost returns and personal gains. When one gets 20% off the top and is managing billions of dollars, it is easy to forget that high multiples of leverage will kill you if things go wrong like they did on August 9th, 2007.
One might also consider that many hedge funds were not using market-neutral strategies at all, but were actually engaged in various forms of statistical arbitrage whereby price differentials in securities, bonds, credit instruments, etc. were “found” by the firms’ quant models and then exploited. This is also an issue frequently glossed over in the ongoing orgy of quant bashing. These sorts of quant funds were not buying and selling stocks based on “old-fashioned” notions like value, they were exploiting loopholes in the system by making thousands or even millions of trades over brief timeframes. These sorts of quant funds also resorted to huge multiples of leverage, watched their loopholes disappear, and then--worst of all, liquidated in a panic as their credit dried up when the subprime crisis spread through the system.
What is truly disturbing about all of this quant bashing are the claims that the models were ill-equipped to predict the future or incapable of reacting to the crisis. That is nonsense. For the past several months, ValuEngine’s quantitative models indicated that ALL tracked sectors of the stock universe were “overvalued.” The last time that this occurred was six weeks prior to the May, 2006 market correction. Regular readers of ValuEngine’s bulletins were constantly reminded of this fact. Of course, timing is always the issue, and when any method of analysis solves this question the markets will cease to exist!
Here are a few things to remember the next time you read an article claiming that “quant has failed” or that “market-neutral approaches do not work:”
1. Not all market- neutral investors are losing money, many did not lose that much relative to recent gains, and many have already reversed recent losses.
2. Not everyone bought Exxon (XOM) and not all quant models provide the same picks.
3. Smart quant-based portfolio managers use human beings to check out model picks via fundamental and technical analysis as well as common sense.
4. Leverage always seems like “money for nothing” but when things go wrong, it will kill you.
5. Despite technological advances, investing still requires a commitment to value, steady growth over time, and the power of compound interest rather than get-rich-quick schemes. A bad month--or even a year, means little over the course of a thirty-year portfolio. Chasing the markets’ ups and downs is counterproductive;
6. “Garbage in, garbage out.” Quant models are only as good as their programmers and their data.
7. You will never see a computer model on CNBC red-faced and blubbering for the Fed Chairman to “open the window!”
