Author Archives: Scalper1

3 Things I Think I Think – Financial Crisis Edition

Here are some things I think I am thinking about: Warren Buffett on the financial crisis, investing with a sound premise & silly Congressional ideas. 1 – What Caused the Financial Crisis according to Warren Buffett? The National Archives released documents related to the Financial Crisis late last week. Among them were some interviews with Warren Buffett on the crisis. I noticed that, aside from being nerdy white guys, the only thing I might have in common with Buffett is that we both believe the cause of the financial crisis was, well, just about everybody: I think the primary cause was an almost universal belief, among everybody ‑ and I don’t ascribe particular blame to any part of it – whether it’s Congress, media, regulators, homeowners, mortgage bankers, Wall Street ‑ everybody ‑ that houses prices would go up. ” I’ve described this several times over the last 7 years and every time I do it, I seem to catch a bunch of flak from people with a political bone to pick. And every time I see someone trying to place sole blame on “the government” or “Wall Street” or “house flippers” or whoever, I am reminded of how common fallacies of composition are in the financial world. We don’t see things in totality. We see what we want to see inside of the big picture so we can confirm what we already believe. This just leads to a lot of narrow-minded thinking that causes more arguments than objective analysis. 2 – Investing with a False Premise. One comment I disagreed with (at least partly) was Buffett quoting Ben Graham on investing with a false premise: ” You can get in a whole lot more trouble in investing with a sound premise than with a false premise .” I don’t know about that. If you’ve read my paper on the monetary system or portfolio construction , you’ve probably noticed that this is the primary thing I am trying to avoid when analyzing the economy – false premises. There are so many myths and misconceptions about money that you can get into a lot of trouble buying into these ideas. Whether it’s flawed concepts like the money multiplier, crowding out, being a permabull/bear, dividend investing for safe income, “beat the market” or whatever. Starting with a sound premise is an intelligent way to improve the odds that you’ll succeed going forward. Of course, you have to maintain some rationality within this context. Extremists get killed in the financial markets because they tend to go all in on what they believe. Believing that house prices never go down was obviously irrational (and I had that argument with a lot of people back in 2005/6), but the fact that asset prices usually go up is not an unsound premise from which to start because the economy usually expands and people tend to become more productive over time. So, in this example, being a rational optimist always beats being a perma pessimist AND a perma optimist. 3 – Let’s talk about that silly balanced budget idea. One myth that just never dies is this idea that the US government is going bankrupt and needs to tighten its belt so we avoid impending crisis. I’ve spent an inordinate amount of time debunking this myth over the last decade, but I wanted to congratulate a group of economists for fighting back against a truly stupid idea – a federal balanced budget amendment. Mark Thoma linked to this letter yesterday highlighting the dangers of a balanced budget amendment. I’ll just point out two facts: First, one of the most powerful economic policies we have in place is what’s called automatic stabilizers. This is the tendency for the budget deficit/surplus to expand and contract naturally to offset economic conditions. So, during a recession, government deficits rise because spending naturally increases due to things like unemployment benefits while tax receipts decline. This leads to more income to the private sector and a flow of net financial assets that helps offset the decline. And the exact opposite happens during booms thereby cushioning against the risk of booms. If we had a balanced budget amendment in place, the economy would likely be a lot more volatile because these stabilizers would be gone. Second, the federal government plays an important role in ensuring that our states don’t turn into Greece. As I’ve explained before , since the states have balanced budget amendments, they are constrained by a true solvency constraint. The states, like Greece, have real limits on how much debt they can issue. But since the US states run trade surpluses/deficits against one another with no foreign exchange rebalancing then the poor states are always exporting more dollars than they’re importing. They can borrow to offset this, but there’s a Congressionally mandated limit to this borrowing. So, where does the income come from that helps avoid inevitable insolvency and occasional financial crisis? You guessed it – it comes from the federal government who takes more from the rich states and redistributes it to the poor states. It sounds like socialism, but it’s actually saving capitalism from itself. And it works beautifully in the case of a single currency system by helping us avoid the debacle of a situation that is Europe….

Does Market Volatility Favor Active Management?

By Aye Soe Twice a year, S&P Dow Jones Indices releases the SPIVA U.S. Scorecard. The scorecard measures the performance of actively managed equity and fixed income funds across various categories. Since the initiation of the report in 2002, the results have consistently shown that managers across most categories overwhelmingly underperform on a relative basis against their corresponding benchmarks over a medium-to-long-term investment horizon. The Year-End 2015 SPIVA U.S. Scorecard reveals little surprise. The second half of 2015 was marked by significant market volatility, which was brought forth by plunging commodity prices, a strengthening U.S. dollar, growing global concerns over Chinese economic growth, and the subsequent devaluation of the Chinese renminbi. Market volatility, in theory, favors active investing, because managers can tactically move out of their positions at their discretion and park themselves in cash. Passive investing, on the other hand, has to remain fully invested in the market. Investors in actively managed strategies should therefore realize fewer losses during periods of heightened volatility, all else being equal. Given this theoretical background, recent volatility in the market has supporters of active investing proclaiming that active management is back in favor. However, over a decade of experience in publishing the SPIVA Scorecard has painfully taught us that active funds don’t always perform better than their passive counterparts during those precise periods in which active management skills seem to be called for. Exhibit 1 compares the performance of actively managed equity funds across the nine style boxes during the 2000-2002 bear market, the financial crisis of 2008, and 2015. As the data clearly show, there is no consistent pattern across most of the categories. Large-cap value managers appear to be the only exception to the losing trend, outperforming their benchmark in both bear markets. Again in 2015, mid-cap value is the only winning equity category, with the majority (67.65%) of them outperforming the S&P MidCap 400® Value . Disclosure: © S&P Dow Jones Indices LLC 2015. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to S&P DJI. This material is reproduced with the prior written consent of S&P DJI. For more information on S&P DJI and to see our full disclaimer, visit www.spdji.com/terms-of-use .

Bill Ackman Is Nothing More Than A Big Bet Gambler

Taking concentrated fundamental bets is no different than playing craps in Vegas. By now, you’ve heard about Bill Ackman and his white whale, Valeant Pharmaceuticals (NYSE: VRX ). In 2015, Valeant plummeted and Ackman’s fund was down 20.5%. His misfortune continued into 2016, with his fund losing another 26% year to date after Valeant’s latest drop. Valeant’s share price was cut in half that day, and the troubled manager lost a cool billion on his position. Talk about a bad day at the office… A billionaire like Ackman could really use a lesson in risk control from a market technician. His hubris and ego has literally cost him billions. He’s failed to execute the most important rule for successful investing and trading – cutting losses. You would think he learned something from his first rodeo when he went “all-in” on a failing company. Ackman’s first hedge fund, Gotham Partners, doubled down on a bad bet and blew up as well. But remarkably, he was able to convince more people to come ride the pain train again in his new fund, Pershing Square. The importance of risk management and trade management in the market cannot be overstated. That’s why at Macro Ops , we use both fundamentals and technicals in our process. Stock picking and conviction is not enough to succeed in this game. In pure fundamental investing, it’s believed that the lower the price (all else equal), the more attractive the trade. This is because price is further away from the investor’s best guess (and yes, it’s nothing more than a guess) of “fair value”. This is not the case in technical investing. Technicians approach the market in the opposite fashion. They would tell you that price below your cost is a signal to exit. You’re wrong, and receiving negative feedback from the market. The attractiveness of the trade decreases as the price moves against you. We side with the technicians on this one. Arrogant fundamentalists like Ackman never admit defeat and never cut losses. Instead, they buy more because they believe they’re buying at a “better” price. At the beginning of 2016, Ackman doubled down and bought more Valeant shares despite piss poor performance in 2015. That’s called doubling down on stupid… The stock just continued to fall lower after his purchase. As you can see below, from its high, Valeant has lost over 87% of its value. Click to enlarge This approach of averaging down and holding onto losing bets is nothing more than gambling. Investing icons such as Ackman like to make big calls. If they’re right, assets under management swell. If they’re wrong, the fund blows out. Which is exactly what happened with Ackman’s first fund, Gotham Partners. This approach to markets has zero risk control. It’s the “pennies in front of a steamroller” trade in different form. No one can continuously outsmart the market, even with a Harvard MBA. If you don’t cut your losses, the market will do it for you with a margin call. And to make matters worse, your precious investors will redeem their assets once they see a big loss on their statements. This may come as a shocker, but the most important thing in trading has little to do with whether you find an undervalued stock that rises in price. Don’t take this the wrong way, trade selection has value, but it’s vastly subordinate to the path the underlying investment takes after you enter it, including how you manage that path. In other words, trade and risk management are a priority over everything else. A lot of people get confused when we talk about the “path of the underlying”, but the concept is simple. Take a look at the chart below: Click to enlarge The three lines represent three different “paths” that could play out after you buy a stock. The blue line trends straight to the target with little drawdown. The yellow line gives you a lot of heat, but eventually comes back and hits your target. And the purple line rewards you right off the bat, but then takes a turn for the worse. The purple line is Ackman’s Valeant. It’s impossible to predict this path with any amount of accuracy. You can try, but attempting to do so is akin to guessing what next Saturday’s Powerball numbers will be. You have zero control over whether people will buy your stock after you. You have zero control over what management will do in a company you don’t even operate. You have zero control over what the stock price does at all. But you DO have control over when you decide to hop on or off the path. At the end of the day, what shows up on your account statements are your entries and exits. Not your 80-page thesis that you touted to your Ivy League colleagues. The cold, hard profits and losses created by your buying and selling are the only thing that matter. Take any of your favorite performance metrics: Sharpe ratio, gain-to-pain ratio, Sortino ratio, and Calmar ratio. They all look at your equity curve, not your research. Your equity curve is what graphs your trading account’s performance. So ultimately, how you manage risk is what moves these numbers up or down. Your returns over your drawdowns is what matters the most, not whether you ended up being right on a thesis. This is why trade and risk management are far more important than investment selection for longevity and performance in the markets. To better explain this concept, let’s go back to the path diagram: Click to enlarge Pictured are three different scenarios, all of which you were “right” about at some point during the trade. Scenario one is the blue line. The blue line is the easiest path to stomach. It has little drawdown and slowly trends upward towards your valuation target. In raging bull markets, like we had since 2009, a lot of hotshot investors saw their picks trade in this fashion. They touted their “genius” and “insight”, which the investing public bought into, causing those managers’ AUM to soar. Scenario two is the yellow line. This is where things become tougher. Yes, your target was eventually hit, but look at the drawdown you had to suffer through to get there. Could you realistically stomach paper losses for the first year or so you were in the trade? How much doubt would you have? Also, holding this will put a dent in your performance metrics. Holding onto any type of drawdown will. Guys like Ackman will typically hold the yellow line, or even double down on the yellow line. This may work great for a while, until a purple line pops into your life… which can happen even if you’re a seasoned billionaire. Scenario three is the purple line – the most painful of them all. You bought the stock and were immediately rewarded. But it didn’t quite hit your valuation target. You were hoping for more from your little darling. Then, unforeseen information comes out and the stock starts to take a turn for the worse. But the initial run-up made you confident that the stock is a good company and that it’ll “come back.” Yet, as time passes, the stock drops, and you become more and more wrong. The anxiety and pain is now at level 11 out of 10. You aren’t sleeping at night. You’re pulling your hair out and questioning whether you had any investing skill in the first place. The problem is you never exit and control risk, because you believe in your own story over the market. The purple path is what finally blows out the arrogant who refuse to respect price. Holding onto a purple path is a career ender. It involves PERMANENT capital loss. And permanent loss in equities happens a lot more than you would think. You just never hear about the losers. Technicians wouldn’t stay on the purple path. They would react to the adverse price action and protect their profits. Or at least, exit that trade for a small loss. If stocks were illiquid like private investments, you would be stuck on the “path” and all the anxiety and negative emotions that come with it. But lucky for us, they aren’t! You don’t need to suffer through a purple path if you have appropriate trade and risk management. Fundamentalists can take a page from the technician’s handbook and have their entry and exit rules determined before they enter a trade. With rules in place, you can recover when you’re wrong and limit your account drawdowns to something that’s not career-ending. If you don’t control the path, the path will control you. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.