April 2010 Commentary
Sound Portfolio Advisors
June 10, 2010
Problems cannot be solved by the same level of thinking that created them
We have reached the point in the credit crisis where the post-mortem has begun of trying to determine what happened, why it happened and perhaps most importantly, what we can learn from it. Of these questions, the easiest to answer, at least on the surface, may be what happened.
As has been pointed out here before, what happened was a classic panic similar to many other financial crises going back (at least) hundreds of years in history. In most ways it is very much the same old story, but much worse than we have seen in modern times and much more unexpected because the widely held assumption was that we were now simply too sophisticated to have a recurrence of a good old-fashioned panic. The severity was greatly exacerbated due to the enormous amount of debt involved across economic sectors as well as the tight integration of the modern global economy.
It didn’t just seem severe at the time, it actually was. As more and more of the details become available, the picture of just how severe the depth of the crisis was has begun to emerge. It isn’t an overstatement to say that we came within days, and perhaps hours, of the failure of the global financial system. As much as that statement may sound like hyperbole, Andrew Ross Sorkin’s book, Too Big to Fail (which will likely prove to be the most complete record of the actual events of the credit crisis) claims that AIG came within 15 minutes of running out of cash and beginning to default on trades. Current efforts to engage in revisionist history of events aside, it’s difficult to make a plausible case that AIG’s collapse would not have resulted in the collapse of counterparties around the world. These were not just large institutions, but included individual life, auto and property insurance policies. Virtually all payment systems would have frozen, resulting in massive runs on financial institutions.
Prime and Proximate
The next and much more difficult question is why did it happen? Before getting too deeply into this question, we should build a framework of causes to work within. In both philosophy and risk management, causes are divided into proximate cause and prime cause. Insurance companies, perhaps ironically, deal with this issue all of the time. For example, let’s say a tree branch falls on your car and destroys it, which you think should be covered by your insurance. So you call the nice folks at the insurance company and they say “Yes, the branch falling was the cause of damage to your car. However, it was the category 5 hurricane that caused the branch to fall and you don’t have hurricane coverage. Sorry you get nothing.” The branch falling is the proximate cause, but the hurricane is the prime cause. This is really the point of the old joke “it wasn’t the fall (prime cause) that hurt him, it was the sudden stop (proximate cause).”
This is an important distinction because coverage of the credit crisis has cited a broad range of causes including excessive amounts of leverage and risk taking, a diminished regulatory structure, lax oversight, excessive greed, loose monetary policy, increasingly rapid speed with which information and panic can spread, the failure of corporate governance, the separation of the negative outcomes of risk taking from the risk taker and allowing financial institutions to become too big to fail. We’ll look at many of these causes in more detail later, where it will become apparent that most of these causes are proximate rather than prime.
Anatomy of a Panic
As mentioned above, the basic mechanics of this crisis were similar to panics throughout history which means that a review of the dynamics of these panics is probably in order. The fuel of panic fires is leverage (often known as debt) and lots of it, but saying a bubble is caused by too much leverage is an oversimplification that ignores how the leverage develops. So let’s explore how excessive leverage comes about.
All debt is preceded by someone extending credit to someone else (as the old saying goes “100% of all defaulted loans were approved by a banker”). Credit is based on faith. This faith is based on an idea that supports the belief that the debt will get repaid and that the collateral is worth at least as much as the loan and will retain its value. The stronger the belief in the idea is, the more credit is available. The more credit that is outstanding based upon a particular idea, the greater the motivation to foster this idea despite mounting evidence against the actual validity of the idea.
It is worth stopping here to point out that these ideas on which leverage is based, and from which bubble ultimately develop, don’t necessarily start out to be flawed or even incorrect. In fact in many cases they have been historically correct, or at least quite plausible, up until that point. However, just because something has always been the case does not mean that it will always be the case. Stating that you have never been in a car accident is very different from stating that you will never be in a car accident. In other words, past isn’t necessarily prologue.
To illustrate this point further let’s take the example of a person who turns 100 years old. We could say that based on past evidence, we have 36,500 instances (the number of days you have to live to be 100) of that person waking up every day, which leads us to the conclusion that the 100-year old will never die. This now starts to look pretty absurd and you’re probably saying to yourself, “just because they haven’t died doesn’t mean they won’t die.” You would say this because you’ve known and heard of lots of people dying and because by this point we are aware of the collective experience of several billion people having lived on the planet and as far as anyone can document (religious beliefs aside), no one has gotten out alive.
Imagine for a moment though, that we have just been beamed down from another planet and our 100-year old was the only person we had ever encountered and we were unaware of the billions of people who had lived and died before. Given the evidence of the thousands of prior days, we might well conclude that with a 100 year track record of successful living, this person will continue on indefinitely.
While this is perhaps an extreme example, it does illustrate how erroneous ideas develop from plausible facts. We’ve seen that these ideas don’t necessarily start out as untrue, but rather over time they are stretched to achieve unsupportable conclusions. In markets this is often done by latecomers to the game in an effort to justify ever greater amounts of leverage. Warren Buffett refers to this as the cycle of “innovators, imitators and idiots.” Innovators discover or create the idea, imitators copy and take advantage of it and the idiots don’t understand it, but try to copy it and make money like the other two, but end up holding the bag.
For an idea to support a bubble it has to be incredibly strong and widely held. Usually they are so strong and widely held that those souls brave enough to question them when the bubble is forming are labeled as heretics, idiots or worse for not buying into the “new paradigm.”
Eventually the evidence of the fallibility of the idea can no longer be ignored and finally overwhelms the firm grip with which it is held. The idea and all of the leverage piled on top of it comes crashing down. In other words, reality turns out be substantially different from what was very firmly believed or “known” to be the case.
Clinically this process of reality being different from expectation is referred to as disconfirmed expectancy and leads to the psychological process of cognitive dissonance. Speaking non-technically this is the mind’s version of short circuiting while trying to reconcile two clearly conflicting ideas. In other words, what happened was profoundly different from what you thought would happen. This is what a friend once referred to as an “aw-shucks” moment (or words similar to that). The aftermath of this process leads to a wide range of emotions including confusion, fear, anger and most importantly in this context, panic. This should sound pretty similar to the experience most investors had in the fall of 2008 and into the spring of 2009.
This process is certainly not limited to market participants and is essentially the same as the moments following an accident or unexpected death. For a useful, if not extreme, example of how we respond to a situation that differs significantly from expectation, we can go the Montana/Wyoming border in the summer of 1876. This was the scene of the Battle of Little Bighorn in which General Custer and his troops were completely wiped out by the opposing Lakota and Northern Cheyenne warriors. In the days following the battle, other Calvary troops, upon making distant sighting of warriors wearing parts of the uniforms of Custer’s troops, were unable to accept the obvious explanation and spent days conjuring often fantastical theories that would explain what they had seen in a way that did not involve the complete decimation of their comrades.
Fast forward more than 125 years from the plains to Wall Street and the modern financial system and you might recognize the same dynamic which took place. Time and technology have changed, but human nature remains constant.
Ultimately the panic subsides, and time fades the memory of the panic. Inevitably a next great idea begins to emerge and the cycle begins anew.
If you found the above description of the dynamics of bubble formation to be too esoteric, or just boring, below is a much more succinct summary.
Real World Karma Runs Over Theoretical Dogma
Now that we have a better sense of bubble dynamics, we can try to fill in some of the particulars of this last bubble and the resulting credit crisis. What may make this credit crisis unique, besides its sheer scale, is the number of ideas that have been heaped onto the bonfire of market reality. These ideas formed the basis for the massive leveraging necessary for a bubble as outlined above. We are, in many ways, now just collectively acknowledging the cognitive dissonance that has resulted from these long held beliefs being soundly disproved. We’ve discussed the importance of an idea to the development of a bubble, but what exactly were the ideas that this last one was built on? Below are what I think were the three prime causes on which the bubble was built in order of increasing importance.
The American Dream and the impossibility of a nationwide price decline in housing.
The idea that everyone should own their own home grew for decades and the ability to leverage home purchases grew along with it. As then President George W. Bush declared in 2003, “It is in our national interest that more people own their home.” This idea was by no means unique to him; rather he was echoing a belief widely held by both parties for decades. In retrospect, it would seem that there is a natural limit to the percentage of the population who can or should own their own home.
As Harvard professor Niall Ferguson points out in his book The Ascent of Money, before the 1930s just over 40% of households were owner occupied and mortgages were the exception, not the rule. What mortgages were taken out were usually much shorter term than the current norm, just 3-5 years. Contrast that with loans that were being underwritten in 2007 featuring the 40 year negative amortization option ARM mortgages with no income or job verification.
The related idea that we had never experienced a nationwide decline in house prices was widely held and often quoted as the justification for ever larger mortgage portfolios of declining quality. Historically some regional markets would decline, but other regions would remain stable or even increase in value. Essentially bubbles would form and burst in isolated markets rather than nationally. Lending, however, was also historically different as well with local banks making and servicing their own loans. The more recent development of national lenders and securitization accelerated the bubble formation.
We can eliminate risk through derivatives. As a refresher, derivatives are simply an instrument whose value is based on (or derived from) another security. They started innocently enough with farmers as a way to reduce the risk that the price of a crop would decline between planting and harvest. Simultaneously crop buyers could reduce the risk of a price increase between planting and harvest. You can see here where both the farmer and consumer reduce their risk because they know what the transaction price is going to be in the future (thus the term futures). Not all risk has been eliminated because there is still the risk that one of the parties won’t pay when the contract expires. Because everything in finance has to have an overly complicated name, this one is called counterparty risk. The other noteworthy feature of this transaction is that both parties had a direct interest in the underlying asset, in this case the crop. Counterparty risk and having an interest in the underlying asset will come to play an important role in the credit crisis.
Futures are the simplest form of derivative. Since the idea (innovation) worked so well for crops, someone thought the idea should be applied to stocks (imitators). Since that worked out so well (i.e., resulted in lots of large bonuses), Wall Street did what it does best and completely stretched the idea beyond all reasonable bounds by coming up with every conceivable type of derivative instrument imaginable, setting themselves up to be the last in the chain of Buffett’s innovators, imitators and idiots progression.
As these derivatives became more complex, they began to abandon the principles that made the simpler derivatives such as futures work so well. As noted above, these include having a direct interest in the underlying asset on which the derivative is based and understanding and acknowledging counterparty risk. By the time we got to the peak of the credit bubble in 2007, derivatives were literally being written on other derivatives that had an underlying asset of yet more derivatives that were ultimately backed by a pool of very low quality subprime mortgages. In this case not only did the end derivative buyer not have an interest in the underlying asset, almost no one knew what the underlying asset was or who the counterparties were. Even worse, it was widely believed that somehow these structures made all of the risk disappear.
But wait, it gets better. Not only did the risk not disappear (instead it just got shifted to another party), but no one could figure out where the risk was or where it could turn up next. It was this piece of cognitive dissonance and the fear of the unknown that it spawned, which took us to the brink of a complete seizure of the global financial system back in September and October of 2008.
An incredible aspect of the derivatives issue is how many times over the last 25 years they have created enormous problems and that we have failed to learn the appropriate lessons and take the necessary safeguards to prevent these blow ups.
Take for example the following description of a congressional hearing on derivatives:
“…then chairman of the House Committee on Banking, Finance and Urban Affairs released derivatives legislation he had been preparing. His bill included a proposal to study whether Congress could tax derivatives speculation and a law making “improper management” of derivatives illegal. Democratic Representative Edward Markey and others joined the fray. Markey’s office announced that he “has been concerned about how the market has expanded from sophisticated financial intermediaries and Fortune 100 companies toward smaller and less sophisticated end-users, either corporations or municipal governments.” ….Markey had asked the SEC to study derivatives more carefully and recent swings in the stock and bond markets…..“Instead of waiting for catastrophe to strike, we should show American financial leadership and take a proactive stance.”
The next day George Soros had the following testimony: “There are so many of them (derivatives), and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated investors….some other instruments offer exceptional returns because they carry the seeds of a total wipeout.” He also warned of a meltdown, in which regulatory authorities would have to intervene to protect the integrity of the financial system.
These hearings weren’t held in the last few weeks or even last few years as you might have thought. No, they were held 16 years ago in April, 1994. They were in reaction to the derivatives crisis at the time which involved the bankruptcy of Orange County, California, and significant losses at a number of companies including Gibson Greeting ($20 million) and Proctor & Gamble ($100 million), among a host of others. Ironically, at almost exactly the time of this testimony the venerable, 130-year old firm of Kidder Peabody was discovering that one of its traders had engaged in hundreds of millions of dollars worth of derivatives trades which had gone bad, effectively sinking the firm.
At the end of 1994 the Mexican Peso crashed, significantly aided by the Mexican banks’ use of derivatives, and resulted in the US and various international monetary authorities having to provide $50 billion in aid to the country to try to prop up its currency.
These derivatives blow-ups were followed the next year by a rogue trader named Nick Leeson using derivatives to make various bets on the Japanese stock market which resulted in the loss of $1.4 billion and in bringing down his employer, Barings, then the oldest bank in England. But, there was plenty more derivatives carnage to come.
In 1997, Victor Niederhoffer lost all of a $100 million hedge fund in a matter of a few days due to bad derivatives bets. Prior to that unfortunate turn of events, he was a widely accomplished and respected academic and hedge fund manager who had managed the top hedge fund in 1996 and was so well regarded that George Soros sent his own son to work for him.
The next year in 1998 the most spectacular derivatives disaster up until that time took place when the hedge fund Long Term Capital Management crashed. The firm’s highly leveraged derivatives bets resulted in losses of $4.6 billion and resulted in the intervention of regulatory officials to save the integrity of the financial system that Soros had predicted in his congressional testimony nearly five years earlier.
Derivatives can create such damage because, unlike stocks and bonds, the losses that many derivatives can generate go far beyond the amount invested and can be almost limitless. If you buy $10,000 of a stock and the company goes out of business you’ve lost $10,000. Buy $10,000 worth of a derivative that goes bad and you could lose millions. Now you can begin to understand why Warren Buffet referred to derivatives as “financial weapons of mass destruction.”
In the end many derivatives were, and continue to be, written not because they serve any social or economic purpose but because they generate enormous fees. This was possible because these derivatives were completely unregulated. How is it that a market of tens of trillions of dollars in size, that has destroyed numerous institutions and repeatedly put the entire financial world at risk, could be unregulated? It’s a good question with a lengthy answer, which just happens to be supplied below.
Markets and Investors are Rational. Of all of the ideas that led to the credit crisis the development of the beliefs that markets and investors are rational was clearly the most important prime cause. This belief and those associated with it, had been building for over 100 years before the credit crisis and ultimately grew to become the bedrock of economic and financial theory and regulation.
Before we start discussing whether markets and investors are rational, a few disclaimers are necessary. First, given that this paper is for general consumption and not a strict academic treatise, I’m going to make a number of simplifications with terminology. I will use the phrases efficient prices, rational investors and efficient markets to encompass the Efficient Market Hypothesis, the Rational Agent and Modern Portfolio Theory generally. It is important to understand these concepts because they have come to be the framework for all of modern finance and how the tens of trillions of dollars of the world’s assets are allocated and managed.
One of the central assumptions of these models is that the price of any security at any given time reflects all known information about that security. This is based on the theory that while each market participant may only have a little bit of information regarding a security, collectively they possess all known information about a security. Because of this, all known information about a security is baked into the price meaning that the price must be correct. The logical extension of this is that trying to pick securities is futile because as a market participant you can’t know as much as the market collectively. There is an old economics joke (that’s not a typo) that goes something like this;
Q: Why did the economist walk past the $100 bill on the sidewalk?
A: Because theoretically someone else already picked it up.
Another assumption underlying modern academic and economic theory is that of the rational agent. In other words, individuals act rationally when making economic and financial decisions and emotions don’t enter into the process. This actually started out not so much as a theory, but as a simplifying assumption that allowed academics to focus more on market dynamics and get past the details concerning individual agents. The problem that developed over the years is that subsequent academics and practitioners forgot that this was a mere simplifying assumption made for the sake of expediency and came to regard it as an inarguable truth.
These efficient securities prices and rational investors then comprise efficient markets. Efficient markets, it follows, provide the best allocation of capital for society and are self-correcting. Those who allocate capital well are richly rewarded and those who allocate capital poorly are brutally punished. The rewards and punishments are meted out by the market through redistribution of capital from those who acted badly with it to those who treated it well. It has been said that market crashes are a mechanism for returning capital to its rightful owner. To summarize, the theories lead to the conclusion that rational investors and perfectly efficient securities prices create markets which themselves create the optimal allocation of capital for society.
Just as derivatives started out to be a very good and useful idea, but eventually became overrun, distorted and overwrought, so too did the concepts of efficient prices and markets and rational investors. We eventually came to believe that markets and prices weren’t just rational and efficient, but that they were perfect. This was academic gospel, handed down from genuine Nobel-prize winners high atop the ivory tower of the University of Chicago. To argue with the established paradigm was academic career suicide.
This belief in the perfection of markets carried over to the regulation (or lack thereof) of those markets. This started in earnest in the 1980s as a reaction to what had been a period of intense regulation and had been building since the aftermath of the Great Depression. The idea culminated in the belief that, since markets were perfect, regulation of them was not only unnecessary, but served to hinder and distort the perfection of the markets.
Eventually a great deal of the regulations put in place following the 1929 crash were dismantled. Probably the culmination of this regulatory dismantling was the repeal of the Glass-Steagall Act in 1999 which separated commercial banks from investment banking and insurance. In addition to the repeal of regulation, enforcement was often politically neutralized as was the case of the Securities and Exchange Commission.
As the regulatory mantle was shrugged off, institutions began to merge and grow larger. This larger size and the accompanying expanded resources resulted in greater influence over the regulatory structure which oversaw them. This led to institutions growing even larger and garnering greater influence over their own oversight and so on, in a self-reinforcing cycle that resulted in institutions that were so massively overleveraged and so systemically important that their failure would be socially catastrophic. Thus the multi-trillion dollar derivatives market went unregulated and the era of Too Big To Fail was upon us.
There was no better poster child for this movement than Alan Greenspan. In his view, the ever-larger financial institutions that came about from a diminished regulatory environment were quite useful because they could underwrite products that reassigned risks that simply couldn’t be done by smaller banks. Furthermore, these financial institutions would be essentially self-regulating because competitors would keep each other in check. It was these philosophical underpinnings that led Greenspan to thwart any attempts to regulate the derivatives markets.
As an aside, it is important to point out that these swings between the Ayn Rand-style, Laissez-Faire approach of virtually no regulation of markets on one end and the populist approach of put the bankers-in-straightjackets and eat-the-rich overregulation on the other is as old as financial bubbles are. In their extreme, neither approach is particularly beneficial to society. A complete lack of regulatory oversight results in dislocations that are too severe for the body politic to endure and can result in social instability. Excess regulation on the other hand, severely limits growth. Historically we swing through just the right mix as we’re busy rushing from one extreme to the other.
A Brief History of Efficiency
To understand why the efficient market theory became so dominant, we have to go all the way back to the late 1800’s when economics and finance first began to show up on the radar screen of mathematics and science. It was then that mathematicians began to look at markets as testing grounds for then-emerging theories and approaches, specifically in the fields of probabilities and statistics. Economists have long aspired to be taken seriously as a “hard” science rather than a social science and this provided just the opening they were looking for. By the mid-twentieth century a full scale move to more mathematical-based models, greatly aided by the advent of the electronic computer, was in full swing and was a great boon to this aspiration. This movement to more scientific (appearing at least), quantitative models resulted in a Nobel award for economics being created in 1968. It is worth noting that economics is the only prize that is associated with Nobel that wasn’t specified in Alfred Nobel’s will.
The problem with economics being categorized along with the natural sciences is that there is an expectation of discovery of objective, immutable, unchanging laws. The discovery of these laws has, in fact, been the primary focus of research in finance and related economics. The underlying assumption was that there was an objective, immutable model and set of laws to be discovered that govern how markets work. Like the laws of nature or laws of science, it was assumed that these laws of economics and finance, once discovered, would be timeless. The laws of gravity haven’t changed much since Newton’s time and so it was believed that the economic and financial laws and models being put forth were equally immutable.
The Price Isn’t Necessarily Right
We can see how theories of markets, prices and investors provided the philosophical cover to create an environment for systemic failure. Were or are these theories fundamentally flawed?
Let’s look first at the rational agent. As mentioned earlier this was actually more of a simplifying assumption to be able to focus on the dynamics of securities pricing and markets than a stand alone theory. The problem that developed over the years is that subsequent academics and practitioners forgot that this was a mere simplifying assumption made for the sake of expediency and came to regard it as an inarguable truth.
The rational agent began to come unraveled as early as the 1970’s with the work of psychologists Ivan Tversky and Dan Kahnemann, whose work shows that market participants really aren’t always rational. The good news, however, was that people did tend to show consistent irrationality. In fact an entire series of identifiable, consistent irrationalities have been shown to exist through a number of very simply replicated experiments. In summary, they show that we are unduly influenced by our environment and recent events. We also tend to be too overconfident in our abilities, much more sensitive to loss than gain and are very influenced by being in a group. In other words, we’re not the cool, objective and rational thinkers we believe we are.
Given the widely erratic price swings and investor behavior of the last 18 months, it would seem all but impossible to defend the rational agent, efficient prices or efficient markets in their strongest forms. Even those who held most vehemently to these principles, many of whom were personally involved in the dismantling of the regulatory structure and building the edifice of the perfect market doctrine, crumbled and recanted in the depths of the crisis. As Ben Bernanke said to Henry Paulson at the height of the crisis, “There are no atheists in foxholes and no ideologues in financial crises.”
What these three failed beliefs have in common is they were used as justification for leverage and involved leaps of faith across chasms that were ultimately too wide. The fact that there had never been a nationwide housing price decline does not logically lead to the conclusion that there can never be a nationwide housing price decline. Derivatives in and of themselves are a very useful concept. Derivatives that contort and hide risk and exist for no economic reason other than fee generation are a very bad idea. A theoretical framework for the making of economic decisions and capital allocation is a very useful concept. A theory that forgets that simplifying assumptions were made in its’ construction and denies regularly occurring real world events might be worse than no theory at all. All are plausible theories and useful facts on the surface, but the overwhelming majority of believers failed to realize when the train went off the track.
The invalidation of the idea of the impossibility of a national housing decline and derivatives’ ability to eliminate risk are more product-oriented, historically standard bubble justifiers. The failure of the edifice of theoretical economics and finance is clearly the most significant and problematic in that it represents the death of a central and very dominant paradigm.
Real Rational Investors
Despite the iron clad grip of the rational market theories and the resulting “why bother” indexing approach by the academic community, a few practitioners had long-rejected the theories. Interestingly, these practitioners include the first and second most successful investors of our (and perhaps all) time, namely Warren Buffett and George Soros. Buffett has made $50 billion from investing while Soros has $13 billion (but he’s given away $7 billion). While united by their rejection of the dominant academic theories of the era, their investment styles, philosophies and even personalities couldn’t be more different.
Soros is a super-sophisticated philosopher/investor that specializes in global macroeconomic trends at their broadest. In the parlance of the industry he is top down and cares very little about specific companies or stocks except as they may relate to an overall thesis. Soros essentially says that of course markets aren’t rational because bubbles form and burst, they always have and they always will as long as people are involved. He further aims to not only identify a bubble, but participate in its expansion, correctly decide where the top of the bubble is and then short the bubble as it deflates. An approach probably best described as simple, but not easy.
In pursuing his approach Soros has formed his own, and by many accounts, arcane philosophy on markets centered on his concept of “reflexivity.” It is based on the idea that systems (like markets) that involve people are not static, but dynamic, that is to say subject to change. In the case of markets, as participants react to market events, it induces changes in the markets, which causes further reaction from market participants, inducing more market changes, and so on such that the outcome is largely unpredictable.
His thesis is somewhat analogous to the idea from the field of quantum physics which says that the observer effect inherently affects the observed. The mere act of observing something changes it. If this is the case, as Soros believes it is with markets, then true objectivity is impossible. He further argues that the mere realization of the imperfection of our information makes our information much more useful (or more perfect to get completely ridiculous).
This imperfect understanding would mean that we can never accurately predict outcomes because we can’t hope to perfectly understand the situation, therefore we must expect the unexpected. This could easily lead one to the question if we expect the unexpected, does the unexpected then become the expected? Soros might say “exactly what I’ve been trying to say for years!” He might also add the caveat that our mere expecting it reduces its likelihood.
Contrast the somewhat complex and arcane philosophy of Soros with the plain, home-spun and usually obvious-sounding approach of Warren Buffet. Buffett lives in Omaha, Nebraska, in the same house he bought in 1957 and drives himself around in a late model Cadillac. In contrast to Soros’ global macro view, Buffett made his fortune focusing on individual stocks. His approach also involves the core thesis that the markets and their participants aren’t always rational or efficient. Buffett’s (and any value investor’s) true skill is in identifying intrinsic value or what the price of a stock should be as distinct from what the markets says it is and exploiting that gap. Again, simple, but not easy. After purchasing a stock that he believes is undervalued by the market, Buffett’s preferred holding period is “forever.” In short, Buffett has shown that it is possible to value securities more accurately than the market does. This has proven so difficult for the rational market and indexing adherents to believe, that they simply choose not to.
The academics discount using either Buffett or Soros as evidence against rational market doctrine by arguing that their results are random, unique events from which we aren’t entitled to more general conclusions. In other words, both practitioners are such rare, unique cases that they just don’t count. The wheels come off of this argumentative wagon with the evidence that their results are neither rare nor unique. Soros has plenty of company among fellow managers following a similar approach, not the least of whom is his ex-partner Jim Rodgers.
Buffett, in typical fashion, addressed the issue quite clearly and well before others in a speech he gave at his alma mater, Columbia Business School, commemorating the 50th anniversary of the publication of Securities Analysis, the bible of value investing, written by his mentors Ben Graham and David Dodd. Perhaps most interestingly this was in 1984, so Buffet has been facing this criticism for over 25 years.
In short, Buffett lays out why he isn’t a freak product of the Gaussian bell curve that we all understand as random chance. If he were, in fact, a freak product of random chance, he shouldn’t personally know any (or at least very, very few) of the other managers (out of a pool of tens of thousands) who significantly outperformed the markets up until the period when he gave that speech in 1984. According to the academics the number that would have outperformed the market consistently over any given time period would have been so small as to be statistically insignificant, essentially random freaks of nature with nothing in common other than their own lucky outperformance.
Buffet goes on to talk about nine managers that he has known, who had until that point significantly outperformed the market on a consistent basis over different time periods. They didn’t all hold the same securities or necessarily even use the same approach.
The only things they had in common were their adherence to the principles laid out by Graham and Dodd and their outperformance of the market.
It’s worth noting that Buffett’s performance wasn’t much inhibited by his speech as he went on to produce a return of 8,420% from the date of the speech, May 17, 1984, through January 30, 2010, versus a return of 586% for the S&P 500 over the same period. That means that $10,000 invested with Buffett would have become $842,000 versus $58,600 in the S&P 500, an outperformance of better than 15 times. This sort of consistent outperformance across multiple, non-random managers should certainly have caught the attention of the academics strongly advocating efficient market theories. Assuming, of course, that they were interested in the pursuit of objective reality above the furthering of their own careers. Apparently it isn’t just Wall Street investment bankers are consumed by self-interest.
So what was the response by the academic community to this evidence? Largely deafening silence punctuated with periodic condescension. According to a paper presented at a conference in Australia in 2004:
Despite this exceptional record, as far as references to either the man or his methods in standard finance or economic texts, Buffett is virtually invisible…..in a search of 23,000 pages of finance only 20 pages referred to Buffett. Similarly, a search of the leading academic journals for references to Buffett and Berkshire Hathaway located only a handful of articles.
Even more, many of the references to Buffett are simply there to dismiss his results as a statistical anomaly…..Nobel Laureate, Merton Miller explains “if there are 10,000 people looking at the stocks and trying to pick winners, well 1 in 10,000 is going to score, by chance alone, a great coup, and that’s all that’s going on.” Burton Malkiel says “In any activity in which large numbers of people are engaged, although the average is likely to predominate, the unexpected is bound to happen. The very small number of really good performers we find in the investment management business actually is not at all inconsistent with the laws of chance.”
Why let the evidence get in the way of a good academic theory? As a practical matter, no one who has had a successful academic career, let alone won a Nobel Prize, based on advancing a theory is suddenly going to say, “Wow, never mind, I guess I kind of really blew that call. Sorry.” No, you’re going to stick with your story at all possible costs.
In the words of Seth Klarman, quite possibly the best value investor of our time after Buffett (and my bet to succeed him at Berkshire Hathaway), “Fifty billion dollars are a lot of aberrations! Rather than abandon their theorizing to study Buffett exhaustively to see what lessons could be learned, too many people cannot bear to re-examine their faulty theories.”
It has been said that science advances in the graveyard. It is an attempt to say that the dominant paradigms of the day are vigorously defended by their inventor/discoverers in spite of the potential validity of other views. It is only when this literal old guard is gone that the field is opened up to other, potentially more accurate views.
In the case of economics and finance it isn’t so much the literal graveyard that sees old theories die, but the graveyards of crashing asset prices and markets. The last 18 months would seem to have provided the silver bullet that finally killed the efficient market vampire that had survived previous attempts on its life in the dot-com bust of 2000, the Long Term Capital Crisis of 1997 and the 1987 crash.
Soros, and his fellow successful macro approach practitioners, have shown that markets aren’t always rational. Buffett and his contemporaries have shown that securities prices aren’t always perfect. Both have shown, as has the field of behavioral finance, that the individuals who comprise markets and set securities prices aren’t always rational. In other words, Kahneman and Taversky killed the rational investor, Buffett killed the efficient security price and Soros killed the efficient market. Academia seems to be in no hurry to schedule the funerals.
Before exploring what all of this means on a practical basis and what the implications are for the day-to-day management of your portfolio, it is worth taking a moment to explore what is perhaps the most critical underlying dynamics that allowed these theories to develop. One of the critical features of developing theories in general and economics in particular is the necessity of making simplifying assumptions. People write papers based on other people’s papers which are in turn based on previous papers. This dynamic continues much like the children’s game of telephone until we no longer know what the original theory was. As part of this, what were originally simplifying assumptions morphed into gospel truth.
I am consistently amazed when I speak with my colleagues at how few of them have ever read the original seminal papers or books in the field. They basically look at other people’s synopsis of them and carry on without ever questioning their validity. This is the dynamic that led us to ultimately go from “markets are mostly efficient” to “markets are perfect.”
Perhaps by necessity, if everyone holds the same market belief, it is surely doomed to failure. Even what had become the most knowable and quotable of all investing truths in recent years, that indexing beats active management is ultimately headed for the graveyard.
The Death of Indexing
Where the rubber of the efficient market theories hit the investing road for the average person was the concept of indexing, also known as passive investing. This was really the distillation of rational market theories which said “the market is so rational and perfect that you can’t beat it, and trying to do so is futile, so just buy all of the stocks that comprise the index and go with the flow instead.” To support this, study after study purported to show that most actively managed funds didn’t consistently beat the index. Like any dominant paradigm that ultimately fails, this one was mostly true but certainly had its short-comings, which were largely ignored.
The concept of indexing eventually came to mean buying the S&P 500 index. The popularity of this approach peaked around 2000 just in time for adherents of the theory to get hit by what was by some measures the worst decade ever for large cap US stocks (those that comprise the S&P 500). Those who bought into the theory wholeheartedly were hit with a double whammy. They avoided all other asset classes, such as small cap, international and emerging market stocks as well as bonds and commodities all of which did considerably better than the S&P 500. In fact, of just about all of the things the average person was likely to invest in starting in 2000, buying the S&P 500 index was just about the worst thing one could have done.
Perhaps more importantly, the average actively managed large cap mutual fund beat the S&P 500 in the decade ending December 31, 2009. Having been there I can tell you with great certainty that if on December 31, 1999, you would have declared that for the next ten years most active managers would beat the index and that the highest returning asset classes would be gold, emerging markets, and real estate you would surely have been carted off in a suit that didn’t allow much mobility. The thundering herd achieves its greatest speed just before going over the cliff.
There were and remain two primary flaws with the indexing argument. The first is, which index should we use? The S&P 500? The Russell 2000? The MS Europe, Australasia, Far East (EAFE)? In short, while the academics claim that it isn’t possible to consistently beat “the market,” they often fail to define exactly which market they’re talking about.
What is also missing in this debate about active versus passive management is the concept of quality. These studies are all quantitative. It is economics and finance after all, and numbers, we’re told, don’t lie. The numbers may not lie, but perhaps they’re just looking at some of the wrong ones. A portfolio assembled by Warren Buffett, Seth Klarman, Julian Robertson or a host of other experienced, successful investors is hardly comparable to the portfolio assembled by the newly minted MBA running a portfolio for a third rate investment shop. Yet these studies don’t reflect anything of the sort. A portfolio is a portfolio is a portfolio.
As with every paradigm that goes through the innovators, imitators and idiots cycle, the idea of indexing went too far. Somewhere along the line the leap was made from “investors are unlikely to beat the market” to “investors cannot beat the market.”
So What Lessons Can We Learn?
The Dominant Market-Related Economic Paradigms Are Ineffective Markets and securities are not always efficient and investors are not always rational, and we have to stop pretending they are. The search for an all-encompassing theory of markets is the domain of the academics. As a practitioner it isn’t my job to solve the world’s problems, but rather to realize that inefficiencies exist and identify and take advantage of those on your behalf.
Too Big To Fail Is Too Big The well documented problem with Too Big To Fail is the implicit guarantee that goes along with that statement. In other words, it’s functional socio-economic blackmail. If the large financial firms don’t get bailed out when they’re in trouble, they’ll bring down the whole system. It’s not just about being too big, it’s about the risks that those that are too big take because they are effectively largely unregulated and have an implied safety net. Academics might call it asymmetrical risk-taking, but the rest of us would better understand it as the equivalent of walking into the casino, having someone hand us a pile of money and saying “you keep the winnings, I’ll take the losses.” Nice work if you can get it.
Since the credit crisis, not only have we failed to address the Too Big To Fail problem, but the Too Big have gotten bigger. Four U.S. institutions -- Bank of America Corp., Wells Fargo & Co., JPMorgan Chase & Co. and Citigroup -- held 35 percent of the country’s deposits on June 30, 2009, compared with 28 percent by the four biggest two years before, according to the FDIC and the Fed. The world’s 10 largest banks at the end of 2008 had 26 percent of the assets out of the top 1,500 banks, up from 18 percent in 1999.
I had a hedge fund manager (yes, I know, my mother would be very disappointed to learn that I talk to those sorts of people) make the argument to me recently that while these institutions might be larger by some measures, they are significantly less leveraged than they were going into the crisis. I would counter argue, that it won’t be long before they start to resume leveraging and they will once again hide it until it’s too late. The point is that there remains much more systemic risk than most people want to admit. In the words of Hank Paulson, “The largest financial institutions are so big and so complex that they pose a dangerously large risk.” This comes from a guy who used to run Goldman Sachs and the US Treasury.
Bubbles Are a Real and Inevitable Part of Markets. As long as there has been money there have been bubbles. While we will hopefully rework and enforce our regulatory structure and reduce systemic risk, we should be under no illusion this will eliminate bubbles. In fact we can be all but certain that even now new bubbles are forming. Just as the low rates following the bursting of the dot-com bubble and 9/11 led to the housing bubble, so current low rates will lead to a future bubble.
Traditional Methods of Diversification Need to be Reconsidered. Despite Andrew Carnegie’s advice to “put all of your eggs in one basket and then watch that basket” most investors agree diversification is a good idea. Unfortunately in bubbles, diversification takes it on the chin in one form or another. For example, in the dot-com bubble people came to believe they were diversified because they owned 10 different internet stocks. They failed to understand that all of these stocks would move up and down together which made them highly correlated mathematically speaking.
Over the course of the last bubble, diversification had been implemented by diversifying across equity asset classes that were believed to have low correlation. Said another way you could put together a portfolio of large cap stocks, small cap stocks and say, emerging markets stocks and the risk to their overall portfolio would be much lower than if you owned just one of the asset classes and overall return would be higher due to more consistency of returns. The elusive free lunch seemed to be in hand.
The problem, as Soros’ theory of reflexivity would predict, is that once everyone started doing it, the game changed. Correlations between equity asset classes rose dramatically over the years taking away most of the free lunch provided by diversification. This didn’t become readily apparent until a broad market meltdown when prices of all equities collapsed, independent of what particular asset class they belonged to.
This approach to diversification worked pretty well until it was needed the most. Sort of like one of those horror movies where the monster chases its victim who jumps into a car that previously had been working just fine but suddenly won’t start. A method of managing risk that works except when there’s a lot of risk probably isn’t a particularly good method.
It has become clear through this episode that diversification among asset classes as they have been traditionally defined is ineffective during periods of intense market dislocation (which seem to be happening with greater frequency and severity). While it can be argued that this approach to diversification is still effective over the long run, such as the dramatic underperformance of gold relative to equities in the 1990s and vice versa in the 2000s, it leaves a very high likelihood of concentrated short-term losses that are unacceptable to the average investor. In short, an approach that works pretty well, most of the time, doesn’t really work at all.
The lesson from the meltdown is that you can’t increase an overall allocation to risk assets just because of diversification among risk assets. What is needed is a return to the distinction of risk assets and risk-free assets and an acknowledgement that risk-free assets have a rightful place in a portfolio. The risk-free allocation serves as a type of insurance that keeps performance in line with investor expectations during times of severe market dislocation.
The great conundrum of investing is over the long run we’re concerned about the return on our capital, but in the short run we’re worried about the return of our capital. Investors have a unique mix of priorities on these two competing ends and the effective combination of risk and risk-free assets allows the coexistence of the long and short-term objectives to the extent possible.
With the risk-free portion of the portfolio allocated, attention can be turned to the management of the risk asset portion. The increase in correlations of risk assets will likely demand that we redefine how these assets are categorized, perhaps along the lines of style or approach rather than simply geography or market capitalization. The allocation to risk assets should then be actively allocated among those with the most attractive valuations. This active allocation within risk assets allows for a Soros-like recognition and exploitation of the inevitable bubbles and their crashes. A subset of the risk assets could also be managed through the selection of individual securities based on a Buffett-like recognition of the inefficiencies of securities prices.
While the credit crisis is usually referred to in the past tense, the reality is that we have yet to fully emerge from it, and the world economy is still very much on life support. Despite the massive rally from the lows of last March, a number of challenges remain.
Unwinding the stimulus and the law of unintended consequences. Adding the massive amounts of stimulus and liquidity was perhaps the easy part and the successful removal of it may present even greater challenges. While massive inflow of liquidity and stimulus appears to have been successful in avoiding what could have been the worst case scenarios with the economy and markets, the successful removal of these “training wheels” remains to be seen. Perhaps a good analogy of the situation is the theft of a priceless work of art from a museum. To pull off the caper it is necessary to both get in and out of the museum without being detected. We seem to have gotten in and gotten the goods, but getting out and away might prove to be a lot trickier. Unfettered belief that this will happen successfully, which the markets seem to have priced in, may represent a triumph of hope over experience. Historically governments haven’t been particularly good at determining the timing of removing liquidity, and the law of unintended consequences tends to rule.
Too Big To Fail remains too big. As noted earlier, the big banks are now even more concentrated and former investment banks now have new access to the fed window for very low cost financing. These banks now a have a lower cost of capital and a demonstrated government backstop. The motivation to pursue imprudent risks is greater than ever.
Housing will also continue to present a challenge. Beyond the subprime issue we are starting to see rapidly mounting defaults on prime mortgages especially the larger jumbo mortgages. This is especially troubling because, consistent with the dynamics outlined above, it was believed that, based on models developed over decades for mortgage holder behavior, these loans would perform as predicted. What the models failed to detect was mortgages going into default not because borrowers are unable to pay, but because they are choosing to not pay. Again, just as Soros’ reflexivity would predict, consumers adapted to the mortgage market and have begun to decide it’s simply not worth it continuing to pay the mortgage on a house they paid $1 million for that is now worth $500,000. The default rate on jumbo mortgages nearly tripled from 3.2% in December 2008 to 9.2% in December 2009. This trend may accelerate as more and more people do it and the moral stigma of defaulting on a mortgage fades.
Commercial mortgages and smaller banks. While the overleverage in housing ended up largely on the balance sheet of larger banks, the overleveraging of commercial real estate has remained with the smaller and mid-sized banks. The effects of these defaults have yet to be fully felt at these institutions, but when it is, the impact will be dramatic.
Weaker sovereign, state and municipal debt. As recent events in Greece and Dubai have shown, national governments around the world have been anything but immune to the effects of overleverage and derivatives exposure. As many states, most notably California, and a growing number of municipalities have shown, the bill from the piper is just now being presented and payment may be a long painful process.
A Better Outcome Ahead
Despite these challenges there is much to be encouraged about over the long run. The economy and sentiment have improved remarkably over the past year. Assuming even a modest continuation of this, stocks are reasonably priced.
Ultimately the good news is that the structural issues and misconceptions that have been building, in some cases for decades, are finally front and center. After sweeping things under the rug for a long time, it’s not necessarily pretty when you ultimately pick the rug up, but it’s the first step in getting things really cleaned up. With this acknowledgement and understanding of these issues, and providing we are able to muster the political will, we should ultimately come through this process with a system that is structured to handle market and economic realities for decades to come.
Perhaps the most encouraging is the general pessimism and lowered expectations. This is encouraging because mass expectations tend to be dead wrong and an excellent contra-indicator.
This is a great point to end on because it ties up many of the core ideas laid out on previous pages quite neatly. Below is a graph of what you would have at the end of 1999 had you invested equally in the various asset classes shown.
Based on the above the consensus of investors in January 2000 was an expectation of a 13% average annual return for the subsequent 10 years (2000 through 2009). In other words investors had an expectation of a total return of about 340% for the upcoming decade. This followed five years of extraordinary returns from 1995 through 1999 which included an annualized return of over 27% for the S&P 500. Remember back a few pages when we talked about investor irrationality and projecting the recent past into the future? Well as the graph below shows, those expectations were bitterly disappointed as the S&P 500 lost an average about 1% per year from 2000 through 2009.
What is perhaps much more interesting is that the first and second best performing asset classes of the past ten years, Gold and Real Estate, were so ill-regarded prior to 2000 they weren’t even included in the data provided by the Wall Street Journal in January of that year. The third best performing, Emerging Markets, was at least included in the data for the 1995-1999 period, but it was the worst performing asset class shown. The best performing asset class for the period, Science and Technology was, that’s right, the by far worst performing for the following ten years.
You could quite possibly have skipped the prior 20 or so pages and simply looked at these two graphs, and along with the information of investor’s wildly outsized expectation in January of 2000, easily concluded that investors and markets are anything but rational. Some things we don’t see because they’re too small, others we miss because they’re too big. This disconnect between reality and markets and their participants provides endless extraordinary opportunities for true investors willing and able to separate themselves from the crowd. And that is precisely what we’ll continue to do.
Indices cited above are as reported in The Wall Street Journal, both print and online, January 5, 2010. Fund averages cited are the respective Lipper Mutual Fund Indices.
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