Relation between green shoots theory and reality

Perhaps this is very obvious to the readers of this blog, but I feel that I should mention this anyway. My recent post focused on the connection between "green shoots" and the "second derivative"; but I never explained why.

There is an implicit assumption at play here. The market is assuming that we will have a U or V shaped recession. Because of that assumption they are assuming that the second derivative change is a sign of slowing downfall, and consequently a turnaround will be visible as an expansion of the first derivative. But that is only an assumption. This is important to note and remember.

The economy could easily slow the rate of decline and then speed up the rate of decline again. To use this information as a basis for making buy/sell decisions should be considered speculation, and not an investment.

Premise behind the green shoots theory

The market is a curious creature, because it is always looking forward. The "green shoots" that the market has been seeing since mid-march of this year, was not because of the economy actually bouncing. However, it was shift in the second derivative. If you recall high school calculus, second derivative reaches an inflection point when there is a change in the "rate of change". That is a mouthful, but it boils down to the notion that "green shoots" are that the rate of decline of the economy has slowed down.

The crucial point is that the economy is still deteriorating, but it just is deteriorating less alarmingly.

Somehow that message was lost and is now ignored by the media. So when Warren Buffett came on TV and announced that the economy is still slowing down (which should be obvious to anyone who remembers the original premise of the second derivative); people freaked out. Someone even went as far and called him an "idiot" [later retracted].

Here is that aforementioned TV interview:

Cost of safety

According to Michael Hartnett, a strategist at Merrill Lynch; if someone today is investing in cash, it would take:

• 360 years to double his/her money in US Dollar ($) deposits
• 150 years, if it was in Pound Sterling (£) deposits
• 440 years, it it was in Japanese Yen (¥) deposits.

I think that it is becoming obvious to many that cash is a horrible investment; especially in currencies of heavily indebted countries.

So long and thanks for all the fish...

So long and thanks for all the fish--- we didn't need it after all!

That is what the stronger banks queuing up to pay back their government guarantees are essentially saying.

There is a startling lack of grace: Jamie Dimon, the boss of JPMorgan, has fantasised about sending an ironic accompanying “Dear Timmy” thank-you letter to America’s treasury secretary, Tim Geithner, saying “We hope you enjoyed the experience as much as we did.” The boss of Wells Fargo has called the solvency tests “asinine”.

Sure that paying back this money has a political purpose. Paying back makes the bank appear strong and also goes a long way to distinguish from the weaker bankers who "really" needed the capital. But the harsh reality of 2008 financial meltdown was that every bank needed the capital. Even if Goldman Sachs or JPMorgan Chase were strong enough to stand, they couldn't have stood for too long if the dominoes started falling. This is a crucial fact to remember when you come across rhetoric from the bankers about them not needing the money in the first place.

More on US Inflation

Economist's Buttonwood column published an article exploring the future of US treasuries. Here is a small excerpt:

America does not formally need to default to penalise its creditors; it can simply let its currency decline. Short-dated Treasury bonds (those with a maturity of one-to-three years) have returned a healthy 18% in dollar terms over the last three years. But when translated into Chinese yuan that return dwindles to just 0.3%.

History is full of examples of sovereign nations failing to pay their overseas creditors in full. When push comes to shove, governments are unwilling to impose the required level of austerity on their voters. This happened in the 1920s Weimar Republic, which opted for hyperinflation rather than paying the reparations bill, and in 1930s Britain, which abandoned the gold standard in the face of the Depression. (Note the results of the recent referendums in California, where voters rejected all budget-balancing proposals.)

In countries that are frequent offenders, including those in Latin America, foreign creditors have in the past demanded that government debt be denominated in a foreign currency. America has been able to borrow in dollars. However, for foreign investors, that means Treasury bonds are not risk-free at all.

Even domestic investors might reflect on the potential for inflation to erode the real value of their holdings. Inflation-adjusted, the capital value of Treasury bonds fell by more than five-sixths between 1962 and 1981.

Inflation-linked government bonds ought thus to be a more appropriate risk-free asset than conventional bonds. Foreign investors might calculate that, over the long run, a dollar decline would be matched by higher inflation, for which they would be compensated. However, the index-linked market is a lot less liquid than that for conventional debt. And cynics might wonder whether governments will really meet their obligations when faced with runaway inflation, rather than finding a way to “redefine” the statistics.

So what might replace Treasury bonds as the global risk-free asset? Some would opt for gold, although it pays no yield and its nominal value is highly volatile. China has no asset that seems appropriate. What about German government bonds? Fiscal policy is relatively prudent and the European Central Bank seems far more committed to fighting inflation and maintaining a stable currency than other monetary authorities.

Audio: More on the MBA hippocratic oath

You can read the Oath itself: Short Version. Long Version.

Yet another personal lesson learned from the recent market turmoil

The lesson that I learned was that I am not the only value investor who suffers from "premature allocation". Even the big names in the value investing universe suffer from the same ailments. These heavyweights are, fortunately (perhaps unfortunately for them), are required by law to sometimes reveal their purchases. During this long-drawn bear market run, almost every major value investor had the opportunity to not only disclose their latest holdings, but some also openly talked about their rationale behind them. Bruce Berkowitz, Warren Buffett, and Tom Gayner come to mind.

This is a gold mine of information because one can use this list as a starting point to do their own research. You may not always see the same value that the famous investor sees; and that is OK. One should not fall into the trap and become a victim of the copycat speculation. Some investors may have rationales that may not work for the individual investor; for example undisclosed derivatives positions, etc.

One must always do their own homework.

Is this Too little, Too late?

Harvard Business School students led a campaign to turn management into a formal profession-- part of that effort involved swearing off greed. (See article)

Recall that these are sobering times for the MBAs. The market itself is on the fear side, rather than greed's. It is almost fashionable to denounce greed and proclaim virtuosity.

I, personally, think that this is no more than just a stunt that will be conveniently forgotten when times are "good" again. There will be a time when it is just too hard to be virtuous and skip on the juicy profits made through "less than honest" means.

Looming Inflation

Image by ZeroOne via Flickr

Reading List:

• Long term appeal for US Treasury Bonds
• Rising importance of China in the global financial system (there is much work to be done)
• Why people cannot ditch the US dollar
  

What I would like to know is what the high US inflation means to people in other parts of the rich and poor world. I live in Canada, and our economies are inexorably linked-- what does the likely fall of the US dollar for Canadians? Perhaps history would answer this question. United States has had double digit inflation before.

Quantitative easing and exit strategies

William Dudley, president of the Federal Reserve Bank of New York, spoke with Economist and the complete interview is published here. He answers to the following questions:

• Treasury yields are up sharply in the past few weeks. Why?
• Under what circumstances would you expand purchases of long-term securities?
• What limitations do you have to keep in mind when considering expanding purchases?
• How do you transition to no more purchases?
• How do you respond to fears you’ll inflate?
• How will your balance sheet eventually shrink?
• What do you say to charges that these unconventional strategies have compromised the Fed’s independence?
• How has the job of managing the Federal Reserve Bank of New York changed?

Fed's Exit Strategy

Perhaps I am too much of an optimist-- I can envision the looming hyperinflation beyond this economic slowdown. I have no idea how far that may be.
As I mentioned in a previous post, it appears that the Fed are working on an exit strategy. This is positive news, but no one expects this strategy to work 100%. Economist's article points out what they are planning to do and why that may not work, pending a change in rules.

The usual approach is to conduct reverse-repurchase agreements, borrowing from one of its 16 primary dealers for short periods of time in order to finance the assets on its balance-sheet. But dealers may not have the necessary capacity for the task.

The Fed is currently absorbing reserves by having the Treasury issue more debt than it needs. When dealers purchase the debt, cash shifts from their reserves accounts to Treasury deposits at the Fed, where they remain, unspent. But the Treasury itself is constrained by the debt ceiling set by Congress, and an independent central bank should not rely on the fiscal authority for one of its tools.

Bernanke's speech

Today, Ben Bernanke mentioned that they are going to work on plan for Quantitative Tightening (reducing the money supply)... but not in those exact words. This is a positive sign. Only time will tell if his rhetoric matches his actions.

The country's near-term actions -- which include dedicating $700 billion to stabilize the financial system and a $787 billion economic recovery package -- were necessary, he said.

Nevertheless, he added, "maintaining the confidence of the financial markets requires the we, as a nation, begin planning now for the restoration of fiscal balance."

Good to Great

I just finished reading Good to Great by Jim Collins. If you haven't read it yet, it is definitely a good read, in addition to the sister publication Built to Last. It is especially good for value investors because the ideas in these books are the same ones that Buffett and Munger often talk about. Warren Buffett often refers to them as "wonderful businesses".

I think every value investor (generally, a long term investor) should read these books because they will help you identify those wonderful companies using the elusive non-financial, softer traits such as management quality and culture.

Canadian mortgage and banking system

An article explaining the differences between Canadian and other Anglo-Saxon banks. Essentially, the US system makes the highs higher and the lows lower-- very different from the tamer Canadian system.

Perhaps the most striking divergence between Canada and America is in their regulation of mortgages. Interest paid on home loans is tax-deductible in America, encouraging people to borrow more; not so in Canada. American mortgages are non-recourse in many states, making it harder for lenders to pursue defaulting borrowers; not in most of Canada. (Then again, Britain is like Canada in these respects but still has soaring defaults).

Canadians taking out mortgages with a loan-to-value ratio over 80% must also take out insurance on them from a federal agency called the Canada Mortgage and Housing Corporation (CMHC). The banks insure the rest of their portfolios with the CMHC, which keeps them honest by applying strict standards to the mortgages they guarantee. Taking out insurance also brings the risk weighting that regulators apply to these mortgages down to zero, which means that the banks derive no capital advantage from funding them through securitisation. Some argue that Freddie Mac and Fannie Mae, America’s housing-finance giants, should likewise guarantee mortgages but not buy them.

Blog Moved

I have decided to move this blog from Wordpress to Blogger. This involves a new look and hopefully a faster web site. I have been busy in personal life and couldn't dedicate the time to care and feed a wordpress instance.

Another change that I would like to try is to write shorter and more frequent posts. We will see how that goes; if there is something long to write, I certainly wouldn't hold back.