In Search of the Obvious

Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.
-- George Soros
One of the most interesting implications of this idea is that an investor is paid in the market not just for being correct--as most people think--but for being different. To make more money than average, you have to do something different from average. Being correct doesn't hurt, but being different is what pays the bills.

This is because most investors crave certainty and are willing to open their wallets for it, even if what they are getting is only the illusion of certainty. As a result, they almost always overpay for assurances about the future. This is exactly what Warren Buffett meant when he wrote that "you pay a very high price in the stock market for a cheery consensus."

Almost as a rule, investments that appear certain to succeed or market theses that seem certain to unfold are overvalued, while investments that have only a possibility of success are frequently undervalued--even if the potential payoff of the second group is far greater than that of the supposed "sure thing."

An exploitable anomaly, seemingly. So how can we put this idea of betting on the unexpected into practice?

Legendary hedge fund manager Michael Steinhardt used a mental model that he termed "variant perception." It sounds esoteric, but it translates roughly as "a different opinion."

In his autobiography No Bull, Steinhardt explains that he wanted his analysts to know four things about any investment opportunity:

1) the idea
2) the consensus view
3) the variant perception
4) a trigger event

This outline presents us with a strange challenge. How do we determine the "consensus view" on whatever subject we are looking for? In short, what is the "obvious"?

This may seem like a simple question to answer, and in many cases it is. In 1999-2000, it was obvious that internet stocks were going up. In 2005, it was obvious that home prices would rise forever. If it ever becomes obvious that stocks are going to go down forever, it will be time to buy them aggressively.

Still, when you apply the question to the flux of day-to-day market activity, it gets quite a bit more elusive. What is the "obvious" belief right now to be bet against? Bulls would say that everyone obviously expects the market to go down. Bears would say that everyone obviously expects the market to return to its previous highs.

To complicate matters further, the "obvious" belief may pointed in the right direction but not going far enough in that direction. For example, if it is obvious to most that we are in a mild recession (and it seems to be), the solution is not necessarily to buy stocks in anticipation of a recovery. It could instead be to batten down the hatches in preparation for a particularly bad recession.

All of this, combined with the seemingly weekly shifts in the consensus about what is "obvious," makes it a tricky time to be using this approach. Still, if the past is any guide, the markets will settle down into a new set of "no-brainer" ideas that we can then fade. I think we'll know them when we see them, but commodities and China seem set up to become good candidates at some point in the future.


Bear Gets Marked to Market

It's amazing what having one of the most powerful investment banks in the world vaporize can do to focus your attention. Accomplishing much more in two business days than I ever have, Bear Stearns (BSC, if you dare) has fallen from over $60+ a share to what will probably be around JP Morgan's buyout price of $2.

I have to travel tomorrow (great timing, huh?), so I won't get to devote the time to this interesting situation that I would like to. But I did want to fire off some quick thoughts that were on my mind.

Please note that I've linked to some old posts here, and I have to cite George Bernard Shaw in my defense: "I often quote myself. It adds spice to my conversation."

Besides, the largest economic forces at play frankly don't change all that quickly. And for the most part I still believe everything I've posted about over the last nine months or so (that is: financials are dangerous, small-caps are dangerous, the dollar is being massacred, emerging markets are more dangerous than advertised, etc.) I don't get (or more accurately, steal) very many good ideas, but if another one comes across the desk, I'll keep you apprised.

Of course, if we suffer a cascading meltdown, I will be sitting glumly in a plane somewhere, hungry and wishing I were short.

  • Drawing from the often-remarked-upon similarities between this market and that of the early 1970s (as that market came to terms with inflation and financial instability), I've recently been thinking of this market in terms of the two-stage decline in the 73-74 bear. By this line of comparison, we're around March of 1974, in which a break through support at 90 started a new cascading phase of the bear market. Similarly, if we break below 1275 on the S&P, I will be forced to act off of the idea that we have moved into the second phase of a runaway bear market. I'm expecting this sort of an acceleration to the downside, but am ready to be proven wrong.
  • Keeping with the title of this post, it looks to me like the JP Morgan buyout of Bear is effectively a mark to market of Bear's assets. The next question everyone has to ask (and, frankly, should have asked themselves a while ago) is: what are appropriate market values for other peer banks? You already know my opinion on Goldman. One thing I have always wondered is why assets that are supposed to be marketable yet have no market value have a book value of higher than zero. I suppose if I worked for a bulge-bracket firm it would make sense to me.
  • Along similar lines . . . a friend and I were discussing recently how there really hasn't been any panic in financials, despite the brutal declines we've seen thus far. We're still in the Oprah, hand-holding "thank God everything's going to be OK" stage. Well, to butcher an old saying, every panic contains a grain of truth. It may be that our bit of bad news has just arrived. Could the more thoughtful individuals out there who are holding stock in other i-banks start getting pretty hot under the collar?
  • I still think the Fed is checkmated. If they cut further (which they will, of course), gold will continue to climb. But the shock of cuts is wearing off, and I don't expect the inevitable "surprise" cuts to provide the same boosts to the upside as previous ones. The market could therefore continue to decline even with further cuts, particularly if those cuts begin to threaten the US price level. Anyway, remember that stocks fell during a substantial part of the Greenspan Fed cuts after the dot.com crash.
  • If I were inclined to be bullish, here's what I'd ask . . . if it's true that pessimism is as rampant as some accounts suggest, could this all be simply the process of putting in a bottom?
  • Anybody else wondering what the effects of the Bear collapse and the other turmoil could have on the world's $500 trillion+ derivatives market? As a point of comparison, the world bond market is estimated to be $45 trillion and the world stock market is estimated to be $50 trillion. No, that is not a typo. And yes, I realize that all of those positions are perfectly hedged and therefore we have nothing to worry about . . . if you believe in the perfect hedge.
  • Finally, financials and market reality, before and after:
Stay safe!


An Important Test

A quick update . . .

After the recent rally, we're now at what I see as a very important test. We're about to find out if the Fed's huge injections of liquidity have indeed ended this bear market, as many seem to believe.

As far as I can tell, this rally is still pretty much textbook bear market behavior, and the long-term path of least resistance remains down.

Along these lines, the chart below implies that there are swarms of sellers in the 1400 range waiting in the wings to dump their stock into another leg up. Any new rally is going to have to work through this pretty serious supply overhang.

Stranger things have happened, of course. Look at 1998, for example, when the markets broke and then reflated with the help of well-intentioned central banks.

Because of precedents such as 1998, as well as the Fed's popular (though not official) mandate to keep equities from declining even at the cost of the purchasing power of the currency, it's absolutely essential to have circuit breakers in place so that if you're wrong you don't lose all your money if you're short.

I've been thinking about how to decide when this move will stop being "textbook bear market action," and when to admit that City Hall (Bernanke, Paulson, Bush) has won. And I still think that if the S&P seizes a position above 1400 and can prove that it can hold it, I will be forced to reconsider my strategy.

If this were to happen, it would be a frankly surprising show of buying power and one that would have to be respected.

In the interest of full disclosure, though, my humble opinion is that we look very well set up here for a potential retreat in the next week and eventually a retest of the 1275 lows on the S&P.

But the market's gonna go where it's gonna go . . .

Oh, and if you were wondering whether this sort of central bank behavior (panic 3/4 point rate cuts when the markets drop, encouraging new debt to solve a debt crisis, etc.) is good for the world in the long term, the answer is no.

A final note: if we do claw back up into the old trading range, the amount of new credit it's taken to pull us out of this natural market downturn is almost certain to inflate another huge bubble, possibly more than one. There's no telling for sure what it'll be, but those who guess correctly beforehand will make armloads of money.

I'll let you know where I think these bubbles might be if another leg up starts looking like a real possibility.

Otherwise, see ya at 1275!


Get to Know the Bear

It's been a very ugly couple of weeks, and if the performance of global markets on Monday's Martin Luther King holiday is any guide, there will be some continued ugliness in the US markets this week too. I hope you all have been managing the carnage OK.

While we appear to be way overdue for some sort of bounce, it doesn't appear that it will happen tomorrow. It now appears that we are right in the middle of a bear market, with the decisive break having taken place below 1400. This drops us out of what I had been looking at as a long-term trading range between 1400 and 1550.

We're likely to have some very sharp rallies soon, but until we can get a foothold above 1400 and hold it, I believe that staying bearish is the right move.

So if the bear is going to be around for a little while, we might as well do like these guys and get to know him.

In a bear market all stocks go down and in a bull market they go up.
--Jesse Livermore
This quote might not literally be true, but I think it has more pertinence for the investor than the more antiseptic definition of "a 20 percent decline." In bear markets, things go down that shouldn't go down. Things go down that absolutely can't go down. Things go down that didn't even go up in the bull market. Things go down further than anyone ever thought possible, and then they go down more.

You can't really believe it until it happens to you personally, but I hope that at least some psychological preparation can help you keep your wits about you.

. . .

So what might we expect from a bear market? What should we be doing and thinking? I can't give specific answers, but here's some food for thought, along with some questions I've been asking myself . . .

  • As Random Roger frequently points out, market declines are nothing unusual.
  • For those who haven't spent much time in bear markets . . . rallies in bear markets are generally much sharper, dramatic, and emotionally charged than rallies in bull markets. This is because they are driven both by relief and by short sellers "covering" (buying back) their positions. Don't confuse the vigor of a move with its sustainability.
  • Check out Bespoke Investment Group's examination of historical NASDAQ bear markets (declines of 20+ percent).
  • The "uptick rule," which was intended to reduce market volatility and to keep speculators from thrashing stock prices around, has gone the way of the dodo. For the first time since the Depression, short sellers can now lean on the market and drive it further down without having to wait for a higher price to come over the tape. How is this change likely to affect market declines?
  • The uptick rule died in early July, 2007. Take a quick look at the above chart of the S&P and see if anything springs to mind.
  • Barry Ritholtz brilliantly borrows from Elisabeth Kubler-Ross to evaluate this market according to her "five stages of grief."
  • Get this book and read it now.
  • Basically everything in the world (except the US dollar) has gone up over the last 5 years. So where do we hide now?
  • Similarly, if you see bull markets as a rush of much-needed capital to undercapitalized assets, industries, and sectors, what happens to all of these destinations of capital when the rush has served its purpose by bringing the necessary supply on line?
  • Following from these points . . . could it at least be possible that the path of least resistance is now down for most of the assets that have seen money flow into them recently?
  • Given the world's massive and rising industrial capacity, the chances of a deflationary period do not strike me as zero in the face of a worldwide economic slowdown. I have to say that I do think that the deflationists' arguments have begun looking better lately.
  • The long trading markets of the 1970s provide a good road map for the current difficult situation. This old post may be worth looking at again.
  • What would have to happen for the market to recover and for the worldwide bull market to resume? What is our sign that this decline has been a fakeout and it is time to get long again? I've given you mine; you may want to think about setting up your own signposts now.
  • The Fed ended previous market declines in 1987, 1998, and 2001 with gargantuan injections of liquidity. With the dollar on the ropes, what options now remain? Is there any alternative that doesn't send gold to $2000/oz.?
  • Could all of these injections of money have convinced investors that truly brutal bear markets a la 1929-33 or 1973-74 are things of the past? Has the Fed inadvertently "trained" investors to try to hold their stocks at all costs?
  • Remember that the market didn't care about you when it was going up, and it doesn't care about you now that it's going down. It doesn't care whether you get even on your positions or whether you have enough money left for retirement in 10 years. Please accept that unpleasant truth and take appropriate steps.
  • Careful with the whole "emerging markets are safe havens" idea . . .
  • This chart from Crestmont Research is fascinating and extremely useful.
  • If we start a bear market from a market P/E near the long-term historical average (which it is now), then what kinds of prices might we see at the bottom? Mind-bendingly low ones, possibly?
  • There have been a handful of times in the last century when investors could go into the markets, buy basically anything with their eyes closed, and make fortunes. One was when the US entered WWII and Sir John Templeton had his broker buy him 100 shares of every US stock trading for less than $1. A little over 30 years later, in the terrible bear of '73-'74, Buffett made his Washington Post buy and his reputation. That was 30-odd years ago. If another opportunity like these comes along, will you be ready?
  • "Rarely do we find men who willingly engage in hard, solid thinking. There is an almost universal quest for easy answers and half-baked solutions." --Dr. Martin Luther King, Jr.
Best of luck, and stay safe.


All That Glitters at Goldman

So, the common understanding is that Goldman Sachs (GS), which had greater percentage exposure to "Level 3" or so-called "mark-to-model" assets than either Citi or Bear Stearns, escaped the subprime crisis, Indiana-Jones-like, completely unscathed.

After the stock crashed in July with all the other ibanks, it dutifully "uncrashed" through September as it was revealed that Goldman was short the very subprime mortgage bonds that they were marketing, as Ben Stein discussed in early December.

In the middle of this improbable success, I've been wondering . . . is it possible that Goldman's choice not to write down its Level 3 assets (a term that means that they have little or no exchange value and therefore must have a value applied to them) has been postponed until 2008 in order to keep the books together for something as trifling as end-of-the-year bonuses? Could we soon see write-downs from Goldman now that these bonuses are safely housed?

I would never argue that this is happening, because I don't know. . . But I believe that it is possible, and that the thesis would help explain an extremely unlikely rally in a company that common sense would tell anyone is in this credit crunch waist-deep. I also think that I'm receiving good odds here, and the chance of any such shenanigans (which would imply a crash in Goldman beginning basically now) is easily large enough to compensate for the risk involved.

As Jack Handey once said, "What is it that makes a complete stranger dive into an icy river to save a solid gold baby? Maybe we'll never know."

Disclosure: the author is short Goldman Sachs (GS)


A Primer on Value

When I started investing, it took me a lot of time and legwork to get a handle on exactly what "value investing" meant. So in an expression of my bounding holiday cheer, I decided to collect all the information I wish I had known when I started investing. Here's hoping this collection of links and discussion smooths the path for others, and maybe provides some old hands with helpful review material too.


Charlie Munger, Vice-Chairman of Berkshire Hathaway, believes that "all intelligent investing is value investing." Others find the term "value investing" redundant, insisting that only a careful consideration of value to be received from a purchase can be properly labeled "investing" at all. So what, exactly is "value investing"?

  • The short answer: Buying dollar bills for fifty cents.
  • The long answer: here's Warren Buffett on "Inefficient Bush Theory," from the 2000 Berkshire Hathaway Shareholder Letters (via berkshirehathaway.com) . . .

"Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush -- and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -- nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation.

Alas, though Aesop’s proposition and the third variable -- that is, interest rates -- are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT -- Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Last year, we commented on the exuberance -- and, yes, it was irrational -- that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return.

Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.

This surreal scene was accompanied by much loose talk about "value creation." We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.

What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the "business model" for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.

But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street -- a community in which quality control is not prized -- will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to "A girl in a convertible is worth five in the phonebook."). Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores."

(source: http://www.berkshirehathaway.com/letters/2000.html)

  • Intrinsic Value: The underlying economic worth of a business, as distinguished from market price. Definitions vary considerably, running the gamut from estimated liquidation (breakup) value to calculations of probability-weighted averages of possible future cash flow scenarios. Generally, though, I would say that any appropriate intrinsic value estimate should account for the future amount of cash to be taken out of a business by shareholders, weighted by the probability that that cash will be received, and adjusted by an appropriate discount rate. This definition, heavily informed by Buffett's above discussion, accounts for virtually any scenario that the value investor will confront -- from determining the value of a real estate holding company to Google -- and it's the one that I use.
  • Margin of Safety
  • Mr. Market

Here are some compelling arguments for thinking about the markets in value-oriented terms.

As you might imagine from Buffett's above assessment of the value hunt as a pursuit that rewards flexibility, there are a number of different paths by which an investor can approach the value "promised land." Here are just a few examples. BOOKS TO READ Once you've digested these, you'll want to study the following very carefully:

Thanks to the internet, you can look over the shoulders of experienced investors as they pursue some of these strategies. Here are some excellent blogs to subscribe to.
Hope these give a helpful introduction. Have a great New Year.