One cannot read the following excerpt from Keynes without being impressed and disturbed by the fact that the same reasons were and are being set forth in support of neo-classical economics even after their complete and utter failure to predict, explain or provide solutions for the current crisis.
The completeness of the Ricardian victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpaltable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted it to the support of the dominant social forces behind authority. But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists...were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation;-a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.
John Maynard Keynes (1936) The General Theory of Employment, Interest and Money, Chapter 3
In my previous post I made the contention that we should not expect a robust recovery and that there was the risk of a "W" shaped double dip. Lets see what the consensus is and whether this is a normal recession as some "green shooters" claim, or something else entirely that no one really wants to acknowledge.
The chart plots the four-quarter growth rate of gross domestic product (GDP) from the trough of a recession against the depth of the corresponding contraction, as measured by the cumulative loss of GDP over the course of the downturn. The points within the red circle represent all previous postwar recessions, and they form a nice, neat, easily discernible pattern. That is, the pace of growth in the first year after a recession has, in our history, been reliably related to how bad the recession was. The deeper the recession, the faster the recovery.
The points within the blue circle are based on forecasts of GDP growth from the third quarter of this year through the third quarter of 2010, obtained from the latest issue of Blue Chip Economic Indicators (which reports survey results from "America's leading business economists"). From top left of the circle to bottom right, the points represent the 10 lowest forecasts of the most optimistic members of the 50 Blue Chip forecasting panel, the panel's consensus (or average) forecast, and the 10 highest forecasts of the most pessimistic panel participants.
I chose the third quarter as the reference point because nearly two-thirds of the Blue Chip respondents indicate that, in their view, the recession will indeed end in the third quarter of this year. Assuming this occurs, this recovery would appear to be a big outlier. Either we are about to continue making history—and not in a good way—or current guesses about the medium-term economy are way too pessimistic.
On another note, if you would like to do a little prognosticating of your own, I commend to you our new weekly editions of Economic Highlights and Financial Highlights.
By David Altig, senior vice president and research director at the Atlanta Fed
Well, if the consensus is that the recovery will be absolutely anemic, judging by these low prognostications, then perhaps the "this is a normal recession" meme form the MSM should be dropped because it is incompatible with the consensus forecasts. But we would not want to scare anyone with more truthful reporting, would we? As it turns out, judging by todays consumer confidence index , the US consumer has become cognizant that if one has no job, then there is little reason to rejoice and go on a shopping spree once again in order to jumpstart that 70% of the US economy that depends on consumer spending.
As always in such debates there is no consensus to be found as to whether the prices will rise or fall in the foreseeable future in the USA. On the one hand, inflation hawks see a Weimar-esque hyperinflationary financial armageddon brought about by what they consider to be profligate government spending and a complicit central bank providing massive liquidity and engaging in „quantitative easing“ all of which, for inflation hawks, is by definition inflationary. The dramatic increase in the monetary base (see Exhibit 1) has led some commentators to predict rapidly rising inflation and high interest rates (Laffer 2009, SeekingAlpha 2009), firmly following Milton Friedman´s mantra that inflation is always and everywhere a monetary phenomenon (Meltzer 2009). But even such a stalwart conservative economist as Mr Laffer admits in his Wall Street Journal piece that the velocity of circulation is important and that banks will eventually lend enough to become reserve constrained again "given enough time."
David Altig, the vice president of the Atlanta Fed, takes issue with Laffer´s claims and points out that bank lending has actually decreased while the monetary base has increased (see Exhibit 2).
This means that money sitting in banks as excess reserves is not in itself inflationary (Thoma 2009) and since the velocity of circulation has dropped (see Exhibit 3 for an historical view) and there is no evidence that consumers or businesses are becoming more rather than less credit worthy, banks have consequently not increased their lending.
Krugman (2009) draws paralles to the liquidity traps faced by Japan in the 1990´s and the US in the 1930´s (see Exhibit 4).
As pointed out by Hoisington and Hunt (2009) only 1.9% of the increase in reserves was available for lending and bank loans fell an annualized 5.4% from December to March. They add that the velocity of circulation of money can be thought of conceptually as being related to leverage and financial innovation. Needless to say, the world has had its fill of financial innovation for some time and currently deleveraging is a pervasive and prevalent phenomenon. The Fed would like nothing better than to increase the velocity of the circulation of money but since it is unable to, for the reasons outlined below, fears of inflation are misplaced and threaten to prevent a robust recovery and lead to a W shaped double dip or worse.
Those who foresee a deflationary spiral point out that the overleveraged US consumer who has seen a massive drop in the value of assets and is facing rapidly rising unemployment will not be able to spend enough to prop up the economy. There would need to be multiple shifts in the aggregate demand curve and with unemployment rampant wages would seriously lag inflation (Hoisington and Hunt 2009). Moreover, unemployed people tend to spend less money, and people who feel poorer because of the drop in their portfolio, IRA, 401k, and house price are also unlikely to spend enough to cause much inflation. That is, asset price deflation can lead to a debt deflation spiral which interacts with the Keynesian paradox of thrift, along with cost cutting deflation and, as pointed out above, the contraction of bank credit, all of which are individually managable, but together a lethal combination (De Grauwe 2009).
To me, the latter view is much more plausible since inflation is not some bogy out to get us lurking in the shadows, but the succesful passing on of price increases by producers to consumers. On June 16, 2009, amid a slew of terribly economic data, Bloomberg.com reported that wholesale prices dropped 5 percent in the past year and that producer prices ex food and energy dropped 0.1 percent in May. Cost-push factors such as an increase in the price of inputs, for example oil, would not be immidiately passed off to consumers who are purchasing less anyway at lower prices. This all but precludes demand-pull factors triggering inflation, since people have to be willing to pay more for certain goods. In order for this latter to occur, consumers have to be willing and able to spend. The US consumer is overleveraged and has maxed out credit cards, which has led to default rates at credit card companies that are more than the unemployment rate (ZeroHedge 2009).
The implied expectations of inflation in long term treasury bond funds reflect constant expectations (see Exhibit 6, Young 2009).
Moreover, even if demand for commodities, especially oil, increases, then there will still need to be a somewhat positive overall sentiment and, actually, dollar weakness, since, when „bearish“ sentiment predominates, then, in a „flight to safety“ investors paradoxically jump into the currency they love to hate, the dollar, whose appreciation will offset the effect of increased demand for commodities on their price. Furthermore, the last oil bubble was undoubtedly fueled by speculation, and, in my humble opinion, so has the current rally in commodities. Aluminum is a prime example of how the price of a commodity can defy supply and demand.
I do not subscribe to the monetarist doctrine that liquidity is per se inflationary. If no one is spending the money, that is, the velocity of circulation is very low, then there will also not be much of a general increase in prices. It should not be forgotten that world demand and consequently economic performance have dropped off a cliff (Eichengreen and O´Rourke 2009) and that because of rising unemployment and the debt and savings dynamics mentioned above we will not return „to happy days again“ anytime soon. What I mean is that the halcyon days of five or ten years ago of rapidly rising asset prices and moderate CPI increases when everyone felt richer and consequently fed huge increases in the value of assets are gone. The US consumer has started to save after decades of living beyond his means but is still faced with a mountain of debt and low or stagnating wages (see Exhibit 6 from sudden debt).
I do not think that much of an economic recovery is going to take place this year and that for the reasons outlined above inflation will not be a problem in the near future.
Of course, I did say „near future.“ To keep inflation in check once a real recovery does set in will take aggressive and, one would hope, enlightened policy responses. Prevention of another massive asset bubble would also help, but this is unlikely. In his book „A Short History of Financial Euphoria“ (1994) John Kenneth Galbraith said that the financial memory lasts about 20 years, until a new generation of wheelers and dealers will fuel the next asset bubble and assure everyone that this time it is different and asset prices can, indeed and contrary to all historical evidence, rise indefinetly.
Doing a search on Goldmanites in Power results in all kind of interesting posts which make one have to wonder. Now, regardless of whether you subscribe to the vampire squid theory or not, you have to be awed by the sheer size and interconnectedness of the network of Goldman Sachs alumni and the US government. But lest Goldman Sachs be accused of provincialism here is evidence that their tentacles reach is not confined to the Corporate United States of America. From a great blog called Future News Today:
Here are some more examples of Goldman Sachs power taken from the article "The Goldman touch". (I have also posted a copy of this article on my blog for safe keeping in case the link gets stale.)
Henry "Hank" Paulson - Current Secretary of the Treasury of the US, former Chairman and CEO of Goldman Sachs. OK, you already knew that one.
Mark Carney - Governor of the Bank of Canada. Before joining the public service, Carney had a thirteen-year career with Goldman Sachs in its London, Tokyo, New York and Toronto offices. He was heavily involved in Goldman Sachs's work with the Russian financial crisis of 1998.
Mario Draghi - Governor of the Bank of Italy. He was a London-based partner at Goldman from 2002 to 2005.
John Thain, who once ran Goldman's mortgage desk, was hired late last year to take over troubled Merrill Lynch & Co. Mr. Thain was running the New York Stock Exchange at the time of his hiring.
Joshua Bolten, took over April 14, 2006, as President George W. Bush's Chief of Staff "with authority to do whatever he deemed necessary to stabilize Bush's presidency, and he has moved quickly with changes". He was Executive Director for Legal and Government Affairs at Goldman Sachs in London from 1994 to 1999.
Robert Steel was appointed by Paulson to be Under Secretary for Domestic Finance. He was lured away from Mr. Paulson's Treasury to resuscitate Wachovia Corp., the fourth-largest U.S. bank. (Or at least they were before they collapsed.) Mr. Steel is a former Goldman Sachs Vice Chairman.
Paulson replaced Mr. Steel with Ken Wilson, the head of Goldman Sachs's financial services group. The Wall Street Journal describes him as, "The Goldman Sachs Man Behind Your Bailouts". I particularly liked this qoute, "[he] will be unpaid until Jan. 1, at which point Wilson will return to Goldman Sachs." So he is working on the bailout as a charity project. Right.
But here's what I really found startling from "The Goldman touch" article. The same phenomenon is visible in other countries, as well. Indeed, there were three ex-Goldman executives at the table in April when the Group of Seven finance ministers and central bank governors turned their attention fully to the credit crisis at a meeting in Washington.
Along with Mr. Paulson, there was Mr. Carney, who had taken up his job as head of Canada's central bank only a couple of months earlier, and Bank of Italy Governor Mario Draghi, who was a London-based partner at Goldman from 2002 to 2005. Mr. Draghi also leads the influential Financial Services Forum of central bankers and regulators, which spent six months preparing the report that became the basis of the G7's demands for more transparency by banks and other regulatory changes. But is there some sort of nefarious conspiracy here? No, of course not according to the article. Of course, this cloistered culture, populated as it is by power and wealth, has roused its share of suspicion among outsiders, who view the firm as a kind of secret society – just do a Google search on “Goldman Sachs and conspiracy.”
Current and former Goldmanites dismiss the notion that the spread of former executives to positions of influence is a Machiavellian plot to further enrich the company. There are no secret handshakes, they insist; no covert collaboration to extend the firm's reach. Oh, I feel much better now.
TREASURY DEPARTMENT Henry Paulson: Served as Treasury Secretary under President George W. Bush. Was CEO of Goldman from 1999 to 2006.
Robert Rubin: Served as Treasury Secretary under President Clinton. Previously, he was co-chairman of Goldman from 1990 to 1992.
Robert K. Steel: Served as Under Secretary of the Treasury for Domestic Finance, the principal adviser to the secretary on matters of domestic finance and led the department's activities with respect to the domestic financial system, fiscal policy and operations, governmental assets and liabilities, and related economic and financial matters. Retired from Goldman as a vice chairman of the firm in 2004, where he worked as head of equities for Europe and head of the Equities Division in New York.
Mark Patterson: Chief of Staff to Secretary Tim Geithner Was director of government affairs at Goldman.
Dan Jester: Key adviser to Geithner, who played a key role in shaping the takeover of Fannie Mae and Freddie Mac. Was strategic officer at Goldman.
Steve Shafran: Adviser helping to shape Treasury's effort to guarantee money market funds. Was expert in corporate restructuring at Goldman.
Kendrick Wilson: Brought in to advise former Treasury Secretary Henry Paulson, another Goldman alum -- after a personal call from his old Harvard Business School classmate, George W. Bush -- to advise him on how to fix the financial markets. Paulson brought Wilson to Goldman in 1998 from Lazard Freres. Before that, Wilson was president of Ranieri & Co., which was established by Lew Ranieri. While at Salomon Brothers in the 1970s, Ranieri pioneered mortgage-backed securities, the exotic financial instruments that helped stoke the mortgage bubble. In other words, the man brought in to fend off a financial crisis appears to be a protege of one of the men who helped cause it. Was senior investment banker at Goldman.
TARP Neel T. Kashkari: Appointed by Paulson to oversee the $700 billion TARP fund and was considered Paulson's right hand man during the crisis, all at the tender age of 35. Kashkari was criticized for the lack of oversight of the funds disbursement, which he said would have been impossible since the funs are fungible. This assertion has been largely refuted by Neil Barofsky, the Special Inspector General for the Troubled Asset Relief Program. Kashkari was also responsible for recruiting Reuben Jeffrey. Was technology investment banker for Goldman in San Francisco from 2004 to 2006.
Reuben Jeffrey: Selected by fellow Goldman alum Kashkari as the interim chief investment officer for the bailout. He was formerly the chairman of the CFTC, a role currently held by fellow Goldmanite Gary Gensler, as well as Under Secretary of State for Economic, Energy, and Agricultural Affairs. Was executive for 18 years at Goldman, beginning in 1983.
Edward C. Forst: Left his post as executive vice president at Harvard to serve as an advisor on setting up TARP, but has since returned to the school. Was global head of the Investment Management Division at Goldman for 14 years.
FEDERAL RESERVE William Dudley: President of the Federal Reserve Bank of New York. Was former chief economist and advisory director at Goldman where he worked from 1986 to 2007.
Stephen Friedman: Was chairman of the Federal Reserve Bank of New York until May 2009, when he was pressured to resign after buying Goldman shares in December and January. Previously, he was director of President George W. Bush's National Economic Council. Joined Goldman in 1966 and was co-chairman from 1990 to 1994.
COMMODITIIES FUTURES TRADING COMMISSION Gary Gensler: Appointed by Obama to head the CFTC. This was the commission headed by Brooksley Born in the late 1990's, when Alan Greenspan and Robert Rubin overruled her attempts to regulate credit-default swaps; fellow Goldmanite Reuben Jeffrey also held this position. Gensler worked in the Treasury Department as Assistant Secretary of the Treasury from 1997-1999 and as Under Secretary from 1999-2001, a position he received from Lawrence Summers. Was partner in Goldman from 1979-1996
OTHER Sonal Shah: Appointed to Office of Social Innovation and Civic Participation and an Advisory Board Member for the Obama-Biden Transition Project in 2008. Shah had previously held a variety of positions in the Treasury Department from 1995 to early 2002. Was a former Vice President at Goldman from 2004 to 2007.
Joshua Bolten: Former chief of staff with the Bush administration as well as former director of the Office of Management and Budget until 2006. Was executive director of Government Affairs for Goldman Sachs from 1994 to 1999. Bolten was instrumental in recruiting his fellow Goldman alum Henry Paulson as Treasury Secretary.
Jon Corzine: A strong supporter and political ally of Obama, Corzine is currently the governor of New Jersey. Before being elected governor, he served as the New Jersey representative to the U.S. Congress from 2001-2006, where he served on the Banking and Budget Committees. Began working for Goldman in 1975 and worked his way up to chairman and co-CEO before being pushed out in 1998.
Robert Zoellick: Currently serves as president of the World Bank and previously was deputy secretary of state. Was previously a managing director at Goldman, which he joined in 2006.
James Johnson: Was involved in the vice-presidential selection process for the Obama campaign and served as president and CEO of Fannie Mae. Board member of Goldman.
Kenneth D. Brody: Was former president and chairman of the Export-Import Bank of the US. Worked for Goldman for 20 years, founded and heading up its high-technology investment banking group and leading the firm's real-estate investment banking group.
Sidney Weinberg: Served as vice-chair for FDR's War Production Board during World War II. The head of Goldman from 1930 to 1969, nicknamed "Mr. Wall Street," he worked his way up at the firm after starting as a $3-a-week janitor's assistant.
LOBBYISTS Richard Gephardt: Was House Majority Leader from 1989 to 1995 and House Minority Leader from 1995 to 2003. His lobbying firm was hired by Goldman to represent its interests on issues related to TARP.
Michael Paese: Former top staffer to Rep. Barney Frank, the chairman of the House Financial Services Committee. Is Goldman's new top lobbyist. He will join the firm as director of government affairs - last year, that position was occupied by Mark Patterson, now the chief of staff at the Treasury Department. Paese has swung through the revolving doors several times - he previously worked at JPMorgan and Mercantile Bankshares and was senior minority counsel at the Financial Services Committee.
Faryar Shirzad: Former top economic aide to President George W. Bush and Republican counsel to the Senate Finance Committee. He now lobbies the government on behalf of Goldman Sachs as the firm's Global Head of the Office of Government Affairs.
Richard Y. Roberts: Former SEC commissioner. Now working as a principal at RR&G LLC, which was hired by Goldman to lobby on TARP.
Steven Elmendorf: Former chief of staff to then-House minority Leader Rich Gephardt. Now runs his own lobbying firm, where Goldman is one of his clients.
Robert Cogorno: Former Gephardt aide and one-time floor director for Steny Hoyer (D-Md.), the No. 2 House Democrat. Works for Elmendorf Strategies, where he lobbies for Goldman and Citigroup.
Chris Javens: Ex-tax policy adviser to Iowa Senator Chuck Grassley. Now lobbies for Goldman.
GOVERNMENT - GOLDMAN E. Gerald Corrigan was president of the New York Fed from 1985 to 1993. He joined Goldman Sachs in 1994 and currently is a partner and managing director; he was also appointed chairman of GS Bank USA, the firm's holding company, in September 2008.
Lori E Laudien: Former counsel for the Senate Finance Committee in 1996-1997 Has been a lobbyist for Goldman since 2005.
Marti Thomas: Executive Floor Assistant to Dick Gephardt from 1989-1998, he went on to serve in the Treasury Department as Deputy Assistant Secretary for Tax and Budget from 1998-1999, and as Assistant Secretary in Legal Affairs and Public Policy in 2000. Joined Goldman as the Federal Legislative Affairs Leader from 2007-2009.
Kenneth Connolly: Was staff director of the Senate Environment & Public Works Committee). Became a Vice President at Goldman in 2008.
Arthur Levitt: The longest-serving SEC chairman (1993 to 2001). Hired by Goldman in June 2009 as an adviser on public policy and other matters.
Having started reading John Kenneth Galbraith´s "The Great Crash: 1929" I cannot help but make a few observations. An old and esteemed professor of mine used to tell us that what was important in critical reading and writing was to answer these three questions: "What does it say? What does it mean? What difference does it make?" Today I can only address the first of these questions, saving the rest for later, hopefully. But back to the first chapter of "The Great Crash."
"[F]or a generation Democrats have been warning that to elect Republicans is to invite another disaster like that of 1929. The defeat of the Democratic candidate in 1952 was widely attributed to the unfortunate appearance at the polls of too many youths who knew only by hearsay of the horrors of those days."
"Historians and novelists always have known that tragedy wonderfully reveals the nature of man. But, while they have made rich use of war, revolution, and poverty, they have been singularly neglectful of financial panics. And one can relish the varied idiocy of human action during a panic to the full, for, while it is a time of great tragedy, nothing is being lost but money."
"On the whole, the greater the earlier reputation for omniscience, the more serene the previous idiocy, the greater the foolishness now exposed. Things that in other times were concealed by a heavy facade of dignity now stood exposed, for the panic suddenly, almost obscenely, snatched this facade away."
"No one was responsible for the great Wall Street crash. No one engineered the speculation that preceded it. Both were the product of the free choice and decisions of hundreds of thousands of individuals. The latter were not led to the slaughter. They were impelled to it by the seminal lunacy which has always seized people who are seized in turn with the notion that they can become very rich."
"It has long been my feeling that the lessons of economics that reside in economic history are important and that history provides an interesting and even fascinating window on economic knowledge."
"Finally, a good knowledge of what happened in 1929 remains our best safeguard against the recurrence of the more unhappy events of those days. Since 1929 we have enacted numerous laws designed to make securities speculation more honest and, it is hoped, more readily restrained."
"The signal feature of the mass escape from reality that occurred in 1929 and before - and which has characterized every previous speculative outburst from the South Sea Bubble to the Florida land boom - was that it carried Authority with it. Governments were either bemused as were the speculators or they deemed it unwise to be sane at a time when sanity exposed one to ridicule, condemnation for spoiling the game, or the threat of severe political retribution."
The relevance and parallels to the current crisis should be obvious.
After reading about Bill Miller´s Value Trust fund, two thoughts spring to mind:
Past results are no guarantee for future performance , therefore I would be careful about using any investment strategy for too long if the underlying economic reality and fundamentals have changed.
And
The market can stay irrational longer than you can stay solvent. John Maynard Keynes
Bill Miller was bullish on financials and homebuilders in 2006 and has progressively increased his positions and thereby his losses by consistently underestimating the depth, breadth and extent of the crisis. He declared in April 2008 that the crisis was over, and his bullishness, to me, is indicative of wishful thinking which is being used to rationalize expended energy, lost money and being wrong in calling the market bottom, his claims to the contrary notwithstanding.
That being said, Bill Miller´s value investing strategy has been burying quantitative momentum funds in the recent rally. From Zero Hedge:
Bill Miller is patting himself on the back for "burying" quant funds as this just released Bloomberg article notes: its timely appearance is critical as this is easily the most important theme in the current market dislocation, and thus Zero Hedge will post it in its entirety... Bill, after the worst year in his career, may be careful with the timing of his self-congratulations though... IQS Commentary for March 2009
Summary
The IQS model was down -16.8% over the past 5 weeks, while the sector-neutral model was down 16.9%. [TD: discussion with the appropriate people indicate that April is on par for even worse performance, which is why Zero Hedge has been sounding the clarion call for normality - if market neutral Quants drop 40% in two months, it is truly game over] • Balance Sheet and Value added to performance, Improving Financials underperformed slightly, while Sentiment and especially Momentum underperformed.
What Happened?
What does it mean when momentum stops working? The stocks that lost the most over the past few months (dogs of the Dow and S&P 500?) outperform the most. (See IQS S&P pdf report for astonishing examples and IQS analysis.)
Without an economic catalyst, fundamentals based model would not predict (nor should they) this “dead cat” bounce. Are we witnessing a sustainable rally for these stocks? It’s possible, but not very likely. Some of these companies are financials, and the “risk” to this industry changes daily, but remains high. However, some of these companies are not financials, and investors are buying up these low priced stocks with the hope that the economic turnaround has started and will continue to improve. With reporting season upon us, guidance will help determine the direction and magnitude of the market during this period. If financials show an improvement, the market may take off. If most companies continue to post low or negative earnings without a clear picture of a turnaround, the market may retract.
Weights
The IQS dynamic weighting system made small changes this month to the weights. With the market and economic conditions still weak.
Some weight was added to Improving Financials (mid), while a little weight reduced Momentum (mid), from Value (low), Balance Sheet (mid).
What is the IQS Model telling us about Sectors? No significant changes from last month.
Best – Aerospace, Retail, Medical, Utilities, Consumer Staples
Worst – Autos, Finance, Construction, Conglomerates, Consumer Discretionary We are at a critical crossroads for the future of efficient markets. If the bear market rally persists, Bill Miller and 401(k) holders will be happier temporarily, however the end result would be a broken market. Readers who took offense to the photo of the Challenger explosion earlier, should wake up and realize that we are on the verge of the very same event occurring within the fabric of the free and efficient market system. The threat to the equity markets is not being exaggerated. If the powers that be are intent on rising stock prices one day at a time continually, then even as retail investors enjoy another day of moderate gains, in a few short days/weeks markets will reach a point of no return, and the resultant collapse in confidence in the free market system will force the majority of investors to forever depart from investing in equity markets. The consequences of this would be beyond the scope of even this blog.
To many this may seem alarmist and overly pessimistic given the “green shoots” everyone is talking about; only time will tell. My reason for posting this, though, is to illustrate that relying on only the value investing strategy would have led to huge losses in the past two years and to gains since March 9, and that relying on quantitative momentum strategies in the same time frame would have led to gains by being short exactly Bill Miller´s favorite sectors, as John Paulson was and managed to earn $3.6 billion for himself in 2008, and to losses in the current rally. Diversification, in my mind, means not only different asset classes, but also using strategies that adapt to changing circumstances.
Bill Miller does not share this view:
From Bill Miller´s April Commentary:
Our portfolios, it should be stressed again, are not built based on macroeconomic forecasts, or expectations about the direction of equity markets in the next few months. They are constructed based on long-term considerations of value under average expected conditions over the next several years. That means that we believe the economy and the stock market will grow over the next few years, even if they do or don’t this year, and that businesses will earn returns on capital consistent with their competitive advantages, the underlying economics of their industries, and the capability of their managements.
To me, it seems that Miller assumes an underlying objective economic reality that is independent of the actions and expectations of the actors. I would point to Keynes´s Paradox of Thrift and Fisher´s Debt Deflation Spiral as reasons why market conditions may not conform to “average expected conditions.”
To say nothing of the lurking bad loans on banks´ balance sheets and their fictitious valuation of “troubled assets” which are once again based on their hubris laden overreliance on risk management models which may not apply given that the fundamental assumptions they are based on have changed or will do so dramatically in the near future. I would further urge Miller and, indeed, all investors, to take a good look at George Soros´s Theory of Reflexivity:
“
I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy.” I did not have time to expound my theory before Congress, so I am taking advantage of my captive audience to do so now. My apologies for inflicting a very theoretical discussion on you.
The theory holds, in the most general terms, that the way philosophy and natural science have taught us to look at the world is basically inappropriate when we are considering events which have thinking participants. Both philosophy and natural science have gone to great lengths to separate events from the observations which relate to them. Events are facts and observations are true or false, depending on whether or not they correspond to the facts.
This way of looking at things can be very productive. The achievements of natural science are truly awesome, and the separation between fact and statement provides a very reliable criterion of truth. So I am in no way critical of this approach. The separation between fact and statement was probably a greater advance in the field of thinking than the invention of the wheel in the field of transportation.
But exactly because the approach has been so successful, it has been carried too far. Applied to events which have thinking participants, it provides a distorted picture of reality. The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.
Classical economics was modeled on Newtonian physics. It sought to establish the equilibrium position and it used differential equations to do so. To make this intellectual feat possible, economic theory assumed perfect knowledge on the part of the participants. Perfect knowledge meant that the participants’ thinking corresponded to the facts and therefore it could be ignored. Unfortunately, reality never quite conformed to the theory. Up to a point, the discrepancies could be dismissed by saying that the equilibrium situation represented the final outcome and the divergence from equilibrium represented temporary noise. But, eventually, the assumption of perfect knowledge became untenable and it was replaced by a methodological device which was invented by my professor at the London School of Economics, Lionel Robbins, who asserted that the task of economics is to study the relationship between supply and demand; therefore it must take supply and demand as given. This methodological device has managed to protect equilibrium theory from the onslaught of reality down to the present day.
I don't know too much about the prevailing theory about financial markets but, from what little I know, it continues to maintain the approach established by classical economics. This means that financial markets are envisaged as playing an essentially passive role; they discount the future and they do so with remarkable accuracy. There is some kind of magic involved and that is, of course, the magic of the marketplace where all the participants, taken together, are endowed with an intelligence far superior to that which could be attained by any particular individual. I think this interpretation of the way financial markets operate is severely distorted. That is why I have not bothered to familiarize myself with efficient market theory and modern portfolio theory, and that is why I take such a jaundiced view of derivative instruments which are based on what I consider a fundamentally flawed principle. Another reason is that I am rather poor in mathematics.
It may seem strange that a patently false theory should gain such widespread acceptance, except for one consideration; that is, that all our theories about social events are distorted in some way or another. And that is the starting point of my theory, the theory of reflexivity, which holds that our thinking is inherently biased. Thinking participants cannot act on the basis of knowledge. Knowledge presupposes facts which occur independently of the statements which refer to them; but being a participant implies that one’s decisions influence the outcome. Therefore, the situation participants have to deal with does not consist of facts independently given but facts which will be shaped by the decision of the participants. There is an active relationship between thinking and reality, as well as the passive one which is the only one recognized by natural science and, by way of a false analogy, also by economic theory.
Here is a great quote from Keynes that I find as relevant now as it was when he wrote it.
Actually, however, we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even tho time and chance may make much of them. But sometimes we are intensely concerned with them, more so, occasionally, than with the immediate consequences.
Now of all human activities which are affected by this remoter preoccupation, it happens that one of the most important is economic in character, namely. Wealth. The whole object of the accumulation of Wealth is to produce results, or potential results, at a comparatively distant, and sometimes at an indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders Wealth a peculiarly unsuitable subject for the methods of the classical economic theory. This theory might work very well in a world in which economic goods were necessarily consumed within a short interval of their being produced. But it requires, I suggest, considerable amendment if it is to be applied to a world in which the accumulation of wealth for an indefinitely postponed future is an important factor; and the greater the proportionate part played by such wealth-accumulation the more essential does such amendment become. By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to he summed.
How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men? We have devised for the purpose a variety of techniques, of which much the most important are the three following:
(1)We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing. (2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture. (3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average.
The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment. Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface.
Perhaps the reader feels that this general, philosophical disquisition on the behavior of mankind is somewhat remote from the economic theory under discussion. But I think not. Tho this is how we behave in the market place, the theory we devise in the study of how we behave in the market place should not itself submit to market-place idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future. I daresay that a classical economist would readily admit this. But, even so, I think he has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be led.
Keynes, John Maynard (1937). `The General Theory of Employment`, Quarterly Journal of Economics, 51. cited in Shaw, G.K. (1988). The Keynesian Heritage: Volume I. pp.11-13
So, I am inherently skeptical of any theory which holds that it is in possession of the truth, especially those which have thinking humans as participants and are based on unrealistic axiomatic assumptions. Furthermore, I am in favor of what Arthur Koestler called open systems which can be changed and adapted as needed, as opposed to closed systems which profess to explain everything. Not even physics manages to explain everything at the macro or cosmological level and the micro or quantum level in a unified theory; therefore, I am even more doubtful that investment or economic theories can accomplish the feat of being always valid at every level.
