Thursday, October 27, 2011

Bloomberg Radio Today

In addition to answering (explaining!?! defending!?!) why I believe this is a counter rally within an emerging bear market, I am hopeful that today's Bloomberg radio segment (4:30 PM easter, "Talking Stock with Pimm Fox and Courtney Donohoe") will touch on the risks inherent in the methodology that most traditionally trained bottom-up portfolio managers and strategists employ in their investment decision-making. And why it is risky to follow those who employ this approach with its faulty premises and embedded blind spots.

To listen to the segment live, click here.

Tuesday, October 25, 2011

Bottoms Up!

Giving the devil his due, the bottom-up crowd has won this round, as earnings results are not disappointing as economists did for the third quarter. Therefore, in light of the recent market action, it seems more than productive to understand the nature of this important (but not dominant) segment of the market.

Most investors are bottom-up oriented. They buy and sell stocks with a passing reference to the sector and style tilt their portfolios produce. Like many sports teams, portfolios are populated with the best ideas. Sectors and styles are a by-product. Individual company earnings results, performance metrics (such as profit margins, growth rates, etc.), and valuation levels determine the buy/sell/hold decisions made. From that comes the action taken.

This situation is largely due to tradition and training: traditional among individual investors, training among the professional crowd (the CFA program, for example). It is what the financial media obsesses on while providing limited, yet sorely needed, education on what constitutes good portfolio management.

As one of the two essential elements that drive stock prices up or down (the other being financial market liquidity), earnings results can dominate the moment, as they appear to have done thus far this month. When good earnings results motivate investors to act positively, the momos (the real power in today’s market) join the party, as they are indifferent to the reasons that drive investors and are far more interested in an excuse to act. As long as money is abundant (financial market liquidity), the upside bias exists. Which brings us back to earnings results.

As long as companies deliver positive earnings results and financial market liquidity remains ample, the bottom-up crew can move markets (aided and abetted by the momos, of course) to a significant degree. Should earnings falter, however, then the dual impact of declining results and diminution of financial market liquidity (in the form of redemptions and withdrawals) can produce a negative feedback loop to the real economy (Soros’ “reflexivity”). Yet, more importantly, within this investing approach lie the seeds of its own destruction.

Bottom-up investing is aided and abetted by ivy tower fantasies about efficient markets, assisted with high-sounding phrases like “price discovery” and “capital asset pricing models”, and supported by economic methodologies that are anchored in traditional metric analyses. Such traditional economic methodologies do, however, come with two significant blind spots: the inability to forecast with any degree of accuracy and consistency (certainly commensurate with a practice that fancies itself as a “science”) and an inability to do global macro analysis particularly well.

The first point is self evident and saturated with historical fact. For example, one need only look at today’s consumer confidence miss to see just how off the mark these “social scientists” can be. The second point was made most evident in the debacle known as the Great Recession. Moreover, the inability to do global macro well also comes with an inability to incorporate contagion’s speed and source (real and/or financial economy).

This is a big part of how the world works in Wall Street. It is the dynamic reality that exists in the surreal world of finance. It is the state of denial that many who play the investing game occupy. And it is why it is so essential to step back and smell the global macro rose, which right now has a decidedly foul odor to it.

But, hey! “Who cares?”, say the bottom-up boys and girls. "Earnings are good and that’s all that matters to me."

Friday, October 14, 2011

Quotable Quotes: China's Ghost Cities

This week's Quotable Quotes takes a look at China's ghost cities via a recent (March 2011) investigative report from SBS Dateline (Australian TV). If investors are looking for the other economic shoe to drop on the tenuous global economic environment, this very well could ultimately be the source.

To view the video, click here.

Wednesday, October 12, 2011

Reasons and Excuses:Taking The Financial Media To Task

The financial media is at it again. "Stocks soar today because..."(you fill in the reason). "Stocks plunge tomorrow because"... (you fill in the reason).

What the financial media fails to recognize is that, over the past several decades, the structure of the market has changed. Today's short-term market moves are at the margin and being driven not by rational ivory-tower-pipe-puffing-erudite academics but by momentum chasing lemmings who have copycat methodologies that require they follow the mob.

High correlations and high volatility are market outcomes in this reign of the momos. Yet, from a real world economic perspective, the financial media insists on attributing their actions as rational. They are not. They are, however, rational from a personal perspective: they are animal-spirit driven creatures intent on maintaining a lifestyle they have become accustomed to. Who can blame them? They are simply exploiting the system as it functions today.

Investment Strategy Implications

Investors look for reasons to take action. The agnostic momos look for excuses.

Investors look for fundamental and/or technical analysis reasons to act. The agnostic momos could care less.

Keeping my house in Greenwich is how I first described this syndrome, in which the momos' relative performance vis-a-vis their "competitors" trumps all else. In order for them to keep their house in Greenwich, they must not underperform their "competitors". Hence, the mob rule of the momo lemmings' effect and its effect on the markets.

It, therefore, behooves the financial media to get up to speed and start educating the investing public about how the changed structure of the market has changed how the game is played. Which brings us to this question: Is the financial media's job to educate or to entertain? (I guess the answer to this question can be found every weekday at 6 PM eastern.)

Monday, October 10, 2011

Another Day, Another Opportunity… to Fade the Rally

Memo to the momo lemmings: It’s more than the Eurozone that’s the problem.

Applying simplistic analysis, the momo crowd has unleashed yet another round of risk-on trades this morning. Jacking stock prices back near their 200 day (exponential) moving average – at least when it comes to developed markets. Emerging markets (remember them, the global economic sector where all the growth is supposed to come from?), however, are lagging the party thus far.

Yet, beyond the short-term wiggles and squiggles that the momo crowd tends to heavily influence, the longer-term picture paints a rather different story. As the accompanying chart** shows rather clearly, the Mega Trend* is decidedly in bearish mode. Moreover, both MACD and RSI are hardly exhibiting robust support for the rally, with MACD yet to crossover to the positive side (when the blue line crosses the red).

As the chart shows, the past is fairly clear what happens when the Mega Trend turns negative. Moreover, only when MACD and RSI register an internal non confirmation (as it did so significantly in the winter of 2008 into the spring of 2009) is there cause to believe the establishment of a negative Mega Trend is at the point of reversal.

To be sure, RSI did register a modest divergence last week but MACD did not. And while one indicator is fine, two is always better.

Investment Strategy Implications

The momo crowd is enthused that another round of inadequate political action will save the Euro day. And perhaps the movement they have fostered these past few days has some lasting power to it resulting in the aforementioned reversal conditions. However, with earnings season starting this week, there is every reason to expect the optimistic bottom-up projections will follow the macro economic forecasts for the third quarter, which were well below economists’ expectations. And that reality may trump the momos rationale du jour. Yet, when it comes to the momos, here's something useful to remember:

Being agnostic when it comes to the longer term and the real world of earnings and economics, they will follow whatever short-term trend they manufacture. That's what lemmings do.
*use search function on the top left to read about the Mega Trend.
**click image to enlarge.
Note: the above chart is a weekly chart in which the 50 and 200 day daily moving averages are converted to the equivalent 10 and 40 week moving averages.

Friday, October 7, 2011

Quotable Quotes: Steve Jobs

Appropriately, this week's Quotable Quotes is the 2005 Stanford commencement address delivered by Steve Jobs.

"I am honored to be with you today at your commencement from one of the finest universities in the world. I never graduated from college. Truth be told, this is the closest I've ever gotten to a college graduation. Today I want to tell you three stories from my life. That's it. No big deal. Just three stories.

The first story is about connecting the dots.

I dropped out of Reed College after the first 6 months, but then stayed around as a drop-in for another 18 months or so before I really quit. So why did I drop out?

It started before I was born. My biological mother was a young, unwed college graduate student, and she decided to put me up for adoption. She felt very strongly that I should be adopted by college graduates, so everything was all set for me to be adopted at birth by a lawyer and his wife. Except that when I popped out they decided at the last minute that they really wanted a girl. So my parents, who were on a waiting list, got a call in the middle of the night asking: "We have an unexpected baby boy; do you want him?" They said: "Of course." My biological mother later found out that my mother had never graduated from college and that my father had never graduated from high school. She refused to sign the final adoption papers. She only relented a few months later when my parents promised that I would someday go to college.

And 17 years later I did go to college. But I naively chose a college that was almost as expensive as Stanford, and all of my working-class parents' savings were being spent on my college tuition. After six months, I couldn't see the value in it. I had no idea what I wanted to do with my life and no idea how college was going to help me figure it out. And here I was spending all of the money my parents had saved their entire life. So I decided to drop out and trust that it would all work out OK. It was pretty scary at the time, but looking back it was one of the best decisions I ever made. The minute I dropped out I could stop taking the required classes that didn't interest me, and begin dropping in on the ones that looked interesting.

It wasn't all romantic. I didn't have a dorm room, so I slept on the floor in friends' rooms, I returned coke bottles for the 5¢ deposits to buy food with, and I would walk the 7 miles across town every Sunday night to get one good meal a week at the Hare Krishna temple. I loved it. And much of what I stumbled into by following my curiosity and intuition turned out to be priceless later on. Let me give you one example:
Reed College at that time offered perhaps the best calligraphy instruction in the country. Throughout the campus every poster, every label on every drawer, was beautifully hand calligraphed. Because I had dropped out and didn't have to take the normal classes, I decided to take a calligraphy class to learn how to do this. I learned about serif and san serif typefaces, about varying the amount of space between different letter combinations, about what makes great typography great. It was beautiful, historical, artistically subtle in a way that science can't capture, and I found it fascinating.

None of this had even a hope of any practical application in my life. But ten years later, when we were designing the first Macintosh computer, it all came back to me. And we designed it all into the Mac. It was the first computer with beautiful typography. If I had never dropped in on that single course in college, the Mac would have never had multiple typefaces or proportionally spaced fonts. And since Windows just copied the Mac, it's likely that no personal computer would have them. If I had never dropped out, I would have never dropped in on this calligraphy class, and personal computers might not have the wonderful typography that they do. Of course it was impossible to connect the dots looking forward when I was in college. But it was very, very clear looking backwards ten years later.

Again, you can't connect the dots looking forward; you can only connect them looking backwards. So you have to trust that the dots will somehow connect in your future. You have to trust in something — your gut, destiny, life, karma, whatever. This approach has never let me down, and it has made all the difference in my life.

My second story is about love and loss.

I was lucky — I found what I loved to do early in life. Woz and I started Apple in my parents garage when I was 20. We worked hard, and in 10 years Apple had grown from just the two of us in a garage into a $2 billion company with over 4000 employees. We had just released our finest creation — the Macintosh — a year earlier, and I had just turned 30. And then I got fired. How can you get fired from a company you started? Well, as Apple grew we hired someone who I thought was very talented to run the company with me, and for the first year or so things went well. But then our visions of the future began to diverge and eventually we had a falling out. When we did, our Board of Directors sided with him. So at 30 I was out. And very publicly out. What had been the focus of my entire adult life was gone, and it was devastating.

I really didn't know what to do for a few months. I felt that I had let the previous generation of entrepreneurs down - that I had dropped the baton as it was being passed to me. I met with David Packard and Bob Noyce and tried to apologize for screwing up so badly. I was a very public failure, and I even thought about running away from the valley. But something slowly began to dawn on me — I still loved what I did. The turn of events at Apple had not changed that one bit. I had been rejected, but I was still in love. And so I decided to start over.

I didn't see it then, but it turned out that getting fired from Apple was the best thing that could have ever happened to me. The heaviness of being successful was replaced by the lightness of being a beginner again, less sure about everything. It freed me to enter one of the most creative periods of my life.

During the next five years, I started a company named NeXT, another company named Pixar, and fell in love with an amazing woman who would become my wife. Pixar went on to create the worlds first computer animated feature film, Toy Story, and is now the most successful animation studio in the world. In a remarkable turn of events, Apple bought NeXT, I returned to Apple, and the technology we developed at NeXT is at the heart of Apple's current renaissance. And Laurene and I have a wonderful family together.

I'm pretty sure none of this would have happened if I hadn't been fired from Apple. It was awful tasting medicine, but I guess the patient needed it. Sometimes life hits you in the head with a brick. Don't lose faith. I'm convinced that the only thing that kept me going was that I loved what I did. You've got to find what you love. And that is as true for your work as it is for your lovers. Your work is going to fill a large part of your life, and the only way to be truly satisfied is to do what you believe is great work. And the only way to do great work is to love what you do. If you haven't found it yet, keep looking. Don't settle. As with all matters of the heart, you'll know when you find it. And, like any great relationship, it just gets better and better as the years roll on. So keep looking until you find it. Don't settle.

My third story is about death.

When I was 17, I read a quote that went something like: "If you live each day as if it was your last, someday you'll most certainly be right." It made an impression on me, and since then, for the past 33 years, I have looked in the mirror every morning and asked myself: "If today were the last day of my life, would I want to do what I am about to do today?" And whenever the answer has been "No" for too many days in a row, I know I need to change something.

Remembering that I'll be dead soon is the most important tool I've ever encountered to help me make the big choices in life. Because almost everything — all external expectations, all pride, all fear of embarrassment or failure - these things just fall away in the face of death, leaving only what is truly important. Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart.
About a year ago I was diagnosed with cancer. I had a scan at 7:30 in the morning, and it clearly showed a tumor on my pancreas. I didn't even know what a pancreas was. The doctors told me this was almost certainly a type of cancer that is incurable, and that I should expect to live no longer than three to six months. My doctor advised me to go home and get my affairs in order, which is doctor's code for prepare to die. It means to try to tell your kids everything you thought you'd have the next 10 years to tell them in just a few months. It means to make sure everything is buttoned up so that it will be as easy as possible for your family. It means to say your goodbyes.

I lived with that diagnosis all day. Later that evening I had a biopsy, where they stuck an endoscope down my throat, through my stomach and into my intestines, put a needle into my pancreas and got a few cells from the tumor. I was sedated, but my wife, who was there, told me that when they viewed the cells under a microscope the doctors started crying because it turned out to be a very rare form of pancreatic cancer that is curable with surgery. I had the surgery and I'm fine now.

This was the closest I've been to facing death, and I hope it's the closest I get for a few more decades. Having lived through it, I can now say this to you with a bit more certainty than when death was a useful but purely intellectual concept:

No one wants to die. Even people who want to go to heaven don't want to die to get there. And yet death is the destination we all share. No one has ever escaped it. And that is as it should be, because Death is very likely the single best invention of Life. It is Life's change agent. It clears out the old to make way for the new. Right now the new is you, but someday not too long from now, you will gradually become the old and be cleared away. Sorry to be so dramatic, but it is quite true.
Your time is limited, so don't waste it living someone else's life. Don't be trapped by dogma — which is living with the results of other people's thinking. Don't let the noise of others' opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary.

When I was young, there was an amazing publication called The Whole Earth Catalog, which was one of the bibles of my generation. It was created by a fellow named Stewart Brand not far from here in Menlo Park, and he brought it to life with his poetic touch. This was in the late 1960's, before personal computers and desktop publishing, so it was all made with typewriters, scissors, and polaroid cameras. It was sort of like Google in paperback form, 35 years before Google came along: it was idealistic, and overflowing with neat tools and great notions.

Stewart and his team put out several issues of The Whole Earth Catalog, and then when it had run its course, they put out a final issue. It was the mid-1970s, and I was your age. On the back cover of their final issue was a photograph of an early morning country road, the kind you might find yourself hitchhiking on if you were so adventurous. Beneath it were the words: "Stay Hungry. Stay Foolish." It was their farewell message as they signed off. Stay Hungry. Stay Foolish. And I have always wished that for myself. And now, as you graduate to begin anew, I wish that for you.

Stay Hungry. Stay Foolish.

Thank you all very much."

The video version of this speech can be found on my media blog, Beyond the Sound Bite.

Tuesday, October 4, 2011

What Is A Bear Market?

To many, especially those in the financial media, a bear market is a statistic. For example, during Monday's swoon, the words "The market, down 20%, is now in bear market territory" could be heard early and often. However, to investment strategists and seasoned portfolio managers, a bear market is not a statistic but a trend established or in the process of being established in which lower prices are the dominant trend. How one comes to this conclusion is a process of the methodology employed. And only time will tell if the forecast is correct.

At present, the view here is that the bear is the operative major trend. This is so for reasons described on many previous occasions, most notably the Mega Trend*. If I (and others) are correct and we are in the throes of the bear, then there are three portfolio decisions that need to be made.

First, what is the appropriate asset allocation mix? The answer depends on one's risk tolerance, goals, objectives, constraints, etc.

Second, what is the appropriate sector mix? The answer here depends partly on the answer to first question but also includes a standard reduced volatility exposure (lower beta) via "defensive" sectors. Thus far, in this bear that has produced some good alpha.

Third, what is the most productive tactical approach to take? Here, the answer resides in what phase of the bear we are in. If in the first wave (which is what I believe we are still in), fade (sell) the rallies is the appropriate course of action. Rallies are a feature of the first phase, as the bulls still have considerable residual strength and the supporting argument that we are only in a correction. This is not the case in the second and third phase, when rallies are few and far between.**

There is a related topic to discuss re the bear: "Because."

Like all market factors, the reasons for the bear (or the bull, for that matter) are many and complex. The simple "Because" reasons given so blithely so often in the financial media are the construct of the business dynamics of the financial media industry and human nature. For many, it is hard to believe that cause and effect (the real world reasons for why markets move) is not always the case. The problem with this is simple: the cause is rarely one thing. It is predominantly many issues with many complex dynamics at work.

One last point: the magnitude of a move is very difficult to forecast. Assumptions can (and should) be made. However, given the highly dynamic nature of the markets (see Soros' "Reflexivity" on this*), it is hard enough getting the direction correct let alone how large the move will be and when it will end.

Bottom Line: A bear market is not just a statistic. It is the view (followed by the reality) that a downward trend is in effect that results in significant loss in value or time. It's a bear until it ain't. Or, to quote the famed philosopher, Yogi Berra, "It ain't over 'til it's over."

*Use search function to find prior posts on this and other topics.
**When entering the 2nd and 3rd phase, the asset allocation should be at the desired level.