Beyond the Sound Bite: An Interview with Christopher Chabris, Ph.D. and Daniel Simons, Ph.D.

If someone told you to keep your eye on a bouncing ball, do you think you would notice a gorilla entering into then departing your field of vision?

We kick off our summer reading series with the authors of "The Invisible Gorilla: And Other Ways Our Intuitions Deceive Us". In a most fascinating conversation with the cognitive psychologists, we explore key elements of behavioral science and many of its applications to decision-making including the myth of intuition, the illusion of knowledge (e.g. Amaranth), and the appeal of confidence and certainty ("...we prefer people who are confident even when we have all the information we need to see that they are less accurate in what they are saying."). Bernie Madoff, anyone?

Investors seeking to gain a better understanding of their own investment decision-making process will find the time spent listening to this podcast as time well spent.

Beyond the Sound Bite podcast interviews can be found at BeyondTheSoundBite.blogspot.com
To listen to this interview, click here

The Greater Good

In between the bowing and genuflecting before the altar of the Oracles, here’s a question I hope someone asks Warren Buffett and Charlie Munger at this weekend’s Berkshire Hathaway lovefest: What is the right balance between acting in one’s self-interest versus acting for the greater good?

If any two people can provide the answer to this question and apply it specifically to economics, finance, and business (not to mention the current regulatory and legislative environment targeted directly at the financial services industry), it’s the Oracles.

Now, we know that the decision regarding self-interest versus the greater good has already been decided quite some time ago in certain realms. For example, the Vampire Squid was certainly acting in its own self-interest when it exploited its market maker position via its prop trading using what one of the Oracles called “financial weapons of mass destruction”. And, despite political posturing from semi-informed Senators, the Vampire Squid is certainly correct in arguing that the “sophisticated” investors on the other side of their prop trades know “buyer beware” applies at all times. Moreover, there is little doubt certain other squid-like entities with prop trading businesses share the same sentiments and philosophy.

Then there is the political realm, which is rife with self-interested behavior. For example, a Senator or Congressperson representing a state or district is elected to do the bidding of his/her backers – a little pork here, an earmark or two there.

Where it gets most intriguing is when the two realms – finance/business and politics – intersect a key moment in time. I am speaking of Senator Ben Nelson of Nebraska (the state within which Omaha and the Oracles reside) and his no-debate-on-financial-regulatory-reform-until-we-grandfather-key-derivativs-transactions vote.

On the surface, Senator Nelson appears to be acting for the sole benefit of a key constituent – Berkshire Hathaway. But is that action in the best interest of the state that Mr. Nelson represents? It’s citizens (beyond the Oracles and their local employees)? The country? What exactly does being elected to represent a state within a union mean?

This is what I hope someone will engage the Oracles for an answer. And I am not speaking of it in the obvious, narrow partisan political sense but in the larger context of individual self-interest and the greater (collective) good.

What is the right balance? What serves the greater good – acting in one’s own self interest even to the seeming detriment of the greater good or deferring (eliminating?) the self-interested benefits at potentially great individual expense (for the moment or longer) and thereby allowing others to gain?

Is the first approach solely about greedy behavior that serves no purpose beyond enriching those directly involved? Or is such a Darwinian/advocate/self-interest approach vital to growth, peace, and prosperity for more than only those directly and favorably impacted – in effect for the greater good?

Or is the second approach one that seemingly enhances the greater good at the expense of a diminished entrepreneurial spirit – a spirit that enabled homo sapiens to evolve out of the primordial swamp (the pleasure principle, writ large)? Moreover, will the second approach produce an arbitrage situation in which self-interested parties seek other outlets thereby damaging the greater good?

What Oracles Are For

These are kind of questions that Oracles are created for: To provide insight into the larger themes that impact all of us. To impart wisdom into areas that require it and that can enrich us in immeasurable ways.

Being in the presence of greatness does not make you great. You cannot gain wisdom and good judgment simply by viewing a work of art or by catching a whiff of a great man’s aftershave lotion. Rather, taking advantage of the collective wisdom of the Oracles is far more rewarding via challenging questions for great minds.

The pilgrimage to Omaha, at this specific point in time under these specific circumstances involving these specific parties, provides the ideal setting for all us mere mortals to derive the benefit of the wisdom of the Oracles. Wisdom that will hopefully serve the greater good.

Happy Anniversary. Now What?

Yesterday marked the one-year anniversary of the bear market low in stocks and the subsequent bull rally. Therefore, a review of where we were, where we are now, and, importantly, where we are likely to be headed, seems to be in order.

To refresh your memory, let’s go back to March of last year and note the following excerpts from commentaries made by yours truly regarding the end of the world as we knew it:

March 5 – “Bears Out of Momentum”
“…are we headed non stop to 600? Before I get to why the 600 call is unlikely right now, let me address 2 factors - one fundamental, the other, a market dynamic.”
To read the complete commentary, click here

March 12: “Why Divergences Work”
“Tuesday’s big up-market demonstrated a tried-and-true investment axiom: When market conditions are ready, a catalyst is all that's needed to get the show on the road. The show, in this case, is a cyclical bull rally. And the catalyst was the Citigroup's earnings statement. Here are some of the particulars….”
To read the complete commentary, click here

March 26: The Cyclical Bull Within the Secular Bear
“In stocks, we seem to have a cyclical bull within the secular bear. Investors (and the world economy) have been given a reprieve - that is, until next year, when all the money and all the regulatory changes thrown at the economy and the financial system must evolve into greater private market participation.

In the case of the US economy, capex must take the economic handoff from government and become the principal driver of economic growth, as US consumer spending continues at a more muted pace. For the consumer, balance-sheet repair will almost certainly continue as its largest component -- the aging baby boomers -- set aside real savings out of income to provide for themselves in the rapidly approaching retirement years.

Therefore, as the US economy goes through its transition from its overly leveraged consumer bias to a greater level of corporate activity -- driven largely by exports to the real growth engine of the next decade and longer, emerging economies -- investors should consider repositioning their portfolios to include more emerging-markets investments.”
To read the complete commentary, click here

The rest is history. Stocks rallied, emerging markets did best, and investors were rewarded for their courage and wisdom in relying on time tested market tools, such as the valuation parameters and the divergences principle described above.

Okay, now what?

Investing is a game of “What have you done for me lately?”. In accordance with that game, investors cannot sit on their laurels and revel in the joy of their courage and wisdom. When it comes to investing, the past is always prologue. And it functions as a guide to what is likely to be.

In attempting to predict where markets are headed, it is just not enough to use the past as a valuable guide to what will be. It is also necessary to remember that markets are driven by investors, and investors are people whose tendencies have a certain predictive dynamic due to the simple fact that they are human. This is just another way of saying that human nature doesn’t change; we, as investors, just emphasize different things at different times. Moreover, the principles of asset values are also a reliably consistent tool, one that enables an investor to estimate what the fair value for any given asset might be.

Taken together, the three principles to follow – history as a guide, the constancy of human nature, and estimates of fair value – enable an investor to apply the same tools and principles that got the above noted rally forecast correctly and apply them to today’s market environment. With that said, let’s first briefly consider where we came from and what it means for the equities markets going forward.*

Back From the Brink

The massive capital infusion governments around the world threw at the financial then economic crisis enabled the world economy and markets to step back from the abyss of global collapse and regain some sense of stability. However, government stimuli are good for only so long. Eventually, end user demand must take over and drive the world economy, which will drive the world’s equity markets higher. In this regard, the jury is still out as to whether such an economic handoff will actually occur.

The US consumer, engine of end user demand for most of the past several decades, remains in the throes of balance sheet repair. Paying down debt and building sufficient cash reserves for that rainy day is still priority number 1. Occasional episodes of spending beyond their means will occur from time to time (as it may have last month based on the surprising increase in consumer borrowing). But with the bulk of baby boomers bordering on retirement, balance sheet repair will remain the secular trend for the foreseeable future.

Therefore, the hope that an emerging middle class in developing economies can pick up much of the global growth slack left by the reduction in US consumer demand. This, along with a sustained level of infrastructure and corporate capital spending (capex) rebuilding vital to both developing and developed economies, are central to a sustainable growth phase for the world economy. However, a hope is not a certainty, and whether the handoff will occur and just how robust will it be is one of the key areas to focus on going forward.

At present, the odds do favor such an occurrence, but many obstacles remain in place not the least of which is confidence. For example, in order for infrastructure and corporate capex spending to occur in earnest, policy makers must muster the political will and organize their priorities and corporate senior management must believe that current long range spending plans will result in future growth rates and profitability in excess of their cost of capital. This is one of the key areas where the analytical focus must be centered.

*In my next commentary, I will address the second and third areas – fundamental valuation models and market intelligence readings. Until then, enjoy the ride.

Doing the Valuation Math

Now that my market forecast events have begun (with NYSSA's event last Thursday), it's time to do a little valuation math for the year ahead. So, based on the initial comments heard at last week's event and elsewhere, here you go:

18 times $80 (S&P 500 operating earnings for 2010) = 1440.
1440 minus a present value discount (12%) = 1267

This is the bulls’ case for why stocks should go higher this year – an above historical average P/E times a robust earnings growth for 2010 minus an historical average discount rate (bringing the future value back to the present*) equals a most profitable year.

The valuation debate is a paradox – simple yet complicated. Simple in that the formula is rather easy to compute. Complicated in that the social science known as investing involves numerous variables, many of which are highly subjective. For example, the P/E used in a valuation model is based on the views of the investor for the economic and market times of the moment and the near future. In the current case, the bulls would argue that an above average P/E is appropriate for the current and near future because history says so – low inflation + robust economic growth + strong corporate balance sheets = above average P/Es. Exactly what level above the historical average P/E (which happens to be 15) is the subjective wiggle room and a key area of the valuation debate. Then there is the earnings number.

$80 operating earnings for the S&P 500 for 2010 is the best case number I am hearing of late. Of course, this number is open for debate. The final two components that investors might want to ponder doing the valuation math involve the discount rate and the time period.

In the above illustration, I used the historical average return for large cap stocks, which has often (but not always) been 12%. Some would argue that 10% (or lower) is a more appropriate going forward expected return for stocks given the slow growth environment envisioned for the next several years for advanced developed economies. Then there is the time period one discounts the future value. In the above case, I use 12 months. Some might argue things are far to dynamic and a 6 month discounting time period is more appropriate.

Investment Strategy Implications

Wherever you fix the fair value of today’s market, the valuation math always needs to be done as it provides the return context for an asset. For what it’s worth, I think these times are extraordinary and do not warrant an above average P/E (which signifies a below average risk climate). Rather, I would argue the uncertainty factor for 2010 is considerably higher than the bulls believe, despite the prospects of a robust earnings period for the large cap, multinational companies that populate the S&P 500. Risks in areas broad (e.g. geo political, US domestic political, developed economies’ internally generated growth) and specific (e.g. sector specific issues such as those facing the financial services and healthcare industries, sustainability of Chinese growth, regulatory change) are abundant and should be ignored at one's financial peril.

All of this leads to the more prudent conclusion that an average P/E times a moderately higher earnings growth rate is appropriate. In other words,

15 times $74 = 1110
1080 minus 12% = 977

Therefore, at today’s price of 1140 the market is currently 14% overvalued.

Liquidity driven markets have a funny way of producing overvalued markets. And an even funnier way of producing justifications for just about any fantasy valuation levels one wants to concoct. At least for a while.

*Note: It is important to remember that on any given day stocks sell at a discount to their expected future value. Therefore, today’s price is always a discount to where stocks should be in the near future.

Minyanville posting: The Rise of Behavioral Finance

This week's Minyanville posting introduces an area that I have been involved with for over a decade - Behavioral Finance.

"Behavioral science will be the next step in the evolution of economic and investment thinking. With the destruction of laissez-faire, American style cowboy capitalism, academics, policy makers, and practitioners will look toward the behavioral sciences to..."

To read the full current Minyanville commentary as well as other Minyanville postings, click here

Advice to Obama Administration – Less Pro-cyclicality, More Contrarian Behavior

Contrarians are a lonely lot. They sell when others buy and buy when others sell. They are not the run with the herd type.

In the world of investing, herd-like behavior is the dominant form of action and can be seen in many forms – high correlations and animal spirits, for example. A pro-cyclical force that leads to bubbles and busts, in the extreme. And a high degree of mediocre investment performance (often via closet indexing).

Yet, pro-cyclical forces are not limited to the animal spirits of Wall Street. Main Street has its own version, one being played out in the form of layoffs and capex cutbacks as the business cycle runs roughshod over the longer-term secular trends. Understandable but very short sighted. Kind of like the preoccupation with quarterly earnings results.

Even in banking, pro-cyclicality is the way business is usually conducted. Consider the accompanying chart from the Economist re lending standards. Easy money when times are good, tight money when times are tough. More often than not, exactly the opposite of what the economy needs.

Now, easy money during good times is a good thing in the early to mid stages of an economic recovery, however it becomes highly destructive in the latter stages of an economic expansion as dubious projects get funded when a more appropriate approach would be toward prudence. The music is playing and everyone has to dance.

Sadly, as we are all learning with great pain, in the extreme, in all facets of the real and financial economy, privatizing gains and socializing losses becomes the end result.

Investment Strategy Implications

President-elect Obama wants to bring change to Washington. Being forced upon his administration and the global economy as a whole is change across all facets of the financial and economic spectrum. A new financial model needs to be constructed as does a new economic order.

One hoped for addition to the change mantra would be finding ways to encourage less pro-cyclical and more contrarian behavior. Perhaps, then the bubbles and busts will be less pronounced and the socialization of losses less costly.

Krugman and El-Erian in the Valley of FUD

In his excellent book, “When Markets Collide”, PIMCO chief Mohammed El-Erian writes about the journey and the destination that the global economy and markets are undergoing and puts in context and helps clarifies much of the current economic and financial chaos. Mr. El-Erian describes a world that will be but is clear to note that the process of getting there may be “bumpy”.

Nobel laureate Paul Krugman points to the same concept in his blog posting yesterday (“After the Stimulus”) in which he lists the components of the US economy for 2007 and their averages from 1979 to 2007. As the accompanying table from his blog shows, the economic mix of the US economy got to be quite imbalanced primarily due to credit inspired high consumption levels by the US consumer. In the process, net exports became the counterbalancing force*.

As El-Erian declares in his book, a transformational world (economic and financial) is inevitable and has been underway for some time (long before the current credit and now economic crisis). And Krugman states, “Consumption probably isn’t going back to a 2007 share of GDP — savings are back. So what will fill the gap, once the stimulus is gone? Housing? Not for a long time. Business investment? Hard to see why. The natural thing would be to trade lower consumption for a smaller trade deficit.”

It is logical to assume that the US economy will experience two mega trends in the coming years:

• US consumer spending will fall while US consumer savings rise (aided by the baby boomers’ need to provide for their retirement years now that the wealth effect has gone kaput)
• Net exports will improve as global growth, particularly in emerging markets, continues to expand (certainly relative to developed economies)

It is also likely that non-residential investments (capex) will move closer to their average as corporations retool to meet the global export opportunities while government spending will increase as the US government seeks to stabilize the US economy (large fiscal deficits and other government programs like TARP).

Investment Strategy Implications

The bottom line for those investors willing to look beyond the valley of FUD (fear, uncertainty, and doubt) that we are currently wallowing in is to position their portfolios (what’s left of them) to exploit these mega trends. To follow this direction, however, requires context, perspective, and perseverance – something sorely lacking in a panic stricken financial climate.

*table contents
C = Consumer
N = Non residential investment (capex)
R = Residential investment (housing)
G = Government expenditures
NX = Net exports (exports minus imports)

The Fear Side of the Greed and Fear Cycle

“The only thing new in this world is the history that you don't know”
Harry S. Truman






Just as day follows night and spring follows winter so, too, does investor psychology follow the seasons of emotions from greed to fear and back. Behavioral finance rules and the Efficient Market Hypothesis remains a hypothesis. Loss aversion over risk aversion.

So, to help investors in need of a little timely perspective, the above two charts (click images to enlarge) reflect the ever reliable greed/fear cycle quite nicely.

Investment Strategy Implications

The contrarian in me believes in the Baron Rothschild saying, "The time to buy is when there's blood in the streets". It is an investing example of President Truman's quote and a testament to the reliability of the greed/fear cycle. Therefore, since the epicenter of the current fear cycle is the Financials, I can't help but notice the recent relative strength in Financials in the midst of outright panic.

Squealing Away

This morning's bold central bank announcement will be seen by some as a capitulation, by the Fed and its counterparts, to yesterday’s negative knee jerk reaction to the Fed’s ¼ point rate cut decision. To see the announcement as such is naïve. Picture the scene: the Fed members sat around last night wringing their hands in woeful lamentation wondering why Wall Street just doesn’t understand us? Nonsense.


The decision this morning is part of the next phase, a series of steps designed to create the game that will be, the Magic Formula*. Like a pig stuck in an investment fence, however, some “investors” want the game that was to be restored asap while this Fed wants the game that will be to emerge*. To understand the difference between the two is to understand the tug of war that erupts every time this Fed chooses not to go back to the game that was via a bailout of bad behavior.

The principal reason why certain “investors” want to reestablish the game that was has much less to do with their crocodile-tear concerns re the real economy and the threat of a recession and much more to do with one simple, logical fact of human nature: When many have made a fortune playing the game a certain way, when their trading systems and information networks have generated seven, eight, even nine-figured incomes, they will do everything in their power to restore what was using any and all means possible, including those like-minded shills in the media.

Investment Strategy Implications

This Fed is attempting to walk that fine line between the real economy effects of the credit squeeze, the moral hazard consequences of a bailout, and the risks that inflation eminating from the global growth story poses. Therefore, it is advisable that real investors, those interested in making investment decisions with a time horizon beyond the next media sound bite, try to best understand the global macro context that policy decisions are being made in. It is also advisable not to become consumed in the moment (what behavioral finance experts call the “availability heuristic”, also known as “recentness”**) at the expense of the larger context as noted in yesterday’s simple stock market balance sheet.

It may be upsetting for some to hear but this far from perfect Fed does know something.

*see blog posting “Searching for the Magic Formula”, November 29
**see blog posting “Just How Smart is the “Smart Money”, May 29

The Complacent Correction

Perhaps my May 24th forecast of a market correction (see blog posting, “4 Reasons Why a Market Correction is Imminent”) is now underway. If so, the issue then becomes just what type of a correction will this be?

I submit to you the following three versions of a market correction that US stocks are likely to experience:

1 – The Alfred E. Newman Correction

This version is more anecdotal than quantitative and easily fits in magnitude with version #2 below although less violent, a relatively tranquil-like downward float. The strategist and pundit talk should center on the “healthiness” of a correction - which is a true statement but of concern when accompanied by a sanguine tone. The quantitative manifestation of this version follows.

2 – Painfully Short and Sweet (scare the bejesus out of ‘em) Correction

In 2005, 2006, and early 2007, this version (<10%) has been the correction du jour. Sharp down, seemingly out of the blue, yet, when completed, not all that bad. Kind of like some nasty tasting medicine – bitter but brief. Final damage is in the 5 to 8% range.

3 – The Real Deal

The US equity markets have not experienced this version at any point during this entire multi-year bull market. I am speaking of the >10% variety. A steady corrosive decline down (versus the sharp, sweet #2 version) that, after a while, shifts sentiment from complacency to concern to capitulation.

Investment Strategy Implications

Regardless of which version you think will occur (I suspect most will opt for versions 1 or 2, which means the contrarian in me says to lean toward version #3), the issue of what to do comes to the fore. If you believe in version 1 or 2, then you’re a buy-the-dip investor. After all, that’s what has paid off recently*. If you’re a version 3 person, however, then the issue of correlations becomes a consideration.

Given the high degree of correlations among and within markets, the ability to “bury the money in defensive issues” is taken somewhat off the table. Granted, there is some comfort in the lower beta aspects of certain sectors and styles, but in fully synchronized, highly correlated markets, across the board losses tend to be more certain. Accordingly, non-correlated assets are nearly impossible to find, which leaves only the asset allocation decision as a tactical course of action for most investors. And that may a problem for some, as it is a market timing approach that many investors (as opposed to speculators) are not completely comfortable with.

Note: Going into this week, the Model Growth Portfolio (MGP) is currently 86% in equities with several hedged positions, including a short in long term US Treasuries (TLT) and a long position in the Ultra Short QQQQ (QID). To learn more about the strategies employed and MGP, click on the Blue Marble Research services link to your left. A modest subscription is required.

*see May 29 blog posting "Just How Smart is the Smart Money" re the behavioral finance tendency of recentness.

The Frontiers of Finance

excerpts from this week's report

“…investment banks have recently changed out of all recognition.”

“We make it impossible for investors and analysts to understand what is going on.”

“A Special Report on International Banking”
The Economist
May 19, 2007

"Next Monday, I will moderate my next Hedge Fund/Alternative Investments seminar for the CFA Society of San Diego. Having conducted numerous such events over the past 4 years, I have a fairly good idea as to one of the main topics to be discussed – risk. Specifically, where does the risk in hedge funds reside? The bottom line answer will almost certainly be (as it has before), “no one knows for sure.” The intermediate answers are complements of the financial engineers at the investment banks – derivatives in all its forms.

At just north of $500 trillion, derivatives are not just staggering in size. They are, more importantly, a black hole of..."

Investment Strategy Implications

"The boundaries of finance are being stretched and tested in ways and on a scale and scope never before seen. The 21st century masters of the universe are producing products designed to satisfy the needs of their clients and the marketplace and, in the process, reaping the rewards for their firms. As long as global conditions remain conducive for growth and stability (liquidity and benign economic conditions), the problems may not..."

Note: To view the entire report (including the all-ETF Model Growth Portfolio) and for information regarding our subscription service, please click on the Blue Marble Research services link to your left.

Quotable Quotes (and a little V - TV)

“…we remain alone in our view that S&P 500 earnings are the most cyclical in history (dating back to 1940!). If that is true, then one should be careful when making statements about low PE ratios for the overall index. If earnings are indeed the most cyclical in history, then a low PE might simply reflect peak earnings.”

Rich Bernstein

“We have trouble recognizing how much information is enough and how much is too much. We pay excessive attention to low-probability events accompanied by high drama and overlook events that happen in routine fashion. We treat costs and uncompensated losses differently, even though their impact on wealth is identical. We start out with a purely rational decision about how to manage our risks and then extrapolate from what may be only a run of good luck. As a result, we forget about regression to the mean, overstay our positions, and end up in trouble.”

Peter Bernstein

"There are two kinds of investors, be they large or small: those who don't know where the market is headed, and those who don't know that they don't know. Then again, there is a third type of investor - the investment professional, who indeed knows that he or she doesn't know, but whose livelihood depends upon appearing to know."

William Bernstein

“To achieve great things, two things are needed; a plan, and not quite enough time.”

Leonard Bernstein


…and for a little V – TV, see the following blog entry.


Have a good weekend.