Rationalizing With Big Red, Ben Bernanke And Harry Markowitz

Rationalizing with Big Red                                                Printer Friendly Version 

On January 8^th we celebrated my daughter Libby's birthday.  As is our tradition, the birthday girl had her choice on where the family would meet for dinner.  This year, January 8^th fell on a Friday, and as many of you know, Fridays in small town America have been unofficially dedicated as "Go Out to Eat Night".  In order to beat the crowds we decided to begin Libby's celebration at 5:15 at her chosen restaurant, The Olive Garden.   Libby has been a vegetarian for a number of years, and her choice of the Olive Garden was somewhat of a relief to this old carnivore, as they have a menu that can satisfy both of us.  Getting there early allowed us to walk in and sit down without the customary forty-five minute wait, and, best of all, park our vehicles without the stressful search for an open space. 

Parking is pretty easy for most people these days, as cars are a bit smaller than they used to be.  The parking lots are designed for this and can hold a lot of little cars.  However, I was not driving a little car; I was in "Big Red."  I'm not sure if I have formerly introduced you to Big Red, who is my 2001 Chevy 2500 HD truck.   I know I should be a little more conscientious of my use of gas, but Libby drives a car that can fit in the back of my truck.  If I average the carbon footprint of the two, we as a team are well within the limits that are considered appropriate.  Besides that, Big Red is a family truck.  Whenever anyone needs to move a piece of furniture or clean out the garage, Big Red is there.    

Because this was a special occasion, dinner went on a little longer than normal.  By the time we were finished, the restaurant was full and people were waiting the obligatory 45 minutes for a table.  As we left, I discovered another problem with Big Red and Friday nights at the Olive Garden.  The lot was full.  Many a small car driver had decided that the parking spaces extended to areas that were clearly marked as driveways.  They were courteous in that they left enough space to squeeze between them and exit the lot, as long as your car was similarly small.  Well, Big Red is not one of those cars, and I found myself in a pretty tight position.  There was absolutely no way that I was going to be able to drive Big Red through the spaces provided by my little friends.  There was only one way out, and that was not going forward, but driving in reverse.  Yes, Big Red and I had to drive by the rear-view mirror. 

The mind is a truly wonderful creation.  It has a built in mechanism that protects us from our own actions.  There are many that would call Big Red a gas guzzling carbon emitting vehicle that should not be allowed on the road.  If I were sympathetic to this cause, then I would need to remind myself that because Libby drives a little car and because family members often need the truck, I therefore have nothing to feel guilty about.  This ability to rationalize our actions keeps our sanity in place.   

Investment Advisors, along with their support personnel, the economists and research analysts (including yours truly), have been practicing the dual art of rationalization and driving with the rear view mirror for as long as there have been markets.  Our ultimate purpose, of course, is to attempt to see into the future.  As we all know, the future is unknown and has a habit of charting new unexpected courses, thus our need for rationalization.  Since most projections in today's world are based on the reality of the past, driving by the rear view mirror is the standard operating procedure used in this business to formulate an opinion about tomorrow.  

The Great Recession of 2008 and 2009 gave ample firepower to any individual that wanted to criticize our economists and to anyone else who failed to see the problems beforehand.  To emphasize this I want to quote the first paragraph from the cover story "What Good Are Economists Anyway?" as it appeared in the April 16^th issue of Business Week.   

"Economists mostly failed to predict the worst economic crisis since the 1930s.  Now they can't agree how to solve it.  People are starting to wonder:  What good are economists anyway?  A commenter on a housing blog wrote recently that economists did a worse job of forecasting the housing market than either his father, who has no formal education, or his mother, who got up to second grade.  "If you are an economist and did not see this coming, you should seriously reconsider the value of your education and maybe do something with a tangible value to society, like picking vegetables," he wrote on Patrick.net.  The author of this article then added, "Take that, you pointy-headed failures!  Go jump off a supply curve!" 

Although I would rather pick on the economists, many of my peers in the investment community have been directly blamed for the recent financial crisis.  Most of this criticism is directed towards those investment professionals who believe in the Efficient Market Theory (EMH).  As Justin Fox states in his book The Myth of the Rational Market, the notion of a rational market "is a myth of great power - one that, when taken too literally, can lead to all sorts of trouble."  Dane Stangler in A Critique of Pure Financial Reason adds, "As EMH came to dominate economics, academic finance, and Wall Street trading desks, its "elegant" mathematical models warped all interpretations of reality." 

With criticisms like these, it is easy to see why those attacked may feel the need to rationalize.  Two of the most prominent economists of our time, Dr. Ben Bernanke and Dr. Harry Markowitz, have done just that.   The very act of rationalizing can provide those subject to criticism some comfort, but it can also reveal some new ideas.  It is these "new ideas" from Dr. Bernanke and Dr. Markowitz that are important for us to see.

Rationalizing with Ben Bernanke 

Dr. Bernanke and his predecessor Alan Greenspan have been held responsible, and, in fact, directly blamed by many for the housing bubble and crisis that followed.  Dr. Bernanke addressed this in a speech given to the American Economic Association on January 3, 2010 where he stated, "Specifically, they claim that excessively easy monetary policy by the Federal Reserve in the first half of the decade helped cause a bubble in house prices in the United States, a bubble whose inevitable collapse proved a major source of the financial and economic stresses of the past two years".  The entire speech is available at http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm. 

Dr. Bernanke is an educator.  This is clearly evident in his speech, along with his slide show of charts and mathematical equations for your viewing pleasure.  The speech is also his offered rationalization of the actions taken by the Federal Reserve during the last decade, proving that an easy money policy, led by low interest rates, was not the cause of the housing bubble.  He concludes, "House prices began to rise in the late 1990s, and although the most rapid price increases occurred when short-term interest rates were at their lowest levels, the magnitude of house price gains seems too large to be readily explainable by the stance of monetary policy alone.  Moreover, cross-country evidence shows no significant relationship between monetary policies and the pace of house price increases." 

The real message I want you to take from this is contained in a couple of sentences that are not rationalizing the past, but giving information about Dr. Bernanke's approach to address the next crisis.  He states, "All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs.  However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks..." 

This clearly shows that Dr. Bernanke is not opposed to using monetary policy to shock the system.  As investors we need to be aware of this possibility.  Given current interest rates near zero percent, any unexpected change in monetary policy that includes a larger than expected increase in short term interest rates could have a serious impact on stock and bond prices.  Just being aware of this does not provide much protection for our investment portfolio.  If there was an easy or cost efficient way to protect us from this possibility then it would make sense to utilize it.  But therein lies the problem:  How do we protect our portfolios from an unexpected event?   Dr. Markowitz has spent a lifetime searching for an answer.  So let's explore Dr. Markowitz "rationalization" and see if he provides a solution.

Rationalizing with Harry Markowitz

Dr. Markowitz, a Nobel Prize winner, is best known for his work in Modern Portfolio Theory.  It spawned the Capital Asset Pricing Model, the Efficient Market Theory and the Black-Scholes-Merton equation.  Although MPT has been noted by many as a great benefit to investors, it is also directly linked to the most recent disasters in financial history, including Black Monday, Long-Term Capital Management (LTCM) and the most recent housing bubble and its aftermath, the near collapse of the world's financial system as we know it.  The theory and its offshoots are highly dependent on past relationships, and this is like driving by the rear view mirror.  If your plans are to go forward, but you are trying to go forward while looking in the rear view mirror, an accident will happen sooner rather than later. 

As many of you know, I have been a critic of the work of Dr. Markowitz for about as long as I can remember.  Not because of the theories themselves, but because they directly reinforce a high level of speculation in our markets.  For the majority of our country's history, the path to wealth has been through the ownership and operation of a business or by sharing in the growth of capital and excess income a business can generate.   MPT removes the importance of business ownership to the point that most individuals no longer consider the business at all when they invest, instead concentrating their research on "the market" or the "economy."   

On September 17^th of 2009, Dr. Markowitz gave a presentation to the CFA Society of Orange County (Los Angeles) titled "Modern Portfolio Theory, Financial Engineering, and Their Roles in Financial Crises" where he rationalized MPT as to their part in the disasters of Black Monday, LTCM and the recent crisis.  As with Dr. Bernanke, Dr. Markowitz cannot blame the Theory and spends the majority of his time rationalizing.  He sums up with, "...All financial models are an attempt to describe an infinitely complex reality.  As a result, to achieve any success at all, portfolio theorists must make certain simplifying assumptions.  But the problem with financial models is not that most of these assumptions are incorrect.  Quite the opposite.  These simplifying assumptions are generally true most of the time.  The problem is that they are not always true."   Dr. Markowitz earns my admiration when he later discusses, and yes, even provides an equation or two that provides some very useful support of, our own common sense beliefs.    

Dr. Markowitz states, "For the individual investor, this means that he or she must not expect wide diversification in an all equity portfolio to provide stable returns.  Bonds or cash must be included in a portfolio to reduce volatility to an acceptable level."   To use Dr. Markowitz words, "This is shocking!" 

A short story may help in understanding why this is so important for individual investors.  A few years ago a "wealth manager" from one of the largest banks in the country called me to discuss managing some of his clients' money.  As with most consultants, he walked through a series of questions to determine if our abilities, as reported, are true, and what, if anything, is unique about our approach to investing.   One group of questions concerned risk protection.  There are many ways to "correctly" answer these risk related questions, but by "correctly" I mean giving the consultants an answer they want to hear.  Most of the accepted risk protection methods include various techniques based on diversification and/or the use of derivatives, or shorting stocks as an alternative.   My answer was obviously not acceptable.  I told him simply "if you don't want to take risk, then don't invest in common stocks."  For me, this was plain common sense, and I believe the best answer for an individual investor.  But for this wealth manager, my answer was shocking.  The idea of using cash in a portfolio as risk reduction was enough for him to end our conversation.  Individual investors are not institutions. We believe it may cause more harm than good for an individual to use an institutional approach to portfolio management.  

Harry Markowitz is absolutely correct in his instructions for individual investors.   We do not need an elegant mathematical equation to verify the effectiveness of buying bonds or using cash to minimize portfolio risk, only simple arithmetic.  The risk in a portfolio of common stocks and cash will be reduced directly by the amount of cash held.  He goes on to give some pretty good advice with these additional comments:  "Excessive leverage is bad; and writing insurance against correlated risk without reinsuring, or without quite large reserves, is an accident waiting to happen.  More generally, evaluating risks one at a time rather than considering them as a portfolio is an all-too-common error." 

We thank Dr. Markowitz for all his common sense advice.

Our Five Year Forecast - maybe just an exercise in futility but well worth the effort 

Many forecasts, including ours, may be quite useless: an exercise in futility.  But we, like everyone else who has excess funds, must formulate some expectations of the future.  When all is said and done, investing is simply a matter of choices as to where we place these funds.  We can lend our funds and charge rent (interest) for the use of those funds, or we can share in ownership and be rewarded by the growth or punished by the loss of our capital.  In each case, we need to have some basis to make a decision as to the amount of money we are willing to rent or the amount of money we are willing to deploy for capital growth. 

This year, unlike in past years, we are including in our forecast some additional work that we complete for each of the major economic sectors as determined by the stocks included in the S&P 500.  Because of the number of tables included, we have decided to add this year's forecast as a supplement to our letter.  My hope is that you will find it more useful and easier to use. 

A Few Notes -

For many years now I have taken on the dubious task of sharing our predictions for the New Year via our good friends at WRHI's "Straight Talk" program.  This year we will be taping a special program that will be aired not on "Straight Talk," but instead as a special Saturday morning segment.  If you have time on January 16^th tune into WRHI, the news/talk radio station that has served our local community since 1944 (WRHI AM 1340 and FM 94.3).  If you are unable to listen, then we encourage you to access the program from anywhere in the world via the internet at www.wrhi.com or at our own site, www.andersongriggs.com . 

During the month of December we posted three new market commentaries and four audio programs to our web site. Our market commentaries are some of our thoughts about what is currently going on in the financial world.  If you do not have internet access, please give us a call and we will be glad to package them up and send copies to you.  For those of you who do have access, please take a moment to visit www.andersongriggs.com and read the commentaries.  As always we thank you for your continued support of our work, and please, if you have the opportunity, recommend us to someone you think we can help.

Until next time, 

Kendall J. Anderson, CFA