Juggling Dynamite

I have been professionally following and analysing world markets for the past 15 years. In retrospect I had no idea what I was signing up for when I started into this work. Fresh from studies of the Efficient Market Hypothesis, Capital Asset Pricing Models and other staples of Modern Portfolio Theory I was initially a confident proponent of widely held views on the merits of stocks for the long run, diversification and passive asset allocations.
But something happened on my way to confident consensus views and complacency: the world entered a blow-off top in stock markets from 1997-1999. A predictable crash followed and governments around the world jumped to “rescue” the system by bailing-out weak companies and slashing interest rates to virtually zero. In that long-building burst, the investing climate made a violent shift from a secular bull to a secular bear. The past 15 years have turned out to be one of the most volatile, risk-filled series of asset bubbles and bursts ever seen in the history of the world. And we are not through to the other side yet.
In the early 2000’s as we were starting our management company, I took great inspiration and help from Peter Bernstein who had managed an investment counsel firm through the secular bull of 1942-1960 and into the last great secular bear in world markets that followed it from 1960-1982. His decades of real life experience in both climates along with his unique intelligence, honesty and humility made Peter a rare mentor in a world of short-sighted nonsense and salesmanship. When Peter died on June 5, 2009 at the age of 90 he left a space that cannot be filled. Thankfully he also left a large body of books and other writings which recorded his insight and wisdom for the generations to come. The last time he wrote to me was September 2007 when I was complaining to him about the perilous prices we saw in asset prices all around us and how dangerous the conventional buy and hold “long-run mantra” seemed to be to real life investors.
Peter replied:

“I do agree with you perhaps more than you realize, because I have been preaching to institutional investors that they lean too much on the long-run mantra. Clearly, individuals should be aware of that strategy. But more people should be preaching your sermon. You put it with great effect.
I also agree that complacency has induced people to take big risks that converted a low-risk environment into a high-risk environment, and recent events prove that to be the case in spades.”

A few years ago I befriended Dennis Gartman on the speaking circuit and instantly also came to appreciate his 30 years + of real life market experience coupled with those rare attributes in the financial world of independence and humble, honest analysis. This morning in his market letter I was struck by what Dennis had to say about the market conditions we are living through today:

“The violence of the moves these days and the unanimity of the moves is unlike anything we can recall seeing in our thirty five years of watching, participating in and commenting upon. We mean that quite honestly. We cannot recall a period of time when all correlations in the forex market have gone so perfectly to “one” and when they have done so with the vehemence we are witnessing presently. Make of that statement what you will and do with it as you must, but to see the dollar/EUR rate move “greenly”… i.e., more than 1% in the dollar’s favour… one day and then to see it move “red-ly” … more than 1% against the dollar… the next seems quite nearly unprecedented. However, to see the dollar do that vs. the EUR and then to see it do the same, and even more radically, relative to the Aussie and Kiwi dollars has to be unprecedented.
…As in the forex market, we cannot recall a time when markets were so correlated into one strangely cohesive unit, rising in international unison and falling the same. There is no such thing, it seems, as diversification. If one is long of Brazilian stocks it is the same as being long of German stocks or of American stocks or of Irish stocks. Almost as puzzling is the fact that one might be long of Indonesian retail shares and that will be almost perfectly equal to being long of Canadian oil shares, within reason. In the past one could diversify across various industries and countries; now there is no such thing. Correlations have indeed “all gone to one.” But in the past they’ve gone to one during periods of duress. Now they are going to one when markets are under duress and when they are joyful. Would that the old days of diversity returned!”

These historical perspectives from sage market followers with twice my experience are valued. It reminds me that like in 2007 just before the bubble burst, risks today are extremely high again. The markets are acting crazy. We are not crazy to be concerned!
I will look forward to telling the youngsters about this remarkable period years from now and how we managed to navigate our capital carefully through it to the next secular bull.

Manic moves in world markets continue today with euphoria this morning (so far at least) on news that Ireland may be accepting a bail out offer from the IMF and EU. The bailout comes with a lot of strings but if accepted would buy Ireland further time to restructure and slash spending. This will be painful to their growth in the near term, but should be better for the country in the long term.
Ireland is near the beginning of a long line here. Others on deck for emergency help include Portugal, Spain, Italy and the 39 US States who have gaping budget holes coming to the end of 2010. US Municipal bonds have been under extreme duress the past couple of weeks, with prices in a free fall. This is a big problem for Municipalities, States, their employees and inhabitants who are depending on social services. It is also a huge issue for pension funds who are heavily allocated to Municipal bonds. This Tech Ticker interview with financial analyst Chris Whalen explains the risks inherent:

“Nowhere has this collapse been more visible than California, which faces a massive $25 billion shortfall and red ink for as far as the eye can see.
After years in which every looming financial crisis has been met with a government bailout, you might think that the same solution awaits California, as well as all the other states that have huge obligations that they can't afford to meet.
Whalen says California will default on its debt–hammering all the pension funds and other investors who have loaded up on apparently safe state bonds. The state won't immediately default, Whalen says. It will start by issuing the same sort of IOUs that it issued to by itself time during its budget crisis last year. But, eventually, the debts will have to be restructured, and this will result in those who own California's bonds receiving less than 100 cents on the dollar.”

Ok, this made me laugh out loud. It is absolutely serious and correct in its points, but the characteristic Ritholtz humour is appreciated.

For many years, I’ve been a fan of Warren Buffett’s long term approach to value investing. Understanding the value of a company, regardless of its momentary stock price, is a great long term investing strategy.
But it pains me whenever I read commentary from Buffett that glosses over reality or is somehow self-serving. His OpEd in the NYT today – Pretty Good for Government Work – paints an artificially rosy picture of the Bailout, ignores the negatives, and omits his own financial interest in government actions.
What might he have written if Sir Warren was dosed with some sodium pentothal before he sat down to pen that “Thank you” letter? It might have gone something like this:
DEAR Uncle Sam Sucker,
I was about to send you a thank you note for bailing out the economy . . . but then some nice men dressed in Ninja outfits came in and shot me full of truth serum. That led me to make one more set of edits to my letter thanking you for saving the economy.
It also helped me recall some things I seemed to have forgotten in my other public pronunciations about the bailouts….

Read the whole letter here for a good chuckle and some excellent insight.