In the realm of academic sciences there sits at the top of the food chain the world of physics. The world according to Galileo, Pascal, and Newton can be quantified and the laws governing cause and effect put forth in intricate formulas and mathematical equations that hold true. Physics, according to Wikipedia, “is the natural science that involves the study of matter and its motion through space and time, as well as all applicable concepts, such as energy and force. More broadly, it is the general analysis of nature, conducted in order to understand how the world and universe behave.” In the world of mathematical physics, atomic physics, molecular physics, and quantum chemistry, one can define the universe in mathematical fashion. For example, as we all know from Newton’s laws of motion, to every action there is always an equal and opposite reaction. If I drop a ball of a specific size and density from a specified height, then based upon the physical aspects of the ball, the length traveled to the floor and the hardness of the surface it hits, a physicist can tell me mathematically how high the ball will bounce once it hits the floor. And not only once, but the height of all the subsequent bounces until it comes to rest on the floor.

In academia, somewhere below the world of physics lives the world of economics. Economists and investment professionals aspire to be physicists. The desire to quantify economic movement or behavior with formulas has become an obsession for the modern-day investor. The attempt to predict future outcomes based upon a given set of historical economic variables is the Holy Grail that we seek. However, there is one huge problem in quantifying the economic and investment world: you are dealing with human behavior that is often rational but at times can be completely irrational. For the purpose of argument, let’s use our above bouncing ball as a metaphor for today’s investor. If you take an investor and drop him from, say, a level of 1500 on the S&P to 700, then from a physics perspective one could project a rebound of returns. Given that humans are perfectly rational individuals who will always invest money to its highest and best utility with the least amount of risk, then one could employ mathematical formulas to draw conclusions as to how high the markets would recover. However, humans do not react to events as does mute physical matter: …we have the ability to be emotional, to rationalize, to anchor, and in many other ways make irrational decisions. For example, economists could apply the number-sequencing theory of Italian mathematician Fibonacci to the above example, and arrive at the conclusion that the investor should bounce to an S&P level of 1206. However, what if the investor behaves irrationally and, upon hitting the floor the first time, grabs an anchor for fear of bouncing again and again? Or what if he hits feet first and has the vertical jump of a Michael Jordan? Although there has developed a series of econometric laws using mathematical trend lines and what is commonly known as technical analysis, I question if we can actually measure human behavior. Are markets indeed efficient? Ben Graham once wrote:

Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from….Whenever calculus is brought in, or higher algebra, you could take as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the guise of investment.”

In my opinion, what Mr. Graham is trying to make you and me aware of is that critical thinking regarding financial markets is an underappreciated asset in this investment world. The trend is your friend, don’t fight the tape, let your herding instincts go with the flow – are all statements that reflect investors’ greed and fear of missing the next upward move in the market, regardless of valuations. Investment professionals have become consumed with sophisticated trade formulas, algorithms, and program trading and have forgotten how to apply common sense to the models. When events like 2008 occur (what the investment world terms as “fat tail” events and what Nassim Taleb referred to as “Black Swans”), the investment world dismisses the bursting of the bubble as a one-in-a-thousand occurrence. But why do investors get caught by these 3-sigma events, such as in 2008? In my opinion, it is a simple lack of critical thinking, where statistics, benchmarking, and status relative to your peers replace common sense. And that brings me back to the title of this newsletter. I am sure many of you are still wondering what the heck is a Tetrodotoxin Investor, and how does Fed policy create such?

Zombie Investing

Tetrodotoxin, commonly known as the zombie drug, is a potent neurotoxin commonly found in puffer fish and toadfish. The drug is 100 times more poisonous than potassium cyanide, with no known antidote. For years in the cultures that practice voodoo, there have existed bokors, who create zombies. “Zombie Powder” is applied to an individual by a bokor, and once the drug takes effect then the individual appears dead and the family buries him/her. Later, when the effects of the drug wear off, the bokor removes the individual from the grave (and, if all goes well) the victim believes himself a zombie and falls under the power of the bokor! As folklore would have it, once a zombie is created then it is relentless and oblivious to pain, and anyone a zombie kills returns as a zombie, and they quickly evolve from a nuisance to a plague.

Since the onset of the financial crisis, bokors Bernanke and Geithner have administered Zombie Powder in the form of ZIRP (Zero Interest Rate Policy), TARP, TALF, GSE guarantees, and bailouts, all the while chanting the most significant and spellbinding expression in investing: “Low rates for an extended period of time.” This exotic mumbo gumbo fed to the investment world has created an appetite for risk that investors have become more and more willing to indulge. Our zombie-like behavior has increasingly assumed that if there are future near-death experiences in the financial world, then we will be rescued from the grave by the government. The “Bernanke Put” has effectively lured the zombies to pursue greater and greater levels of risk, without critically thinking about the ramifications of upcoming mortgage resets, consumer spending versus income, credit contraction, valuations, and unemployment.

I have often asserted that when everyone starts thinking the same then no one is thinking. Several factors of market activity reveal investor somnolence, but one of the better measures is the trend of the VIX index. The VIX (commonly called the “fear factor”) is the ticker for the Chicago Board Options Exchange Volatility Index, which measures the implied volatility of the S&P 500 based upon traded options activity. The following chart demonstrates the movement of the VIX from October of 2007 to March, 2010: 

 

 

Low volatility leads to complacency, and investors grow happy in zombie land. The most recent Investors Intelligence data supports my thesis of zombie behavior, in that 48.9% of money managers are bullish, with only 20.5% bearish. This is a level of separation last seen in the fall of 2007.

If one accepts bokor Bernanke’s incantation that he will prevent any future catastrophic event in the marketplace, then one must also note that he is doing so by means of an unprecedented increase in the Fed’s balance sheet. By what legerdemain? Simply by creating assets out of thin air to support further zombie lending programs, which have increased the Fed’s balance sheet from $869 billion on August 8, 2007 to $2.311 trillion at the end of March, 2010, as shown in the Bloomberg chart below.

 

What is the Fed doing with an extra $1.4 trillion dollars? Where did they get the money? And why is the Federal Reserve fighting a lawsuit filed by Bloomberg under the Freedom of Information Act for disclosure details of what makes up the $2.3 trillion of assets on their balance sheet?

My point here is that no one seems to be questioning the Fed, the effects of trillion-dollar deficits, the effects of a health-care bill on US balance sheets, or the oncoming tide of real estate defaults. No one knows the long-term effects of a Fed “gone wild” by becoming the lender of last resort. Operating off-stage, the bokors have transmuted a once-solvent Federal Reserve balance sheet into one littered with $1 trillion or more of mortgage obligations (bought in the last year), TALF loans that securitize student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. Add to this fetid mix the leftovers from the bailout of the financial community (remember Bear Stearns?) that created the “Maiden Lane” LLCs and the ALICO Holdings, and one sees a mutant Fed that has gone from a triple-A balance sheet of Treasury bills and bonds in 2007 to a “less than investment grade” portfolio of God knows what. Our country has never experienced leverage of this magnitude.

However, even Bernanke is beginning to reduce the amount of dust he is willing to sprinkle. The first warning of reduction, or at least preventing further expansion of the Fed as lender of last resort, was their announcement in December of 2009 that as of March 31, 2010 the Fed would no longer be a purchaser of mortgages. The chart below illustrates the rise in 30-year mortgage rates since the Fed’s announcement:

 

On the day of the announcement we witnessed an immediate spike in mortgage rates, followed by a decline to 4.6% and now a rise to 5%. If the Fed takes away the liquidity punch bowl of the mortgage markets, then it stands to reason we will see higher rates, and that cannot have a positive effect on residential real estate values.

 

Future Fed Policy and Defaults

 

There appear to be two current courses of action the Fed can take as it relates to overall monetary policy:

 

• Plan A: Begin implementing tighter policy, add a tax increase (is there one person out there who believes taxes will go down?) and we get higher interest rates due to tightening of policy. The outcome is a further decline in home prices (higher interest rates make homes less affordable) and potential mortgage defaults, which results in a more withdrawn consumer and a slowing economy.

 

• Plan B: Continue the existing loose policy of low rates and expanded money supply, add another stimulus package and more government spending. One would expect a weaker dollar and higher inflation, which would eventually lead to higher interest rates and slower economic growth.

 

• Anyone have a plan C?

 

The eventual result, regardless of which path the Fed takes, will be an economy that grows slower than expected once the government ceases to be the lender of last resort and the stimulus money is exhausted. The wire Bernanke walks is politically and economically daunting. Prior economic cycles, where recessions were the result of inventory buildup and cyclical in nature, allowed governments to inflate/grow their way out of fiscal debt incurred while stimulating the economy. However, I see the problems this time a little differently, due to several factors:

 

1. The financial crisis that began in 2007 was global in scope, caused by asset deflation and a deleveraging of corporate and individual balance sheets worldwide. US policy alone will not ignite a recovery.
2. Inflate or Die. The end game for the current stimulus and fiscal policies is to eventually create inflation. The effects of continued deflation (declining home prices, excess supply, increasing trade deficits, further unemployment, etc.) are far more dangerous than an environment of inflation.
3. Deleveraging and continued contraction in commercial and industrial loans. With delinquency rates at 20-year highs and banks showing continued reluctance to lend, traditional sources of expansion credit do not exist. Debt in the private sector is also a part of this picture, with a steady increase in personal bankruptcies.
4. The US consumer and the US government expanded their debt by record amounts over the last five years. How does the Fed Reserve “rein in” the debt without creating another financial crisis?

 

 

The above graph shows mortgage delinquencies as a percentage of total loans for 30, 60, and 90 days past due, but does not include foreclosures. The reason I include it in this discussion is to contrast what is going on in the world of real estate with what has happened in the world of real estate stocks. The combination of continued high unemployment, along with increasing mortgage interest rates, will result in declining real estate values. Yet the Dow Jones Real Estate Index of stocks is up 13% year-to-date and up 68% from a year ago. The average P/E for real estate stocks is 38.94, the estimated P/E is 39.95, and the current dividend yield is 3.82%. And yet, people are still buying the real estate sector. Sound logical?

Why all this discussion of Fed policy? Because it is precisely these policies and investors’ belief in the Bernanke Put that has, in my opinion, propelled today’s stock and bond prices past levels of reasonable valuations. Zero interest rates, along with a steady diet of bailouts for corporations and individuals who make bad decisions, has fueled zombie investing at today’s prices. And now that markets are up 70% from a year ago, the individual investor is funneling 401k funds and savings back to stocks, for fear of missing the next bull market. 

 

 

Expected Returns

Individual investment returns have lagged the overall market over the last 12 months by being underweight stocks after the 2008 fallout. And now that the world has seemingly returned to normal, individual investors are being lured by zombie dust to take on more risk than valuations warrant. According to data at EPFR Global, since the trough of the stock market in March 2009 money market funds have seen $750 billion of outflows. The flip side is that inflows to stock mutual funds were only $40 billion, in contrast to inflows to bond mutual funds of $360 billion. (The remaining $350 billion probably went to consumption, debt reduction, and “nest eggs.”) Also, the data at EPFR indicates that the net outflow of retail equity funds was $82 billion since March of 2009, while at the same time institutional equity funds saw a modest increase of inflows. The startling part, though, is that the latest numbers from EPFR indicate that during the month of March 2010 retail stock mutual funds had greater inflows than bond funds. I will not take you through the history of how these fund flows act as inverse indicators, but needless to say the individual investor – now that stocks have appreciated 70% since March 2009 lows – is just beginning to favor investment in stocks versus bonds. Which leads me to question: what are the expected returns for stock investors who buy at premium levels of valuations? What can an investor expect in 10-year returns if he/she enters the market at today’s valuation levels?

I am going to rely on data produced by my friend Prieur du Plessis of Capetown, South Africa who writes a weekly letter called Investment Postcards from Cape Town: http://www.investmentpostcards.com.  In his March 26th letter, Prieur sought to understand whether there was a relationship between one’s entry point into the S&P 500, based on value and the expected returns over the next ten years. From Postcards:

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns (considering total returns, i.e. capital movements plus dividends). The study covered the period from 1871 to March 2010 and used the S&P 500 (and its predecessors prior to 1957). In essence, PEs based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.

In the first analysis the PEs and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).

What Prieur demonstrated is that when you buy stock at the upper ranges of earnings multiples, the odds are not with you for expected future rates of return. For example, take group 4, where the S&P 500 P/E multiple is between 10 and 11: during the following 10 years the minimum annualized return for stocks was 0.4%, the maximum 10-year annualized return was 17.6%, and the average return annualized at 9.3% per year. Today’s normalized P/E for the S&P is 20.3; go to Group 9 for your expected 10-year return. Prieur’s conclusion:

Based on the above research findings, with the S&P 500 Index’s current ten-year normalized PE of 20.3 and ten-year normalized dividend yield of 2.1%, investors should be aware of the fact that the market is by historical standards expensive. As far as the market in general is concerned, this argues for unexciting long-term returns, possibly a “muddle-through” trading range for quite a number of years to come.

 

The Good, The Bad, The Ugly

 

In my opinion the positives and negatives of today’s market break down as follows:

 

1. Major Positives

 

1. Government spending without restraint
2. Election-year manipulation
3. Corporate balance sheets are as strong as they have ever been.
4. Bernanke Put – no change in interest-rate policy until after the November elections

 

1. Major Negatives

 

1. Credit is still shrinking / deleveraging continues.
2. Real estate valuations and toxic assets on bank balance sheets
3. High unemployment
4. Continued bank failures
5. Stock valuations
6. Rising taxes

                                          

The Good: Corporate Cash and Positive Balance Sheets

 

According to Bloomberg, S&P 500 companies increased their cash in 2009 to $1.18 trillion while simultaneously reducing spending and keeping a jobs recovery on hold. Companies such as Exxon, Procter & Gamble, Walmart, and Microsoft ended the fourth quarter of 2009 with $518 billion more cash than a year earlier and effectively cut capital spending by 43%. The phrase “lean and mean” would apply to most US multinationals, as they stand to greatly benefit from any top-line sales growth. By holding down costs and applying productivity increases from existing capacity to handle increasing sales, corporate America is positioned to profit from any type of recovery. Keep in mind here that the National Bureau of Economic Research, the official arbiter of U.S. recessions, has yet to call an end to the recession that began in 2007, as of their most recent meeting on April 8, 2010. However, a clear positive for today’s investors is that balance sheets are strong – but what will they do with the cash? From a survey of chief financial officers published by CFO magazine:

 

The survey asked the CFOs what their firms plan to do with their cash holdings. The majority report they simply plan to hold on to their cash. Only secondarily, some of the cash will be used to increase investment and acquisitions and, to a lesser extent, increase repurchases and dividends and pay down debt.

 

The No. 1 risk factor for corporate America is intense global competition, listed by nearly half of CFOs as one of their top three worries. The second-biggest worry is rising health care costs. A cluster of other factors are also on the CFOs’ radars, including increased interest rates, high fuel costs, economic stability and declining consumer demand.

 

CFO’s top economy wide concerns include weak consumer demand, federal government policies, price pressure and credit markets.

 

In my opinion, CFOs well remember the liquidity crunch that occurred during the fall of 2008.  These executives are anchored in the issues their companies faced at the peak of the credit crunch and have adopted a philosophy of survival whereby cash is to be maintained, since traditional lines of credit and bank lending can seemingly disappear overnight. Whereas in prior years these companies would rely on credit for short-term financial needs, they no longer feel comfortable and therefore are hoarding cash for survival.

 

The Bad: Unemployment

 

“The second way government assistance programs contribute to long-term unemployment is by providing an incentive, and the means, not to work. Each unemployed person has a ‘reservation wage’ – the minimum wage he or she insists on getting before accepting a job. Unemployment insurance and other social assistance programs increase the reservation wage, causing an unemployed person to remain unemployed longer.”  Lawrence Summers, current economic adviser to President Obama

 

Is it any wonder that Mr. Summers’ star has fallen in the Obama administration? The latest job numbers were reported this morning, with the number of Americans filing claims for jobless benefits increasing 24,000 to 484,000 in the week ended April 10, to the highest level since Feb. 20. The average duration of unemployment is now greater than six months, which is a level not seen since 1948 when the Bureau of Labor Statistics began tracking this number. More depressing is the broadest measure of unemployment that includes people wanting to work but having given up the job search, as well as those working part-time but wanting full-time jobs: it stands at 17.4%.

 

“No other circumstance produces a larger decline in mental health and well being than being involuntarily out of work for six months or more. It is equal to the death of a spouse.” Andrew Oswald, University of Warwick

 

The Ugly: Relative Performance and Benchmarking 

 

The question here is, why are managers of money becoming more “relative” to their peer groups and wedded to short-term performance? The answer: because the majority of managers are either employees who are continuously scrutinized by their owners or they are managers hired by consultants, trustees, and individuals who all expect “superior” performance by their manager but certainly no less than their benchmark. Therefore, the simple reason why fund managers are so wedded to benchmarking is that clients and consultants force them to be.

 

However, in the search for superior performance relative to a benchmark, what investors often get is simply average performance. From a study by Goyal (Emory University) and Wahal (Arizona State University):

 

We examine the selection and termination of investment managers by plan sponsors, representing public and corporate pension plans, unions, foundations, and endowments. We build a unique dataset that comprises hiring and firing decisions by approximately 3,700 plan sponsors over a 10-year period from 1994 to 2003. Our data represent the allocation of over $730 billion in mandates to hired investment managers and the withdrawal of $110 billion from fired investment managers. We find that plan sponsors hire investment managers after these managers earn large positive excess returns up to three years prior to hiring. However, despite general persistence in investment manager returns, this return chasing behavior does not deliver positive excess returns thereafter; post-hiring excess returns are indistinguishable from zero. Plan sponsors terminate investment managers after underperformance but the excess returns of these managers after being fired are frequently positive. Finally, using a matched sample of firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be larger than those actually delivered by newly hired managers.

 

From the early ’60s to the late ’80s the role of “investment consultants” was one of tracking performance of money managers for the benefit of pension funds or Taft Hartley plans. In the late ’80s that began to change, when the investment world followed Jack Welch and Six Sigma and began to actively benchmark investment performance. “Tracking error,” “risk ratio,” “beta,” “alpha,” etc. began to permeate reviews of investment returns and manager selection. The result of benchmarking by investment consultants was whole new class of investment managers that I label “closet indexers”.

 

Therefore, what occurs in the investment world when one is constantly being compared to one’s peers?

 

1. Fund managers are prone to adjust their asset allocation to that of other funds, even if this means they neglect their own superior information. To be different and be right is one thing; to be different and be wrong is to risk your career.
2. You create a situation where a smart manager will herd with the dumb manager and trade in a direction completely opposite from that dictated by the smart manager’s information.
3. Fund managers become closet indexers, because they buy/sell the same assets as their peers, even when doing so reduces the expected return.
4. Clients who write investment policy statements with strong adherence to benchmarking accept relative performance, even if that leads to catastrophic times like 2008. Better to be Manager A and down 30% but up 20% with your peers, than to be manager B down 10% and up 8%. Why? Because investors are completely myopic and will only compare the most recent returns, and in this example Manager B loses.

 

Three years ago at Rob Arnott’s conference, the late Peter Bernstein made the statement that all clients should have to sign a 5-year contract when they select an investment manager. His thesis was that if you take away this constant quarter-by-quarter evaluation of performance and ignore benchmarking in the short term, then it would free the investment professional to act according to his information, as opposed to constantly being afraid of losing his job. In my opinion investment performance suffers when a manager is constantly held to relative performance and benchmarking. In the next downturn of stock prices, ask yourself whether it’s okay to be in the same boat as everyone else, or would you occasionally prefer to be standing on dry land?

 

Summary

 

I will leave you with Ben Graham’s concept of Mr. Market.

 

The concept of Mr. Market goes something like this: Imagine you are partners in a private business with a man named Mr. Market. Each day, he comes to your office or home and offers to buy your interest in the company or sell you his (the choice is yours). The catch is, Mr. Market is an emotional wreck. At times, he suffers from excessive highs and at others, suicidal lows. When he is on one of his manic highs, his offering price for the business is high as well, because everything in his world is cheery. His outlook for the company is wonderful, so he is only willing to sell you his stake in the company at a premium. At other times, his mood goes south and all he sees is a dismal future for the company. In fact, he is so concerned, he is willing to sell you his part of the company for far less than it is worth. All the while, the underlying value of the company may not have changed – just Mr. Market's mood.

The best part of this entire arrangement: you are free to ignore him if you don't like his price. The next day, he'll show up at your door with a new one. For your interest, the more manic-depressive he is, the more opportunity you will have to take advantage of him (don't worry, he doesn't have feelings or mind being taken advantage of). As long as you have a strong conviction as to what the company is really worth, you will be able to look at Mr. Market's offers and reject or accept them; the choice is yours. Mr. Market is there to serve you, not to guide you.

 

And the final lesson from Graham:

 

“The margin of safety takes priority over all other investment considerations. “

 

Cliff W. Draughn, President and CIO

IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article) (including the investments and/or investment strategies recommended or undertaken by Excelsia, Inc.), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Excelsia, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.

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