Some interesting commentary from Frank Martin’s Q2 2014 commentary, “Slaying Goliath,”, starts with macro but gets into value investors…
Federal Reserve Chairman Alan Greenspan delivered a rather dry and complex speech on December 5, 1996. The reaction, however, to such a seemingly mundane oration was unexpectedly immediate and powerful. It rattled Alan Greenspan’s confidence. He had innocuously uttered the now infamous phrase “irrational exuberance,” and the mighty market roared its disapproval.
For several days, Bloomberg screens turned an angry red around the world. The “Maestro” was no David when he came face to face with Goliath. Alan Greenspan cowered in the giant’s presence, fear blinding him to the ogre’s fragilities. Sadly, it was an opportunity lost because it is in the crucible of confronting giants—with everything on the line—that true grit makes the most difference in what the future will hold.
Many of us have had to square off with Goliaths in our own lives. The fact that you’re still reading and I’m still writing is probably all that needs to be said.
Tragically for the victims of misguided policies, it would appear that appointed Federal Reserve Board chairpersons, with no skin in the monetary policy game, are exempt from the consequences of their own actions.
As speculation became more pervasive and the bubble expanded, Alan Greenspan stood by passively, neither raising interest rates nor imposing the more subtle so-called macroprudential financial regulatory and oversight weapons in the Fed’s arsenal. Instead, he dosed the bipolar Goliath with easy money whenever an intense mood swing threatened the market’s upward trajectory, a crowd reassuring maneuver he had first executed after the crash of 1987.
The easy-money elixir was administered again in 1998 after the Russian debt crisis and the collapse of Long-Term Capital Management, and then two years later on the eve of the millennium when the Fed was spooked by Y2K. By the dot-com bust in the early 2000s, Alan Greenspan’s deep-seated apprehensions about the economic aftershocks of a potentially significant market decline were well known and programmed into investors’ expectations. Emboldened, they began to refer to the seemingly autonomic response as the “Alan Greenspan put.” He used the tactic again on January 3, 2001, even though evidence of impending recession was vague at best. The NASDAQ applauded, rising 14% on the news, its single biggest one-day advance ever. Lest we forget, central bankers are human, and (like most of us) they yearn for approbation. Money, a tangible and eminently fungible surrogate, tends to flood in over the transom only after they leave office.
Less than two years later, on October 15, 2002, Princeton professor Ben Bernanke gave his first speech just two months after being appointed by President George W. Bush to Alan Greenspan’s Federal Reserve Board. Bernanke’s lecture came in the midst of the dot-com bust that his mentor, the chairman, had some hand in fomenting. Perplexingly, given Bernanke’s nonexistent front line experience, the topic was: “Asset-Price ‘Bubbles’ and Monetary Policy.”
Obfuscating the difficulty of the Fed pinpointing, let alone pricking, bubbles, faithful understudy Bernanke cited the earlier work of Yale financial economist Bob Shiller, who had testified at the Fed on December 3, 1996.2 The presentation was published in 1998 by the Journal of Portfolio Management.3 Shiller, Bernanke observed with the air of déjà vu that only hindsight affords, was among those warning of a bubble in stock prices. The Fed rookie staked his claim as a card-carrying member of the board with “a simple quantitative point.” Referencing the Journal article, Bernanke noted Shiller had argued that at 750 on the broad-based S&P 500 index, the market was trading at three times its fundamental value. Shiller used a rudimentary but reliable dividend/price regression model.4 The S&P continued to rise, peaking at double that number three years later.
Future Fed Chairman Bernanke declared:
I do not know, of course, where the stock market will go tomorrow, much less in the longer run (that’s really my whole point) [emphasis added]. But I suspect that Shiller’s implicit estimate of the long-run value of the market was too pessimistic and that, in any case, an attempt to use this assessment to make monetary policy in early 1997 (presumably, a severe tightening would have been called for) might have done much more harm than good.
Bernanke’s assertion is absurd on its face. The surreal and revealing first point seems more suitable to weather forecasting where long-term forecasts are much more difficult than short-term ones, the antithesis of the way any rational investor thinks about equity market dynamics over the dimension of time. If we didn’t have confidence that stocks would generally rise in the long run, why in the world would anyone invest a dime? The last point, a counterfactual assumption about the effect of tightening, was never tested by Bernanke. The signature policy of his eight-year tenure as Fed chairman was its polar opposite: unprecedented and unrestrained massive monetary easing.
Prem Watsa, the iconoclastic CEO of the Toronto-based Fairfax Financial, a $35 billion insurance company, understands both the importance of identifying the problem and the pain of preparing for it well in advance of others. He offered the following candid insights in his 2013 letter to shareholders:
In this environment, with zero interest rates and high debt levels prevailing in most developed countries, giving them limited flexibility to react to unintended consequences, we think it is prudent to have a very strong balance sheet with a large cash position and to be protected on the downside. When problems hit, only those with cash and very liquid assets can take advantage of them. While it is very painful and costly waiting, we think your (and our!) patience will be rewarded. We are reminded again of the warning from the distant past from our mentor, Ben Graham, which I have quoted before: “Only 1 in 100 survived the 1929–1932 debacle if one was not bearish in 1925.” We continue to be early—and bearish!
Watsa is a David. His equity portfolio is 100% hedged with equity index swaps, and he also has a huge economic derivatives hedge that anticipates deflation will appear before inflation has its day. He argues that deflation would wreak havoc on most of his businesses. Since taking his stand in 2010, the book value of Fairfax has withered from $376 per share to $339 in the rising market, with the cost of hedges more than offsetting solid returns in his operating businesses. Lest Watsa be thought a Cassandra, Fairfax’s book value was $150 in 2006 when he positioned the company’s portfolio to benefit from tail risks that he saw as a problem—even though he had no idea when they might occur. When you tally things up, including those years when Fairfax badly lagged behind the indices, the company’s book value has compounded at 21.3% since its founding in 1985. Seth Klarman (Baupost Group), about whom I’ve written extensively, has a similarly successful contrarian streak.
Like Bob Shiller, Prem Watsa, and Seth Klarman, we believe we know how to do battle with our Goliath. The key is to not do it on his terms. As emphasized in our 2013 annual report, we will surely lose if we fight conventionally. We must be cunning and creative in our decisions and actions. Off the field we must be open to suffering the ridicule of the majority; we must even be willing to look stupid. The story of David and Goliath is embedded in our language as a metaphor for improbable victory, which Malcolm Gladwell eloquently argues is a near universal misunderstanding of the biblical showdown. As one discovers in reading the latest of Gladwell’s “improbable” books,9 David’s tactics and strategy actually stacked the odds decidedly against Goliath. David’s victory was anything but improbable. Breaking convention, using speed and surprise, brandishing the sling and not the sword, David triumphed over the myth of power being solely a function of physical might or, in our field battle, the manic/depressive brute of a market that by dint of size and anonymity intimidates so many—even “The Maestro.”
Our victory becomes much more probable if we first avoid loss by turning a deaf ear to the siren song of the amorphous crowd of which the market is a manifestation, and then figuratively using the leverage of the sling rather than the limited edge of the sword to seize the advantage. Ultimately, though, we simply want to have lots of liquidity when others are willing to pay a fortune in lost opportunity to take it off our hands.
One final observation: Notice that Ben Graham said (see Prem Watsa’s blocked quote above) an investor had to be “bearish in 1925” to avoid the 1929–32 debacle. You may ask yourself, “Was that a misprint? Didn’t he mean 1928 or early 1929? Why so early? Investors would have missed three full years of strong returns, wouldn’t they?” Well, there are very good answers to those insightful questions … and like the keep-you-coming-back tactics of “House of Cards” on Netflix, we’ll share our research and insights—including a plausible response to your rhetorical inquiries—in the 2014 third-quarter QCM Review. ?
See full Alan Greenspan – Slaying Goliath: MCM in PDF format here.