Don’t Fear the Inflation, Goldman Says

Via FT Alphaville:

Goldman Sachs is putting an end to the deflation vs inflation debate, once and for all!

In a 30-page research note out on Wednesday, the bank comes down firmly on the side of (moderate) deflation in the near-term.

Here, GS analyst Andrew Tilton says, is why:

• Inflation is already low, with the core CPI down to 1.4% on a year-overyear basis and the overall CPI in deflation territory.

• Excess capacity in the economy is huge, probably at least 6% of GDP and possibly at its highest level since the Great Depression.

• Spare capacity is likely to persist for years [see below table]. While the financial crisis and recession probably have reduced the economy’s production capacity somewhat, we do not see strong evidence for persistently lower growth of capacity going forward. Even if we assume substantially above-trend real GDP growth of, say, 5% per year, it will take more than three years to get back to equilibrium in the labor market and two in the manufacturing sector. Our own assumptions of a somewhat slower recovery suggest it could well take more than five years to reach equilibrium in the labor market and nearly as long in housing.

• Monetary policy is arguably too tight despite a near-zero funds rate and unconventional easing. Our own calculations using estimated Taylor rule parameters, as well as those in recent research from the San Francisco Fed, point to an `appropriate’ funds rate of -5% or below.
  

• The default path of current policy is for removal of stimulus. Fed asset purchase programs are scheduled to end within the next several months and its balance sheet will begin to shrink after that point, while the growth impact of fiscal stimulus is already peaking.

Nevertheless, Goldman’s Tilton gets why investors are worried about inflation, and the bank itself is not oblivious to the possibility, given the massive unconventional fiscal and monetary policies undertaken by the Federal Reserve. In fact, Tilton says, there are a few inflationary warnings signs investors should be looking out for.

Continue reading the article here

Bill Gross Bets On Deflation

Via Bloomberg:

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said he’s been buying longer maturity Treasuries in recent weeks as protection against deflation.

“There has been significant flattening on the long end of the curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re- emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.”

Gross had said during the midst of the credit crunch that Treasuries offered little value as investors seeking a refuge from turmoil in global financial markets drove yields to record lows in December. He boosted the $177.5 billion Total Return Fund’s investment in government-related bonds to 44 percent of assets, the most since August 2004, from 25 percent in July, according data released earlier this month on Pimco’s Web site. The fund cut mortgage debt to 38 percent from 47 percent.

…Officials at Pimco have forecast a “new normal” in the global economy that will include heightened government regulation, lower consumption and slower growth. The economy will likely expand at a 2 percent to 3 percent rate going forward, Gross said.

The world’s largest economy shrank at a 1.2 percent annual rate from April to June, more than the originally reported 1 percent contraction, according to a Bloomberg News survey before the Commerce Department’s Sept. 30 report. The jobless rate climbed to 9.8 percent this month, from 9.7 percent in August, according to a separate Bloomberg survey before the Labor Department reports figures on Oct. 2.

Read the full article here

How to Turn a 100% Gain into a 1,400% Gain

Via Growth Stock Wire:

It never was my thinking that made big money for me. It was always my sitting. Got that? My sitting tight!” – Jesse Livermore

Jesse Livermore was one of the most respected traders of the 1920s. He built one of America’s largest fortunes at the time with his skills in the stock and commodity markets. The classic book Reminiscences of a Stock Operator contains his story.

“Sitting tight” was Livermore’s term for not selling when he was up 20%… 50%… or 100% on a position. Sitting tight is the art of not taking quick profits.

You see, most traders and investors get tempted to sell their winners after they see a modest profit… like, say, 33%. They get fidgety. They tell themselves that, “You can’t go broke taking a profit.” They always feel like they should be doing something, so they take action and jump out of the winning trade.

This strategy will kill your long-term trading performance.

…When you are right on a trade – whether it’s tech stocks, biotech stocks, oil, or gold – ride it for all it’s worth. Don’t cut your profits short. Don’t sell until you see a legitimate reason for concern… like a decline of more than 15%… or an asset’s refusal to rise on bullish news. One of the best ways to get rich in the stock market is to get in early on a big trend and ride it for years… You can’t ride a trend if you don’t sit tight.

Read the full article here

How Do Hedge Fund Clones Manage the Real World?

Via SSRN:

Interesting paper from authors Nils Tuchschmid, Erik Wallerstein and Sassan Zaker of Julius Baer Asset Management. They suggest that hedge fund clones are broadly succeeding in replicating the investment returns of real hedge funds. At the same time, however, some clones have exhibited too much correlation with equity markets and also have raised fears among some investors about the increasing complexity of replication models, the researchers warned.

The report, which looked at 21 clones over the period April 2008 to May 2009, concluded: “Hedge fund replication products seem to deliver competitive performance relative to hedge funds. More importantly they are able to deliver this at a far lower fee level than hedge funds.”

The authors’ research found that the vast majority of clones exhibited a correlation of at least 70 per cent to industry benchmarks operated by Hedge Fund Research and Credit Suisse/Tremont. Most lost less than the typical 10-15 per cent declines recorded by the industry at large, although Wallerstein cautioned,  the relative performance of clones in a bull market remained unproven. “Shortable” clones, which allow investors to benefit from losses in the underlying industry, appear to succeed in mirroring long approaches, he added.

Read the paper here

Can Irrationality Be Rational?

Barry Ritholtz responds to John Cassidy’s Rational Irrationality article:

(Cassidy’s analysis) asks us to ignore the repercussions of our behaviors. We can rationalize short term gains at the expense of long term losses, because we need to obtain quarterly profits regardless. Apparently, when it bankrupts the company, only then with the benefit of hindsight can we see what went wrong.

I am terribly sorry, but that is precisely the sort of thinking that led to the crisis in the first place. Making loans to people who cannot pay them back is not rational when its profitable — its NEVER rational.

Goldman Sachs avoided most of the credit debacle — were they being irrational when they forewent short term profits for a few years — but avoided the worst of the sub-prime debacle? And what about hedge fund manager John Paulson? His fund bet against all of these other players, netting several billions in profits while others suffered from their “Rational Irrationality.” How irrational was Paulson’s investment posture?

On a risk adjusted basis, the behaviors of Citi, Bear, Lehman, New Century and others was hardly rational. Call it whatever you want, but do not forget this simple fact: It was the sort of narrow, risk-ignoring thinking that is ALWAYS rewarded in the short term, and ALWAYS punished in the long term.

Great stuff from BR! Read the full post here

In Defense of Financial Innovation

Robert Shiller writing in the FT:

The problem is that financial breakdowns come with low frequency. Since flaws in the financial system may appear decades apart, it is hard to figure out how some new financial device will behave. Moreover, because of the low frequency of crises, people who use financial instruments often have little or no personal experience with the crises and so trust is harder to establish.

When people invest for their children’s education or their retirement, they are concerned about risks that will not become visible for years. They may not be able to rebound from mistaken purchases of faulty financial devices and they may suffer if circumstances develop that create risks that could have been protected against.

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. They must work towards clearing the way to widespread use of better products, concerning themselves with both safety and creative ideas. They must not simply be law enforcers against the shenanigans of cynical promoters, but also be open to making complex ideas work that have the potential to improve public welfare. Unfortunately, the crisis has sharply reduced trust in our financial system.

…Unfortunately, people do not trust some good innovations that could protect them better. The innovations in mortgages in recent years (involving such things as option-adjustable rate mortgages) are not products of sophisticated financial theory. I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.

Another example of a potentially useful innovation is the target-date fund (also called life-cycle fund) that invests money for people’s retirement in a way that is specifically tailored for people their age. Such a fund plans for young people to take greater risks and for older people to invest more conservatively. Target-date funds, first introduced by Wells Fargo and BGI in the 1990s, are growing in importance, but few people commit the bulk of their portfolio to such funds, or make use of target-date funds that might make adjustments for their other investments. It appears that people do not fully trust that these funds are designed correctly, or would protect them from crises.

…It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. Despite the apparent improvement in the economy, the crisis is not over and so the public continues to support government-led interventions. Doing this means encouraging better dialogue between private-sector innovators and regulators. My experience with regulators suggests that they are intelligent and well-meaning but often bogged down in bureaucracy. Regulatory agencies need to be given a stronger mission of encouraging innovation. They must hire enough qualified staff to understand the complexity of the innovative process and talk to innovators with less of a disapprove-by-the-rules stance and more that of a contributor to a complex creative process.

Read the full article here

Brain Scans Reveal What You’ve Seen

Via Wired:

Scientists are one step closer to knowing what you’ve seen by reading your mind.

Having modeled how images are represented in the brain, the researchers translated recorded patterns of neural activity into pictures of what test subjects had seen.

Though practical applications are decades away, the research could someday lead to dream-readers and thought-controlled computers.

“It’s what you would actually use if you were going to build a functional brain-reading device,” said Jack Gallant, a University of California, Berkeley neuroscientist.

The research, led by Gallant and Berkeley postdoctoral researcher Thomas Naselaris, builds on earlier work in which they used neural patterns to identify pictures from within a limited set of options.

The current approach, described Wednesday in Neuron, uses a more complete view of the brain’s visual centers. Its results are closer to reconstruction than identification, which Gallant likened to “the magician’s card trick where you pick a card from a deck, and he guesses which card you picked. The magician knows all the cards you could have seen.”

In the latest study, “the card could be a photograph of anything in the universe. The magician has to figure it out without ever seeing it,” said Gallant.

Read the full article here

Related: Brain Scanner Can Tell What You’re Looking At

The Myth of the All-Weather Portfolio

Via Abnormal Returns:

For quite some time now financial advisers of all stripes have been in search of the elusive “all-weather portfolio.”  That is, an asset allocation that serves to protect investors in bad times (bear markets) and performs well in good times (bull markets).  Does an all-weather portfolio really exist?

Prior to the economic crisis many would have answered in the affirmative and would have pointed to the large university endowment funds as examples of investors who had achieved this goal.  However the aftermath of the credit crisis and ensuing bear market indicate these funds have failed to achieve this goal.

Maybe it isn’t that case that asset allocation models are broken.  It may simply be the case that we are asking too much of asset allocation as a discipline.  In what other investing endeavor do we expect to have the best of all possible worlds?

Read the full article here

Predictably Irrational – How Investors Frame Decisions

Via Advisor Perspectives:

One of the most provocative sessions at Schwab Impact conference was given by Dan Ariely, who deftly summarized his current research in the important field of behavioral finance.  Ariely is a professor of economics at Duke University and a visiting professor at MIT’s Media Laboratory.  He is also the author of the popular book, Predictably Irrational.

Ariely’s message was that, no matter how good their intentions or how deep their experience, people – investors specifically – consistently make the wrong decisions.  They behave irrationally, and predictably so.

Advisors who understand the natural biases in individual behavior can frame questions that will steer their decision-making process in a more rational – and economically better – direction.

Read the full article here

Which Sectors Look the Best

David Rosenberg has an answer:

We ran screens looking at three variables:

• Equity sectors that have seen the least pronounced jump in price-earnings multiples (a sign of neglect).

• Equity sectors that have seen the most pronounced increase in earnings revisions in recent months (signs of improved fundamentals).

• Equity sectors that have the lowest analyst earnings growth estimates for 2010 (a low hurdle to jump across).

The envelope please …

…the winners would be consumer staples, health care and technology.

Note that these three sectors should also benefit from a weaker U.S. dollar (currency translation effect) given their relatively high share of foreign-derived revenues. We may not be bullish on the overall market, but it does not mean that investors should completely shun the space … there are specific opportunities out there.