Saturday, December 09, 2006

Gone Fisherin'

It must be obvious to anyone who has suffered through more that one bowl of Guambat's Stew, especially if it is stock market related, that Guambat is a horrible innocent, with all the infirmities that innocents suffer, including an over-rated opinion of his own opinion.

And, in markets particularly, where Guambat too often dwells, Guambat is hopelessly ill equipped to fair well for long. Fortunately for Guambat, the great bulk of the people in the markets are little more prepared than Guambat, though many of them are far more adequately compensated.

The inadequacies of Guambat's talents were driven home by a bit of checking up on a bookmarked website that had not been explored until today. Not that the website is without criticism, itself, but it does offer a chance for honest reflection and transparent opinion.

The site: CXO ADVISORY GROUP, INC.

Guambat found himself nosing around the site on this Guam Half-a-day Saturday morning and thought others might want have a taste of the roots, shoots and leaves found there, too.

There is much Guambat has left to explore at the site, but he got particularly amused by the Guru Grades page, where the authors do a hatchet job, or analysis, depending on your point of view, on famous name brand-irons like Jim Cramer, John Mauldin, Mark Hulbert, Jim Jubak, and on and on.

Guambat was intrigued to find Ken Fisher at the top of the Guru Grade. In all of Guambats studies and experiences, up to the time a little over 20 years ago when Guambat felt compelled to open an IRA, Guambat had never really looked hard at the world of stocks, bonds, currencies and the like. Guambat had hardly ventured out of his burrow, after all, and had an ingrown belief that such things were crap-shoots filled with banditos, snake-oil salespersons and witch doctors. Guambat can't really say that ingrown belief has changed much, but he has come to admire the pas-de-deux that passes for working in the world of finance.

And one of the happy coincidences that led to that appreciation was serendipitously picking up Ken Fisher's second book, The Wall Street Waltz, in a little bookshop in Larkspur about 2 decades ago. It was simply a book of graphs and short notes, covering what little history there is of market behaviour over the past couple of centuries. It was Guambat's first, and most influential, books on the market in Guambat's little library, and the thing he remembers most is the picture Fisher paints of a globally connected system of capital funding needs described, in broad terms, as competing and complimentary forms of debt and equity, and always relating back to the fundamental notions of real inflation and risk free rates. That may easily not be what the book was about and may be a distortion of what it says, but that is how Guambat tends to see the world, so is what passes for truth between Guambat's ears.

Anyway, and this is already getting to be a long read in a blogoshpere ascustomed to shorter readbites than the soundbites on radio or the sightbites on tv, Ken Fisher gave CXOAG a description of how he does what he does that resulted in his top grade, and here is a bunch of what he had to say:

Forecasting (Macro and Micro) and Future Concepts by Ken Fisher
My experience tells me that the only basis for making a bet is believing somehow, some way, that I know something other people do not know. If I make bets based on things others widely believe, I will end up being wrong/unlucky as often as I am right/lucky, with transaction costs leaving me worse off than if I made no bets at all.

Professional investors and investment advisors typically go to school and then extend their learning via apprenticeship with a master craftsman focused on a particular investing style (value, growth, small capitalization...). Once they learn the craft, they "practice" like a doctor or a lawyer. They seldom try to change the craft, and the rare changes they introduce are minimal because they believe the craft basically sufficient to the task at hand.

Craftsmanship is fine. I want any doctor hacking into me to have had one heck of a lot of mentoring and practice. But craftsmanship assumes the existing body of knowledge is sufficient, and that kind of complacency does not support outperformance in investing. Markets discount all widely known information, including the traditional craft.

I focus on building capital markets technology that explains parts of the investing world never understood before.

When I envision the future, I try to answer three basic questions. In fact, I am in the process of writing a book about these three questions that I hope to have out in early 2007. Briefly, the three questions are:

1) What do I believe that is actually wrong?

2) What can I fathom that others do not?

3) What is my brain doing to mess me up right now?

I am better trained, apprenticed, educated and practiced as an investor than the average person, so if I believe something is right when it is actually wrong, most of the world is probably about to get snookered. Suppose I, along with most people, believe X causes Y. But through systematic self-critique, I determine that my belief is wrong. X does not, in fact, cause Y. Then X happens, and most people bet on Y, but I bet against Y. I have an edge, what finance theory calls the rational basis for a bet, because I know something others do not know.

I start contemplating what variables might generate causality. I seek correlations, and then look inside them for causality consistent with fundamental economics and capital markets theory. Invariably, I try to link any conclusions back to shifts in supply and demand for securities.

Framing is important in all fields, but solutions to financial market problems seem to be especially blinded by an endless array of bad frames. So I try to look at things upside down, backwards and inside out! I make a point of finding new perspectives. That’s how I first cooked up the Price/Sales Ratio decades ago and why I think in terms of E/P instead of P/E. Further, I always test in other countries everything that we believe works in the United States, because foreign perspectives might present better frames.

Over the course of my career, I have learned many things that a lot of people do not believe. Differences in beliefs are fine with me. How else could I know something that others do not know?

For example, it is easy to prove that current account and trade deficits are not bad for an otherwise healthy economy. I know that fact and have publicly covered it a fair amount. The United States and most of the western world are not over-indebted but, in fact, markedly under-indebted and need more debt of almost any type. That assertion elicits an almost religious hostility from many people, but their anger does not negate the truth. They just do not want to believe it. I like that. When I see people freaking about a big current account deficit, I can bet against them. Understanding that we need more debt changes the way I think about many other things.

I know if most people forecast something, whatever it is, it cannot happen, and I have learned how to forecast against the consensus with the bell curve technology I talked about in Forbes many years ago. And, as the years have gone by, I have learned how to adapt that technology to a variety of obscure markets — always trying to do something new and assuming that what I have done before will soon be obsolete. I aim all this effort at simply trying to know something that others do not know. The crazier others think my beliefs are, the better I like it. It means they will work longer. I find that rejection of seemingly offbeat views stems from a lazy reliance on market mythology. I repeat, I like that.

Within this framework, I always think globally. A global perspective helps me see my home markets better, as it would for anyone from any country. Because I spend a lot of time in Great Britain, I often compare supposed truisms in both countries and translate them from one market/economy to the other to test consistency. Both commonalities and differences teach me lessons. Britain is the best single laboratory for validating the U.S. frame of reference, although many other countries provide good tests.

For perspectives on stocks, I always think in terms of the MSCI World Index or the MSCI All Country World Index before I ever think of the S&P 500 Index. I think about the S&P 500 Index no more often than I think of the FTSE 100 or the Topix 150.

I never think in term of the Dow — haven’t in decades.

Our long-term interest rates are fully set in global markets, so I think in terms of global money supply growth, global interest rates and global yield curves. Late in 2005, as the yield curve in the United States inverted, lots of folks assume that bad times lie ahead. Because of the adequately steep global yield curve, I am unconcerned. Major banks will just borrow in one country and lend in another.

At worst, the inversion of the yield curve in the United States argues for underweighting domestic securities in comparison with foreign stocks. Most people see my view as simply unbelievable. And that’s fine with me.

I have learned that, other things being equal, federal budget deficits are great for future stock returns. Therefore, I look for countries where deficits are worse than expected, with investors illogically recoiling in fear. I bet against that fear. Ultimately, I progress from selecting countries and sectors to picking specific stocks within them. I want to own individual securities, because it is way too expensive in the long term for active investors to own packaged financial products. (Packaged products are OK for passive investors who accept not knowing something that others do not. Just not my style.)

When Graham and Dodd prepared the third edition of Security Analysis, the last revision they did themselves, mutual funds and other packaged products were well known — tiny by today’s standards but still well established. That edition appeared 11 years after the Investment Company Act of 1940, in large part a regulatory reaction to the emerging world of mutual funds. Yet Graham and Dodd purposefully did not include mutual funds in their book — not even a mention. They considered them to be artificial securities unworthy of real security analysis. They would look askance at the degree to which current investors use expensive packaged products today in preference to primary portfolio building blocks. I want to hold the underlying fundamental securities.

So, I am finally down to picking individual securities. Stocks! Bonds! Primary instruments! It is easier to do this now than it was 25 years ago. Back then, there were so few securities in most categories that it was hard to find stocks (except those of tiny firms) not completely picked over by everyone else. Today, with over 20,000 equities around the world you can find many relatively ignored opportunities. All I do is choose those with underappreciated attributes and good relative pricing from within the categories I like.

[And Guambat appreciates the following bits particularly, because Guambat had not read this far down into Fisher's article before he started this post, which included a reference above to the space between Guambat's ears.]

I am sure I do not see myself accurately. None of us do. Our mental machinery was not built to do this stuff. We got our brains from thousands of generations past, and our brains are little evolved from their brains. I have a neo-stone-age information processor in my head trying to deal with a post-industrial information explosion in extremely complicated capital markets that my great, great grandfather could never have contemplated. The biggest advantage I have over most people is I know I am blind. But even if I screw up a lot, and I do, I have been getting by using the approach described above for more than a third of a century. My time is running out fast, with less ahead of me than behind. I am not yet quite adjusted to that fact.

Meanwhile, I like what I do. I like looking for new things. I like trying to figure out the next new thing. I like it when I shift frames and discover something that was right in front of me the whole time — that makes me feel really stupid. It is awe inspiring. Developing new things is the most important, exciting and contributing part of being alive at this point in human evolution. It is a lot more fun than applying, with a few minor modifications, some craft I learned 30 years ago. If I were a doctor or accountant, I would get bored fast. I hope to have some more years to have fun.

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