In the second half of last year I started thinking about potentially leaving my current employer and starting my own investment firm.  There were many reasons for this, not the least of which is complete disillusionment with company management.  For a number of months now I have been exploring this possibility, researching regulatory requirements, interviewing financial service providers, developing a business plan, etc.

I started this blog as part of this research.  The concept was to incorporate it into a more traditional business web site and use it as a way of effectively communicating updates to clients and prospective clients.

The blog has turned out to the the easy part.  Creating one and filling it with content has been simple compared to the other tasks.  And, after a very detailed examination of the alternatives, I have decided to shelve the idea of launching own firm for now.  The rate of change and amount of uncertainty in the financial services industry is at extreme levels, and I may end up elsewhere, but for now it will not be of my own volition.

So, this is the last entry for the Durable Investor.  I will turn my efforts back to concentrating solely on success in my current role.  Yes, management at my company remains questionable, and perhaps has even been borderline criminal in the past, but I have the ability to work independently to a very large extent and protect my clients from my own company as well as the overall markets.

To close, here’s a final thought: while the future does not look appealing right now, it does not look as bad as many think.  We may be in a “Great Recession”, but it remains highly unlikely that we are in Great Depression II.

Look at this entry from Calculated Risk.  CR was one of the very early voices warning about the bubble economy.  Behavioral investing is all about being aware of crowd dynamics and irrational actors.  We are currently in a pessimism bubble; try to keep things in perspective.

Today’s Financial Times has a second great column to go with Martin Wolf’s, mentioned in the prior post.  This column is from Robert Shiller, again talking about Keynes, his concepts of capitalism, the need to balance it with government, and the chaos of human emotion or “animal spirits” that adds a wild card to what classically trained economists wish would be a rational and easily modeled social science.

The column is an excellent read.  The best sound bite is calling modern investment products the “financial equivalent of snake oil”.

The concluding paragraphs read:

There is a broader moral to all this – about the nature of capitalism. On the one hand, we want to take advantage of the wisdom of Adam Smith. For the most part, the products produced by capitalism are what we really want, produced at a price that we are willing and able to pay. On the other hand, when confidence is high, and since financial assets are hard to evaluate by those who are buying them, people will and do buy snake oil. And when that is discovered, as it invariably must be, the confidence disappears and the economy goes sour.

It is the role of the government at two levels to see that these events do not occur. First, it has a duty to regulate asset markets so that people are not falsely lured into buying snake-oil assets. Such standards for our financial assets make as much common sense as the standards for the food we eat, or the purchase medicine we get from the pharmacy. But we do not want to throw out the good parts of capitalism with the bad. To take advantage of the good parts of capitalism, when fluctuations occur it is the role of the government to see that those who can and want to produce what others want to buy can do so. It is the role of the government, through its counterbalancing fiscal and monetary policy, to maintain full employment.

The principles behind such an economy are not the principles behind a socialist economy. The government insofar as possible is only creating the macroeconomic conditions that will allow the economy to function well.

That is the role of government. Its role is to ensure a “wise laisser faire”. This is not the free-for-all capitalism that has been recommended by the current economic theory, and seems to have been accepted as gospel by economic planners, and also many economists, since the Thatcher and Reagan governments. But it also is a significant middle way between those who see the economic disasters and unemployment of unfettered capitalism, on the one hand, and those who believe that the government should play no role at all.

The idea that unfettered, unregulated capitalism would invariably produce the good outcomes was a wrong economic theory regarding how capitalist societies behave and what causes their crises. That wrong economic theory fails to take account of how the animal spirits affect economic behaviour. It fails to take into account the roles of confidence, stories and snake oil in economic fluctuation.

In at least parts of the investor class there is certainly a brewing crisis of confidence with Obama’s economic policies.  I believe it’s too soon to pass judgment, but the cries of alarm are on the right (“socialism!”) and left (“nationalize the banks now!”).

Getting back to my favorite topic of behavioral economics / investing, here’s a relevant post via Economist’s View.  An excerpt:

However, Keynes can be our savior only to a very partial extent, and there is a need to look beyond him in understanding the present crisis. One economist whose current relevance has been far less recognized is Keynes’s rival Arthur Cecil Pigou… Pigou was much more concerned than Keynes with economic psychology and the ways it could influence business cycles and sharpen and harden an economic recession that could take us toward a depression (as indeed we are seeing now). Pigou attributed economic fluctuations partly to “psychological causes”…

It is hard to ignore the fact that today, in addition to the Keynesian effects of mutually reinforced decline, we are strongly in the presence of “errors of…undue pessimism.” Pigou focused particularly on the need to unfreeze the credit market when the economy is in the grip of excessive pessimism… One of the problems that the Obama administration has to deal with is that the real crisis … has become many times magnified by a psychological collapse. …

Let me preface this by stating that I am an unabashed capitalist.  I believe in the free markets and the entrepreneurial spirit that makes our economy the most robust in the world.  I am confident that these forces will lead us to recovery in due time.

But let’s be clear about the root cause of the current crisis. We are in the current economic crisis because the banks are publicly traded.  Before you burn me at the stake, listen to my argument.

The public markets offer wonderful benefits to our economy and are an asset to us all.  But, they do pressure management teams to constantly grow the bottom line on a quarterly basis.

This is true of all publicly traded companies.  Companies are established based on a new product offering, service model, cost structure, distribution mechanism, etc.  Companies grow and compete based on this sort of innovation.  It fuels our economy and has delivered us the highest standard of living in the world.

But, the financial services market is completely saturated.  Over the recent past, the only way to continue to grow the bottom line at the pace required by the public markets was via questionable financial engineering.   We’ve seen what this sort of financial innovation has brought us: no-doc mortgages, credit-default swaps, unregulated hedge funds, etc.

The bottom line is that demand for growth from the public markets, and the personal financial reward that growth can impart, is the root impetus for the risk-taking we have seen over the recent past.   De-regulation, outrageous compensation packages, and the like are part of the mix, but they are secondary forces.

The markets can remain irrational longer than you can remain solvent.  Today’s market action was just bizarre.  Obama’s speech last night had nothing in it that should have triggered the drop we saw, unless the markets were hoping that he was just going to roll over and abandon his prior stated positions altogether.

One of the “legs of the stool” that Obama outlined was a stimulus package that passed today in the Senate.  The contents of the Senate’s version of the this bill has been pretty well known for days, so any new negative reaction to it today is odd.

Another leg in the stool is getting credit flowing.  Geithner’s speech laying out the broad outlines of his plan certainly did lack specifics, as he has said all along would be the case.  So, if the markets were hoping for strong assurances that current investors in the financial sector would be made whole going forward, there was reason for disappointment.  But, that seems like an unreasonable expectation to me.

So, I have to chalk this one up to pure human emotion, underlining once again the difficult position that believers in efficient markets have been placed.  Behavorial investing seems to offer a more plausible explanation for current investor behavior.

While I am certainly disappointed in the lack of specifics in the Geithner plan, he warned us of this so it is not surprising.  My outlook for the markets holds: trading in a tight range where we have seen the bottom, or something very close too it, but are unable to break through to new highs until significant new economic news emerges.

Robert Schiller, the famous Yale economics professor (see the Case-Shiller index mentioned above), has a great opinion piece in today’s WSJ, Animal Spirits Depend on Trust.  I have referred to “animal spirits” more than once, here is Schiller’s description:

The term “animal spirits,” popularized by John Maynard Keynes in his 1936 book “The General Theory of Employment, Interest and Money,” is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings, and our sense of the extent of corruption and bad faith. When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people.

The article goes on to say that recovery will not commence until trust is restored in the business and consumer sectors.  Given the conversations I have been having with my clients, I can say that trust is very low at this point.

Another entry in the classical vs. behavioral economics debate: we are not always the rational actors that classical theories rely upon.

Never one to pull a punch, Grantham’s latest quarterly letter is out and titled Obama and the Teflon Men, and Other Short Stories (Part 1).  (I’m not sure about who can register to get access to this.) This is going to be a long post, but one very much worth reading if you like to think about the big picture and investment trends.  If you want the quick bottom line: 2009 and even 2010 could easily see new lows in the stock markets but we will avert a new Great Depression.  The 7-year outlook for stocks looks good with traditional average annual returns over that time frame.

A quick review for new readers: Grantham is one of the titans of investing.  Not as well known as others who cherish exposure, but known to almost everyone inside the industry.  Jeremy is the inventor of the “quant” model of stock analysis – the dominant model today.  In the 1960s he was the first investor to use computers as a tool in analysis.  He was also one of the first to implement index investing.  He is one of the founders of GMO, a money manager for institutions, and a predecessor to hedge funds.

While his timing has not always been perfect, his themes have been prescient.  He clearly described the housing bubble in 2005 – a time when Alan Greenspan was vigorously denying it.  He also accurately forecast the current economic crisis stating in 2007 that within 5 years at least one major bank will have failed and half the hedge fund industry will have disappeared.

So, what does he say now?  Follow the link above to get the full analysis, but here are some highlights along with commentary.

The current disaster would have been easy to avoid by making a move against asset bubbles early in their lifecycle. It will, in contrast, be devilishly hard to get out of. But, we are deep in the pickle jar, and it seems likely that, in terms of economic pain, 2009 will be the worst year in the lives of the majority of Americans, Brits, and others.

Grantham has been railing against Fed policies for years.  He blames them for creating the asset bubbles we have experienced this decade.  Alan Greenspan and more recently Ben Bernanke are villains in his mind.  The result is that 2009 is going to be even worse than 2008 in terms of the real economy (not necessarily worse in terms of stock market returns).

Why did this happen?  Because “Greed + Incompetence + A Belief in Market Efficiency = Disaster”.  I think we’re all familiar by now with the greed on the part of so many at the top of the financial sector.  We’re also familiar with the incompetence shown by the regulators.  Which brings us back to one of my favorite topics: classical economics vs. behavioral economics.

A simple question that I keep asking myself is, if markets are truly efficient, then how do bubbles form?  Grantham’s answer is that markets are not efficient.

The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and governmental establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments led to our current plight. “Surely none of this could happen in a rational, efficient world,” they seemed to be thinking. And the absolutely worst aspect of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking – the very severe loss of perceived wealth and the stranded debt that comes with a savage write-down of assets. Well, it’s nice to get that off my chest once again!

Why is this important to us as investors?  Simply because the entire economic edifice that we have been operating under for decades is based on the idea of efficient markets.  The idea that government regulation is bad and that markets should be left to their own devices to self-regulate is based on a theory that just does not seem to hold up to scrutiny.

Looking ahead, rather than behind, Grantham thinks that the stimulus package will help our “animal spirits”, i.e., the emotions that are core to human behavior and hence behavioral investing.  But, the scope of the problem is now so large that recovery is going to take some time.  After discussing various paths to recovery might he states:

Each of the three realistic possibilities listed above would be extremely painful, each is loaded with uncertainties, and even the quickest of them would take several years. Our path this time is likely to involve a hybrid approach: we will certainly take some painful debt liquidations; this crisis will almost certainly take far longer than normal to play out; and probably, before a new equilibrium is reached, we will see inflation rates that are well above normal.

Grantham goes on to draw parallels between our current situation and Japan starting in the 1990s.  To summarize, while the parallels are not perfect, we are likely facing a similarly protracted episode.  The good news is that Japan avoided a depression and we are likely to as well.

To finish this section on an optimistic note (my civic duty), it is worth remembering that real wealth lies not in debt but in educated people, laws, and work ethic, as well as in the quality and quantity of fixed assets and the effectiveness of corporate organization. We, like Japan, are not proposing to destroy any of these assets. We, like Japan, have just tripped on make-believe assets and we now have to deal with chronic deleveraging and bruised animal spirits. When we have dealt with this crisis, all of our assets will still be sitting around waiting to be fully used once again. It is helpful to consider that after the Depression, the U.S. GDP got back on its original trendline as if the Depression had never occurred. Also remember that although your portfolio is down 40%, just as you own the same house, you still control the same number of shares and hence the same fraction of long-term wealth that you had before.

And while he believes that market returns will be normal on average over the next 7 years, they may not be over the next 2 years:

But be prepared for a decline to new lows this year or next, for that would be the most likely historical pattern, as markets love to overcorrect on the downside after major bubbles. 600 or below on the S&P 500 would be a more typical low than the 750 we reached for one day.

An unexpectedly busy day at work yesterday dealing with a small crisis threw me off, so here’s a summary of what I meant to post:

1. David Brooks had a column on the emergence of behavorial economics and what he claims are the now obvious failings of classical economics and the notion of rational actors and efficient markets.  This is one of my favorite topics.  Interesting to see it come to the forefront among general interest columnists.
2. Another warning on the rise of protectionism and nationalism, this time from Paul Krugman.
3. If some banks are too big to fail, then let’s make them smaller – and quickly!  We are essentially nationalizing the biggest banks, so if we own them, let’s break them up and fire the managers who led us into this mess.  As taxpayers we should all be outraged by the deals that the “too big to fail banks” are getting.  No, they cannot be allowed to fail, but there’s no reason to allow them to continue on in their present form – a form that has proven to be disastorous.
   
4. The risk of ETNs vs ETFs is becoming quite clear as the banks that back ETNs, Barclay’s for example, come under increasing financial pressure.
5. If you want to get a taste of the sort of financial regulation that is coming, see this article in the latest The Economist.  A report from a group of economists and policy makers that includes many of the senior people in Obama’s circle.  It calls for some big changes, including separating much of the banking and investing functions that have been getting merged together of late.  “All that talk of the biggest overhaul of financial regulation since the 1930s just took a step towards reality.”  I hope this sort of thing gets implemented quickly.

Dismal employment and manufacturing reports coupled with a Congressional Budget Office prediction of prolonged economic contraction this year cap another week of grim economic news.  Job losses in 2008 were the worst since 1945 and the contraction is now widely expected to continue through the end of the year.  The WSJ notes that today’s report marks the worst job creation track record of any administration on record.

On top of that let’s add more scandals in the business (Satyam) and financial markets (muni bond price fixing) and throw in a dash of enhanced geopolitical risk (Gaza battles, Russia/EU natural gas deliveries).  Frankly, there has been little positive data or news in this very New Year.

But, rather than further commenting on why things are gloomy, it’s probably time to take a step back and attempt to assess the big picture.

The “consensus” view among economists is something that can be gleaned from surveys and daily reading of the business, financial, and investment press.  This view remains that the economy will bottom sometime in the middle of this year.  The markets will anticipate this and turn around before then.  The year will end with the stock markets higher, probably by double digits, than it began.

I certainly hope this view is correct.

This opinion comes from the same people who in 2007 predicted that 2008 would see a weak first half, that we would narrowly miss a recession, and then finish the second half of the year strongly.  They also predicted that global markets would decouple from the US and that commodities would continue their breathtaking rise.

While this view proved to be dramatically wrong, that is no reason to discount consensus opinion in 2009.  Rather, a good reason to discount it is lack of strong supporting evidence.

Like most investors, most economists and forecasters are blinded by behavioral biases.  A primary example of this is to look for and discover patterns in data where none truly exist.  Humans do not work well with chaos; we have to create constructs that allow us to deal with the world around us.

So, strategists conclude that since most recessions following WWII have been less than 12 months, the longest being 16 months, and we have already been in a recession for 12 months, then this recession will end in the first half of 2009.  Or, since markets typically anticipate the end of a recession by approximately 4 months, the market is close to rebounding.  Or, since there is a “mountain” of cash that has been withdrawn from the markets over the past year, this cash will soon come back into the markets.  Or, that record amounts of selling, as has recently occurred, always mark secular lows.  Or, that that record bearish sentiment is a reliable contrarian indicator.  Etc.

Heuristics like these in the financial world are endless and ultimately meaningless.  Future events may or may not follow patterns from the past.  Even broadly accepted concepts like reversion to the mean depend on interpretation, time sample, and other variables that reduce objectivity and usefulness.

To my mind, this sort of “analysis” is akin to reading tea leaves.  Unfortunately, it is often the extent of the reasoning employed in forecasting.

Another factor to consider in consensus opinions is career risk.  Strategists never get fired for being wrong when they are in agreement with the consensus crowd.  They can, however, become singled out for going out on a limb and being off the mark.  Bearish strategists in a bullish industry get fired fairly quickly.

A great example of this is the chief economist at my firm.  To be fair, in his writings intended for client consumption he is more bearish than consensus.  But off the record he is dramatically even more pessimistic is his outlook.  The firm would not allow that sort of talk officially, however, as clients might take their money away.

To be clear, I am not stating that the consensus opinion is wrong.  The simple truth is that no one knows the future. However, the sort of reasoning being used to support consensus opinion seems flimsy at best.

On the other hand, we have the views of the people who called 2008 right as well as the growing band of more recent converts, including parts of our own government and the International Monetary Fund.  The view here is that we are in for a very difficult economic period that will continue at least through the end of 2009.  In this group the outlook ranges from a recession of about one more year, to a Japan Scenario of many years, to Great Depression II.

Clearly, these forecasters are not relying on heuristics, but are drawing conclusions from current data.  Housing markets, employment reports, manufacturing and retail data, credit market liquidity, personal savings rates, etc., are all being analyzed and fed into models that in turn predict a worse economy than the consensus view.

These bearish forecasters could easily be wrong.  It could be that these pundits were merely lucky in their prior predictions – even a broken clock tells accurate time twice a day.  But, given the difficulty of predicting 2008 in 2007, given the nature of the analysis that was done to accomplish that, and given that the same analysis now predicts a lengthy period of economic difficulty, I believe that we must take this view seriously.

To me, this means that investors should remain defensive.  Heavy allocations to cash are still to be avoided, but near-cash, generous portions of fixed income, and select high quality equities should dominate a broad range of portfolios.  In periods like this, I believe that safety should be important to all, regardless of age, risk tolerance, and other “normal” considerations in portfolio construction.  Hedging strategies may also be of interest to those who want to protect against the threat of a very deep and severe recession.  In spite of the near term outlook, equities should continue to be part of the mix as markets can recover quickly and often without warning.

A closing thought.  If we are faced with a prolonged period of economic hardship then we need to keep an eye out for the emergence of protectionism and nationalism.  Inevitably, the need to support one’s own economy will lead governments around the world to introduce measures that will favor national over global trade.  Setting aside the geopolitical risks that may emanate from this, there are investing implications as well.  Restricting and regulating the flow of goods and services across borders changes investing dynamics via simple supply and demand.

If you like to read longer, detailed discussions from economic professors, there are 2 good posts in The Baseline Scenario today.  One provides much more commentary on a topic I posted on 2 days ago, the Fed’s new fear of deflation and actions they are contemplating to counter it.  The second discusses another of my themes, the human tendency to create bubbles and the structural issues in the financial system that need to be addressed.

A third post is a guest post, Obama Plan Is Bold, but Not Bold Enough, from The Baseline Secenario team in the WSJ’s Real Time Economics blog.  This is a lengthy post with commentary along the now common themes of the need for massive government spending to substitute for the lack of private sector and consumer spending, the need to recapitalize banks to restart lending, and the need for a pro-inflation policy to fight deflation.  The final point that they make that has not been discussed enough of late is the need to put a floor under the housing market.  It is abundantly clear that the recession in the housing market is far from over with housing prices continuing to fall.  This creates an insurmountable negative-wealth effect in the consumer sector, the single largest sector in our economy.  There can be no larger economic recovery if there is not also a recovery in the housing market.