The Fed Grasps At Straws

Here is a really stupid headline and story summary from the WSJ, which I believe is worth saving for posterity as it is indicative of the times in so many ways:

Federal Officials Say No Thanks to Negative Rates
Fed officials don’t think negative rates are needed in the U.S. because the economy and job market are improving and they are hoping they will never have to use them in the future given their uncertainty about whether the policy works.

They claim they don’t “need” negative rates because things are improving, but they won’t raise rates, which is what typically happens when they’re done subsidizing with monetary policy.

But despite their present judgment, they’re simply “hoping” they wont have to use them in the future, which suggests they’re not confident about their present judgment.

Meanwhile, the reason they’re hoping they won’t have to use them is because they don’t know if they work. So, they’d be willing to try something that has some chance of making things worse, in order to see if it has a chance of making things better.

So this is the era we live in: the central bank refuses to return things to “normal” while insisting things are on the mend, is open to conducting monetary science experiments on the economy despite initial misgivings, and reporters write stories about this chicanery as if these are all serious and respectable ideas to entertain. Couldn’t a bunch of Fed chimpanzees at the trading consoles have a reasonably good chance at improving upon this model?

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The Thousand-Year Reich Fallacy

Nothing is more permanent than “temporary” arrangements, deficits, truces, and relationships; and nothing is more temporary than “permanent” ones.

~Nassim Taleb

The Nazi regime in Germany, which was early on referred to as the “Third Reich”, was also popularly referred to as the “Thousand-Year Reich”, the implication being that it was a regime which would stand the test of time and last over a period of many multiple generations.

An intellectual problem I’ve always had with this is that the seemingly ever-lasting circumstance has an explicit, definite end point. In the case of the Thousand-Year Reich, that end point is 1,000 years from the time it was established– and then what? More importantly, why only 1,000 years? If the Thousand-Year Reich represents some kind of political ideal, how would it be possible for the society underneath it to transcend these arrangements over any conceivable period of time? And what changes in circumstance would lead them to do so?

As an observer of financial markets and business cycles for going on a decade, I see the “Thousand-Year Reich Fallacy” with some frequency. For example, a market prognostication might be made in the following form: “Earnings growth is strong and sustainable, rather than seeing the S&P 500 tail off from current levels, I believe it will continue to rise and will be ten or fifteen years before we see a correction.”

Ignoring even the problematic metaphor of a “correction” in this context, I always find myself thinking in these circumstances– and then what? And what is it, 10 or 15 years from now, that finally precipitates this change in price?

The most obvious example of the Thousand-Year Reich Fallacy (which is really just a variant of the hot hand fallacy) lately is the specious reasoning we hear about about Zero-Interest Rate Policy (ZIRP), its longevity and the “new normal” economic paradigm it engenders. Many people, simpleton and sophisticate alike, have reasoned that central banks have painted themselves into a corner with their ZIRP attempts and having arrived at this corner, there is no way out that will not impose enormous social costs to exit, which they are beyond reluctant to effect as a result. The implication is that interest rates will not rise because they can not rise without grave disruption to economic activity.

The incentives of ZIRP and even NIRP (Negative-) are intuitively perverse. Under ZIRP, borrowers pay no costs and lenders earn no return for parting with their money, meaning lenders have become indifferent from the standpoint of time preference, preferring a dollar today equally to a dollar tomorrow. Under NIRP, borrowers are rewarded for borrowing and lenders are glad to pay them for their privilege, meaning that lenders prefer a fraction of their dollar tomorrow to their whole dollar today. Anyone who listens to this realizes that this is not a sustainable arrangement, ceteris paribus, and that studied in isolation they would not willingly behave that way as a lender.

So, the Thousand-Year Reich must come to an end. But when? And why? Here is where the fallacy rears its ugly head, as people will project an arbitrary time frame which seems sufficiently long to hedge against immediate uncertainty, ie, 20 years, 30 years, but they will not then reason about what changes must occur 20 years or 30 years from now that bring ZIRP/NIRP to an end.

For ZIRP/NIRP to truly be the “new normal”, there can not be any end point to it. But it is not anticipated to be the new normal, but only a Twenty-Year Reich. But what then? And why will it remain stable along the way?

The funny thing about the Thousand-Year Reich fallacy is how short of the initial timeline events end up, and how violently the trend unravels. In the case of Nazi Germany, a regime slated to last 1,000 years in fact lasted 12 years, from 1933 to 1945. Of course, it was a horrible 12 years, punctuated by a ghastly death toll, gross destruction of capital and property in Germany and abroad, and enormous political ramifications that reverberated outward from Berlin and into the present day. All the martial glory, all the eternal recognition and all the national greatness imagined at its inception was dashed to the rocks in just over a decade which, for those experiencing it, must’ve seemed like 1,000 plus forever years.

The ZIRP/NIRP paradigm is a similarly crowded trade from a social expectations standpoint. Anecdotally, I have seen that it is believed from shady, proletarian used car lot operators in Appalachian Tennessee, to educated, middle-aged professional bankers on the West Coast. Everyone knows it can’t go on forever, but they can’t see how it will end in the next five, ten or even fifteen years and certainly no one wants to try to imagine what it might be like. It will be truly unprecedented. But it will end, because it must end, and since it will end it’s worth thinking about what it is that will deliver the finishing blow, and why it could be a much shorter Reich than one could anticipate right this very moment.

Are Cash-Flush Corporate Balance Sheets Hiding Stagnating Operating Efficiencies?

In an article entitled “Too Much of a Good Thing” from CFO.com, we learn that American businesses have become less efficient with their use of working capital over the last year:

Days working capital (DWC) — the number of days it takes to convert working capital into revenue — did decrease marginally in 2011, from 37.7 days to 37 days. But REL downplays the improvement, attributing it in part to the companies’ 13% average revenue growth. “To have a 1.9% decrease is a positive, but not by a lot,” says Prathima Iddamsetty, senior manager of operations, research, and marketing at REL, a working capital consultancy.

Cash on hand across the group of surveyed companies, dubbed the REL U.S. 1,000, increased by $60.3 billion in 2011, helped in part by companies taking advantage of low interest rates to issue more debt, up by a record $233 billion year-over-year. Those companies now have a staggering $910 billion in excess working capital, including $425 billion in inventory, according to REL. “Way too much cash is being left on the table and not being put toward growth objectives,” says Iddamsetty.

But why does it matter?

Indeed, cash is still king for the REL U.S. 1,000. This is clearly evidenced by the $60 billion increase in cash on hand and the $233 billion increase in debt in 2011. Over a three-year period, cash on hand was $277 billion and accumulated debt $268 billion.

But using debt instead of efficient working capital management to get more cash into the bank account “comes with a long-term cost: eventually they will have to pay [the debt] down,” points out Ginsberg. “They’ll also have to generate a return on their existing assets that exceeds the interest rate, which is not what we’re seeing.”

It’s better to tap working capital as a funding source for long-term growth strategies, says Ginsberg. REL Consulting cites top performers in a broad range of industries, leveraging working capital to open up new businesses in emerging markets with growing consumer demand, for instance.

“Top performers have very tight manufacturing timetables and inventory management practices, in addition to strict collections and payment systems that are standardized across all locations,” says Michael K. Rellihan, an associate principal at REL. “The cash they generate from this high level of working capital efficiency is then applied to the growth agenda. Long-term, the result is a powerful benefit to the bottom line.”

“Only process improvements will provide sustainable cash flow benefits,” adds REL’s Sparks. “This requires working more closely with customers, getting better information to suppliers, and improving demand forecasting. You need to have an underlying process in place to manage working capital on a day-to-day basis; if not, it will be difficult to sustain.”

In other words, the growth in corporate debt and the resulting excess cash on the balance sheet gives the illusion of financial and business health in the short-term, when in the long-term these companies still must find ways to improve operating efficiencies and thereby generate profit. Ironically, even as the cost of debt in a zero-interest rate policy environment falls, this is getting harder and harder to do because there are fewer and fewer genuine opportunities to drive real growth and expand the top line while maintaining operating efficiency. It makes you wonder how much of this working capital problem is a symptom of our ZIRP-economy.

There was also a helpful chart showing the state of working capital efficiency by industry that can give you a quick high-level look at winners and losers in terms of working capital management.

Video – Michael Mauboussian On Forbes

Intelligent Investing with Steve Forbes presents Michael Mauboussin, chief investment strategist, Legg Mason Capital Management, author of Think Twice

Major take-aways from the interview:

  • 9%, 7.5% and 5.5-6%; the rates of return, respectively, for the S&P500, mutual funds and mutual fund investors, on average– why the discrepancy?
  • Mutual funds underperform the S&P500 on a total return basis due to fees; mutual fund investors underperform the funds mostly due to timing– most individuals buy when funds have done well, sell when they’ve done poorly, exposing themselves to underperformance and missing out on subsequent over-performance
  • Curiously, institutional investors underperform as well; the culprit is overactivity– people believe “if you work hard, you’ll be rewarded”, so institutional investors try to “earn” their returns by moving money around constantly
  • Increasingly, investment returns have to do with luck and not skill; all activities in life fall along a continuum between pure skill and no luck (running competition) to pure luck and no skill (the lottery); the “Paradox of Skill” states that the more skillful competitors are, the more uniform their results become and the more important luck is to explaining differences in results
  • How to accurately judge a manager’s returns? Sample size is important: the more decisions the manager has to make over time, the shorter time horizon can be used to judge them; the fewer decisions they make over time, the longer the time horizon used to judge them
  • Focus on process, not outcome; in investing– analytical process of ideas, behavioral/psychological process, and organizational process (constraints w/in the organization that impede performance)
  • Investing boils down to two activities: handicapping (looking at market assumptions via price and then backing into the scenario that would have to occur for that price to be reasonable, and judging the probability of it occurring) and bet-sizing (waiting until you have a strong advantage and then betting big)
  • Expectations-based investing process: back into the cash flow assumptions that justify current market price; financial/strategic analysis of the company and its industry to see if the company is likely to do better or worse than the market implies; then decide to buy, sell or do nothing– what’s built in? what’s likely to happen? then “over-under” rather than “I know precisely what those cash flows will be”
  • Systems that are entirely skill-based don’t revert to the mean at all; aside from fatigue, running a race 5x will result in the same, highly-skilled winner each time
  • The extent to which a system is not all-skill is the extent to which it can mean-revert, but the question is, what mean? A highly skilled person might come down off a peak but they will not revert to the mean of more normally skilled individuals, for instance (tall parents tend to have tall children, but they might not be as tall as the parents — mean reversion — but you also don’t expect them to go down to the height of the average population)
  • Investing is not all-luck, but it is luck-leaning on the continuum; the best way to judge managers is by process, not performance
  • “Buy cheap and hold”: consider the story of Bob Kirby and the “Coffee Can Approach” [PDF]
  • What can older investors do in today’s interest rate environment? Follow Jim Grant’s advice, “Roll back the calendar 30 years”, ie, nothing, they’re screwed
  • “Patience is the key” to great investment returns

More Interviews With David Baran Of Symphony Fund

For reference purposes, here are three more recent interviews with David Baran of the Tokyo-based Symphony Fund, which is involved in shareholder activism and management buyouts of undervalued (especially net-net and net cash bargain) Japanese equities:

Investing in a ZIRP environment:

I’ve been trading Japanese equities since 1990, so I’ve seen it all twice [laughs]…

I think [it’s influenced] our views on how the world is going to look as a result of, not just the current sovereign debt crisis in Europe, but the entire cycle of over-leveraging in the world and the shifting to an almost perpetual low interest rate, low growth scenario.  We’ve lived it in Japan already—we know what it’s like, we know what it does to asset prices, we know you’re going to get attractive bull market runs but you’re still going to be in a long-term bear market. Being able to look back at our own experiences of having dealt with that in Japan gives us a completely different perspective, I think, from other managers who would be relatively new to the market—by relatively new, I mean, they’ve got 10 years experience—and they’ve only seen bull markets with some deep corrections that are reversed by policy.

I don’t think there’s a policy solution for what we have now. You’ve got to get rid of all the debt. The global debt overhang is huge, it’s historic. The amount of unfunded liability in the U.S. can cripple the country. And you have that situation amplified in Europe with fewer policy tools to rectify the problem.

The M&A trend in Japan:

MBOs [management buyouts] first came to prominence in Japan in 2006 with the Skylark MBO. This caused corporate Japan to first sit up and take notice that this was a possible road that management could take. At the same time, there began a series of changes to Japanese corporate governance that aimed to increased corporate disclosure and increase transparency. The most recent of these came out in 2010 and included requirements for director/statutory auditor independence, disclosure of executive compensation, and explanations for cross shareholdings. All of these are hard to swallow for many Japanese companies. In addition, with all these new rules, including IFRS accounting rules that will soon be introduced, the costs of being a listed company was getting high. Too high particularly for smaller cap companies for whom these costs were now of a material size relative to earnings. It is no coincidence that we have seen a steady increase in MBO activity in Japan, with 2011 on track to be the highest in five years.

They’re not activists, they’re advisors:

We are not activists. The whole activist approach doesn’t work in Japan. It probably works better in the U.S. because the shareholder base is more diversified and economically motivated. Shareholders in Japan may not necessarily use the same formula. The activists who tried a hostile approach here before, and this is where the cultural biases come in, they never had the ability to force management to do anything because they never had control. So they were requesting management to do something but doing it in such a way that management would just turn their back on them and say, ‘Well, we don’t even really need to talk to you,’ and the other shareholders really didn’t care, and would side with management.

We take a much more cooperative approach with management…We’ll act more as their counsel, their consigliere, guys they can talk to about things as opposed to the squeaky wheel.  We’re not interested in being the squeaky wheel.