THE IMPORTANCE OF UNDERSTANDING MACRO
Whitney Tilson’s latest monthly letter provides us with some insightful lessons for the current market environment. Regular readers will know that I believe there is no such thing as a one size fits all investment strategy or a holy grail approach. Instead, investors must understand the macro environment and apply the correct strategy to fit that particular environment. That micro approach could involve buy and hold, trading, value investing, etc. But the likelihood of success using one strategy in all environments is unlikely. The current turmoil and unusual asset class correlation is making for a very difficult environment for value investors. Tilson explains (thanks to Zero Hedge):
“Regarding the latter, it ’s been very frustrating to accurately predict the primary causes of the current market turmoil – the weak U.S. economy characterized by persistently high unemployment and a feeble housing market, plus the sovereign debt crisis in Europe – but to have done so a year too early (lest you think we are engaging in revisionist history, we’ve attached excerpts from our July 2010 and 2010 annual letter in an endnote at the end of this letter). As a result, we were positioned too defensively in late 2010 and our short book hurt our returns so much and grew so large that we were forced to trim it back and forswore making major market calls in the absence of high conviction of a major bubble. Thus, we were positioned normally – substantially net long – when the recent market storm hit.
So what are the lessons we’ve taken from our experience over the past year? That we’re much better bottoms-up stock and industry analysts than we are macro prognosticators. Making (and acting on) a bearish macro call a year ago was a mistake that we learned from and corrected earlier this year. In contrast, we do not think we made a mistake by failing to predict the latest market turmoil. Other than in rare circumstances, it’s just not what we do because we don’t think we’re good at it.”
As I’ve previously explained, one has to remain incredibly flexible given the unusual environment. This all begins with an understanding of the macro environment. We no longer live in a micro world. What happens in China and Europe impacts us all. And if you don’t understand what’s going on outside of the USA or your own backyard you’re taking excessive risks (perhaps without knowing it).
Value investing might not be dead (it’s certainly not dead for those who have the ability to implement it in the actual way that Warren Buffett implements it – no, not the “buy and hold” myth that Wall Street has sold to everyone), but we can be almost certain that it’s more important than ever to understand the macro. If there’s one great lesson to learn from the recent turmoil that should be it….
Couldn’t agree more Cullen on the importance of Macro!
Ha, giving money to this guy would be a mistake. If he is not a specialist in macro, why does he run a high net exposure? He lost 33% between May-2007 and Feb-2009. Anyone who did not sell on his fund’s recovery afterwards has to blame himself only. In his partial defense, Tilson has outperformed developed equity markets since inception.
Thanks for this Cullen, this post reminds me of one of my favorites by Dylan Grice from last year titled “What’s the point of Macro”
http://www.ritholtz.com/blog/2010/06/whats-the-point-of-macro/
Great post! I will try to contribute my two cents.
IMO, the biggest mistake investors (I am including myself here) make when translating a macro forecast into portfolio actions is acting too early. I believe there are several reasons fro this.
1. The timing of the negative/positive macro environment – value/bubbleforecast is invariably too early. Think Shilling, Rosemberg, Michael Price buying citi too early back in the late 80′s (early 90′s?) etc. Smart guys invariably see things playing out in the economy/markets at a MUCH FASTER pace than how they actually evolve in practice.
2. The stuff on efficient markets they teach you in business school can be bad for your investment health. In theory, markets are supposed to reflect available information as soon as it becomes available. This is nonsense. This is not a good model of how the market actually operates. Do you really think many smart market participants were not aware of the sub-prime originated mess that was coming, as early as the beginning of 2006? Or that they didn’t know how the European story would unfold as early as the first signs of trouble in Greece (and even much earlier)? Or about internet bubble as early as 1997-1998?
They know what is coming but they play the music chairs game to the very last moment. Why? Because they are playing with OPM (other people’s money)and it is safer to follow the pack (read the GMO letter on Money Managers behavior Cullen posted a while ago) than to have the cojones of being a contrarian and end up loosing their job/fee paying clients it they are wrong.
3. A belief in the efficient market hypothesis (2 above) combined with greed can mean disaster for your portfolio. What the average smart investor does as soon as (s)he is aware of the Macro forecast/news that reasonably indicate what is coming down the pike, is to go out and make the proper moves in his/her portfolio as soon possible so as to profit by being ahead of the market (a big factor on this rush to act is greed).
But what usually happens is that the market keeps going its happy way for a loooong time, and the “smart” investor ends up with the opposite result: Loosing money instead of making money.
This is getting too long. In a future post I may discuss how I try my best to deal with items 1-3 above. In particular, on how I try to control my tendency to make mistake number 3 over and over again despite being fully aware of this!
Yes, the amazinf ability of the market to follow momentum after fundamentals are long gone elminates “logical” types from the market at high rate. The ones that are left are trend-followers, reinforcing the strenght of the trends, turning them into bubbles. And the policy maklers are only too happy to oblige.
I do agree that the efficient market hypothesis is extreme (I earned my MBA at U Chicago and I walked away thinking that I had just escaped from a religous cult). But I do beleive that new information is incorporated into prices quickly. I just don’t believe that the markets always get the price right.
“Markets can remain irrational longer than you can remain solvent.”
~ John Maynard Keynes
U R rite. it is not that the efficient market hypothesis and other finance/business models have no value. They provide the foundation on which one can evaluate deviations from the ideal models. All the physics body motion models one studies in HS/College ignore friction. That does not mean they are useless in practice.
I believe the markets are mainly efficient but there are time and space pockets of inefficiency. I will elaborate:
1. The market is not priced right 100% of the time. There are times when it is easy to see the market is undervalued (March 2009) or overvalued (1998-2000, late 2007).
2. At times of a fairly priced market, most securities are priced right but there is always a number of securities whose price does not reflect the fundamentals: Value plays if they are cheap/short candidates if they are expensive.
Your Keynes quote is quite spot-on lol
One additional point…Anticipating the interventionists is impossible.
You might not be able to time when to target is going to appear, but you can keep one chambered with your finger on the trigger for when it does.
Octavio, Im with you on #3.
Im usually ok with buying, but my selling sucks.
I get the feel that I should be selling, but always think, what if Im wrong and it goes higher…
Looks like Tilson is undergoing a very rough patch as of late with his fund. That’s too bad as I like his newsletters as they are well-reasoned and thought out. I too suffer late last year after QE2 was announced as I was net short, like him. However I did stay net short in Aug which benefited me a great deal, unlike him and thus ending up 8% YTD for 2011.
I hope he turns around soon but looks like he is still very much net long, which does not bode well for the next 2 months IMHO.
Well here is a macro moment for U:
http://mikenormaneconomics.blogspot.com/2011/09/enough-already-with-business-is-not.html
This explains the disconnect from what I’m seeing in my job category (automation jobs-a-plenty) and the claims that corporations are not spending.
Tilson: “…it ’s been very frustrating to accurately predict the primary causes of the current market turmoil – the weak U.S. economy characterized by persistently high unemployment and a feeble housing market, plus the sovereign debt crisis in Europe…”
Absent from his list of “primary causes” is the current psychological outlook of investors … at least in USA. We’re in a downer, my friends, general negativity revealed in these very pages every day.
I can’t speak for others and don’t wish to get into politics, but we have been on a downhill outlook-trend ever since late 2008 when TBTF became a buzzword and early 1999 when the government took over 2/3 of the US auto industry, screwing bondholders in the process.
We hear of government – including FRB – plans to right the ship, but it just keeps slowly sliding into submersion while our leadership myopically pursues political/ideological self interests at the cost of the electorate’s interests.
It’s no wonder those of us who wish to invest hold back or, in some cases, behave schizophrenically in reaction to the latest promises from on high, thereby generating frustration in reasonably predicting “market turmoil”.
Whoops! Third paragraph … make that 2009, not 1999.
I track about 40 macro indicators every day as well as read quality blogs like yours Cullen. The macro impact on my portfolio bit me once badly many many years ago and hasn’t since.
Unless it has a negative beta, (almost) all high quality stocks will take a serious hit when the market tanks. I cannot believe that people continue to ignore this.
I started off as micro.
That’s why I’m now macro.
Timing is tough. As OR & ES say, it’s one thing to see what’s coming, it’s another to know when to act upon it. You have to wait for the point when the dead avg investor / manager figures it out before acting yourself. That can be a long time. Keynes was right.
To remind myself just how long it can be, I keep and reread this timetable at least once a month, trying to get it to sink in:
- – -
Mid 2006
• Housing Prices peak
Feb 2007 (~ 8 months)
• REITS peak, start slowly falling
• Banking stocks peak, meander, lose almost no value until …
Jul 2007 (~ 12 months)
• Banking stocks start to fall
Oct 2007 (~ 15 months)
• Stock market peaks, starts slowly falling
Apr 2008 (~ 21 months)
• Banking starts falling hard
Sept 2008 (~ 26 months)
• REITS start falling hard
• Stock market starts falling hard
- – -
26 months for the totality to really sink in to the market’s consciousness. On an issue you’d think Wall Street might know something about, RE and derivatives (as opposed to say, that new interweb, where they may have been blinded by the flashing computer lights).
Far longer, Keynes … far longer.
You should add one more very important date to your list. In Mar 2009 Obama bailed out GM, the market FINALLY stopped going down, down and down.
I have been saying this very same thing for quite a while now, see here:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1904992
The mistake that bottom-up value investors make is to assume that stocks will eventually “revert” to fair value over the long time. This totally neglects the macro drivers of individual stock prices. This is even more true in these markets where so many stocks are included in indices and mutual funds.
The problem is that we have “Dogmatic Capitalism” instead of “Pragmatic” …
Value managers like Tilson can be exceptional stock pickers, but tend to be early at times. I do enjoy the letters and presentations and have come away with many excellent stock picks.
I’m starting to build some positions now in Tilson’s losers which he holds high conviction. I would not have discovered Iridium (IRDM-$7.25) or Grupo Pris (PRIS-$5.75) if not for Tilson’s research since they are off the radar.
FYI.. check out IRDM next week as I expect some groundbreaking announcements of how they might begin to utilize their highly valuable satellite network for new devices (iPad?)and content. Dirt cheap fundamentally, profitable and with a much repaired balance sheet.
Oh, I should add that I’m probably 75% net short – selectively buying value and names with catalysts. Anyone have an opinion on Morgan Stanley (MS-$15.85)? Seems to cheap if they are alive next year with their significant AUM business. Using as an “anti-hedge” against the short REITS/R2K/XRT positions.
Orboros, great timetable. You have got to start working on one for The European/Sovereign Debt Crisis… Let’s see how long that one takes. The Europeans seem to be the kings of scam when it comes to manipulating the media/markets with a continuous stream of useless actions that the market loves even though everyone involved knows it is just can kicking… Until one day…. Da’ music stops!
Sovereigns can kick the can for far longer than mere mortals or corporations. They can pull rabbits out of their hats that you never knew existed, until some huge externality stresses their political systems more than they can cope with. Then they quickly cross the event horizon.
Also posted in QE3 operation twist:
Just came out! Bloomberg video of today’s Lakshman Achuthan appearance:
http://www.bloomberg.com/video/74769051/
Tom Keene uses the words “near recession call” and Lakshman did not refute the use of these words!
From this article, http://money.cnn.com/2011/09/02/news/economy/jobs_double_dip_recession/
It looks like ECRI’s LA believes:
“When employment drops, incomes fall. When income falls, sales fall. When sales fall, production falls. When production falls, employment falls,” said Lakshman Achuthan, managing director of Economic Cycle Research Institute.
It’s a tough cycle to break.
“You can scream and shout, you can be the President, you can be the Congress, you can be the central bank, you’re not going to stop that once it gets going,” said Achuthan.
Even so, the economy is still technically creating jobs — albeit very slowly — and Achuthan thinks the economy would need to actually lose jobs before tipping back into recession.
The second line above is incomplete:
From the article above, it looks like LA believes the economy needs to loose jobs before tipping back into recession. Today we got zero jobs. Let’s see what September brings.
The job picture in the US is depressing.
I agree with the comments above and the most difficult is getting the timing right and trying to outsmart the market by taking a contra-trend bet against the macro-trend.
So what are folks macro views?
Recession on
Profits/Stocks down
Unemployment up
Yields/USD rally
Gold deflates with commodities but occasionally rallies with fear trade
Government debt/GDP rise
No political will for additional deficit spending
A few banks holding euro debt will collapse or be nationalized
See losses by pensions/institutional investors holding euro debt (perhaps muni)
Euroland saga will continue to produce market volatility
Either Euro debt default or a substantive ECB/Euro kick the can plan
U R on the rite track. C the GS PPT presentation I posted in the QE3 “Operation Twist” post below.
Octavio,
I don’t see the link to the Operation Twist presentation. Could you repost?
Thanks
do you mean the LA video or the GS ppt?
The LA video at bloomberg: http://www.bloomberg.com/video/74769051/
The Gs ppt:
Via ZeroHedge:
Here It Is: Presenting Goldman’s “The World Is Ending So Let’s All Profit” Report:
http://www.scribd.com/fullscreen/63818804
OR,
Certainly longer, as a) it effectively started when ‘subprime’ did (well, started imploding, ‘started becoming a problem’ late-90s, I suppose), and b) sovereigns are much more aware of what’s at stake, and are much more actively attempting to suppress the inevitable.
During act 1, the problem didn’t even exist (contained, it was, I remember hearing). Act 2 is about constant delays and endless meetings to start thinking about looking into solving the problem (so European, n’est-ce pas?). Act 3 will likely be the death of a grand dream. But let’s deal with what’s at hand at the moment … the long and drawn out act 2 … you know, the slow part of the movie / play / kabuki theatre.
Dennis,
The GM bailout doesn’t address the main reason for the timeline – that it takes a lot longer than the market wants to admit for the market to grasp what’s really happening, and that I have to take this into account when investing / speculating / gambling. The timeline reminds me of just how long it can take.
The GM bailout highlights a different factor in today’s ‘investing’ world – increased sovereign intervention. And the overall effect it’s having. For example, how much of Europe’s current problems are private vs public now? I’m not sure there’s meaningful separation between the two anymore.
But this sovereign issue I don’t need reminding of; I already understand and expect it.
The time factor, though … good lord, the time it takes …
I understand, I’m always a bit off topic. The realization that the US could not let GM (and thus its partners) go under took a long time. I just thought this marked the end of your particular timeline, but maybe not.
I think you bring up another issue which could result in another timeline – the ‘how long it takes officialdom to figure out what’s happening’ timeline. That one would probably be a lot longer, I suspect.
The market can stay irrational longer than most investors can remain solvent. I consider it a dangerous game, even if you are a pro, to make bets on the next movement when you’re dealing with serious money. Playing with a $10,000 portfolio is a nice hobby, but how does one manage their retirement nest egg of $500,000 or more? Are you willing to bet your and your wife’s financial future on your security picking acumen? Would you feel comfortable employing such a strategy on behalf of your brother-in-law’s portfolio? Just look at how poorly John Paulson’s hedge fund is doing this year. Bill Gross got it seriously wrong on the US Treasury market. All it takes is one really bad year to wipe out some hard earned gains. I would be willing to bet that I can accumulate more capital by investing $25,000 a year in a well diversified equity income fund than the majority of the investors on this blog could do with their active trading strategies. And I would do it with less risk and more time for my golf game.
I imagine this will attract a lot of flak, but I’m just throwing it out there…….
One reason markets take so long to reflect the big macro trend is that everything can’t go down at once. All money has to go somewhere, until it is destroyed. With yields on “safe” Gov’t bonds at record lows there is little incentive to put money into “safe” investments. There is a huge incentive to speculate on something – anything – that actually has yield. Money is only “destroyed” when the Treasury takes it back in the form of taxes, or when fractional reserve loans are paid off or defaulted. Since the Treasury is spending more than it takes in, and Governments are actively preventing loans from defaulting (or the defaults being recognized on balance sheets), that soccer ball is kicking high in the air, and can stay aloft for a very long time. Every time the ball falls down toward earth, another sovereign actor kicks it high in the air again. Until one day someone misses their kick, and the ball hits the ground and rolls into the ditch.
Honestly, you’re probably right.
Even so, you’ll notice pros still play the game, clients still give them money, and every once in a while, lose that money spectacularly. Many people (on both ends) are in the finance business for more than simply the money, whether they realize it or not.
Plus, don’t assume you know how everyone invests. While I can’t speak for others, I’m actually a pretty conservative investor myself, say 75% “safe”, 25% “risky”, of not a trivial amount, and not unsatisfied with my results. I’ve been bruised enough in my past to now know which alleys not to travel down these days.
Who is macro?
An irrational representative agent.
“Macro” is the alias of Bernanke-Trichet, the two headed monster.
http://www.nytimes.com/2011/09/04/business/economy/on-wall-st-a-keynesian-beauty-contest.html?_r=1&ref=business by Shiller
Interesting link Octavio, but I think there is more to that, than the “beauty contest” concept. I think it has more to do to the fact that markets seem to some extent to have lost their compass, namely the concept of risk-free interest rates, which is the anchor of what Modern Portfolio Theory is based on.
Best,
Martin
Risk free rate as given by 3mo T bills is now 0% for practical purposes. So the CAPM line goes through the origin with a slope that is supposed to be the market historical risk premium over the risk free rate; which out of the top of my head is about 5% real, 8% nominal.
So the market, which is assigned a Beta of 1, is supposed to have an expected nominal return in the neighborhood of 7% if we believe what TIPS are telling us in regards to future inflation.
This translates into a theoretical market multiple for the current market (fair PE)=1/0.07=14.28.
Since the FED has promised us ZIRP at least through part of 2013, zirp provides a good anchor for the risk free rate for the foreseable future. Thus, it may seem reasonable that a lot of WS talking heads now see stocks as being cheap since they are trading at a multiple of about 12 based on historical earnings, But:
1. The earnings in the denominator may be peak earnings.
2. The economy is highly likely to be about to start to deep into recession. Check out the WLI growth rate which seems ready to start nosediving:
http://www.zerohedge.com/news/weekly-event-summary-and-look-europes-upcoming-lehman-moment
I have read LA’s little book and there is clear evidence that, regardless of theoretical valuation models, stocks have a high probability of doing poorly during growth cycle downturns.
In other words, if we do hit recession, stocks will come down, even high quality ones; regardless of what Randall Frosty wrote in a recent Barron’s column, tittled something like don’t buy economy headlines (GDP) buy high quality Amerikan Blue Chip stocks.
More good stuff from you, Cullen…..
Dug up a valuable page from Paul:
http://www.paulchefurka.ca/Food_Energy.html
Here are some a macro-instructing images that are easy to forget about when the head has been buried in the nonsense of economics for too long.
Cullen,
What about this as a solution for EU euro mess? Not sure how well it can work if village by village issues it own currency but maybe they are heading in the right direction. Now I wonder if local taxes are paid in Euro or this funny money.
http://www.reuters.com/article/2011/08/29/us-austerity-principality-idUSTRE77S39B20110829
I like the idea of the “Fiorito”. If everyone in town said “OK” let’s use the “Fiorito” it would work, and then nobody would have to pay sales taxes, and if they used the “Fiorito” on payday, no more income taxes either!
See http://www.moneyasdebt.net/ Money as Debt III – Evolution Beyond Money
Absolutely right. Everyone who discards the macro picture is fooling him-/her-self. It’s bad for your portfolio. And parts of that macro picture that often are ignored are:
- the importance of a thing called “”Foreign Currency Reserves”" (FCR).
- US foreign policy.
- Commodities (especially oil) priced in USD.
- Credit market conditions (e.g. LIBOR, TED spread, bond spreads).
But I didn’t get clobbered by the recent downturn of the markets. I knew it was coming.
BTW: the Eur/USD is falling today for the third day in a row. Are the chinese selling their T-bonds ?
German politics are essential in the current macro view. Here is AEP is in fine form again (as always): http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/8740389/German-endgame-for-EMU-draws-ever-nearer.html
A consistent message from AEP regarding Europe – one with which I agree completely – is that “unity or bust” is a fallacy of false choice.
Yep “we are all macro guys now” whether we like it or not. The problem is “optimism bias”: most people are optimists and believe the “better case” scenarios. But if you look deeply at history, you will see there are entire decades when cash was the best-performing asset class. Very boring, I know.
Most macro guys are “misunderestimating” two powerful deflationary and disruptive forces. The first is GATT/WTO, the second is the internet (and software/technology generally). Prior to GATT/WTO, there were 1 billion mostly unemployed people walled off from the developed world labor pool. The world economy is not quite a zero-sum game, but almost. If China etc grow 8%…then the West goes the other direction, simple as that.
In 2000 it cost $150K per month to run a basic transactional app on the net, today it costs $1500. Now that’s deflation…
the importance of understanding macro?
well, a lot of very prominent people thought they understood macro in 2007, and what happened? a major bear.
……and in 2009, many people like mr. tilson were right about the macro picture, but their investments did not do well.
i prefer a top down approach to trading/investing, however, if you’re going to invest based on some brillant economist’s call on the economy, good luck. the market has a mind of it own.