Saturday, July 10, 2010

The Big Unknown --- a market commentary

It seemed right to qualify the title. This is about the stock market and not about the universal existential dilemma. The Big Unknown here refers to that attribute of the stock market that makes it unpredictable even to the writers at Barrons, not that The Big Unknown is even necessary for them to recommend topped out stocks.

This may be boring but some groundwork is needed. For simplicity, I'll cite three aspects of market analysis that are knowable even though interpretation is subjective. The first is economic data and the range of forecasts derived from that data for corporate earnings, government finances, and consumer balance sheets. The second is knowledge of the actions being taken to influence the future by those same constituencies, corporates, governments, and consumer aggregates. The third is a picture of trading dynamics including money flows, diversification imbalances, interest rates, foreign exchange rates, and relative returns. For a securities analyst or economist to get his or her arms around all of that is a daunting task but in a way it's a level playing field. It's a competition to see who can figure it all out and come to the most coherent conclusion.

The Big Unknown is what can't be analyzed except by the lucky or smart few. This is not referring to unexpected cataclysms like Archduke Ferdinand's assassination leading to WWI within a few weeks, 9/11 , environmental disasters, or other seismic events that defy analysis. The Big Unknown here refers to macroeconomic trends that are bigger than any one discipline or set of facts. These trends are not seen by specialists and only through interconnecting multiple trends intuitively and creatively is there a chance that they can be seen. Even after the fact they may not be obvious. What the heck is being discussed here.

As one example, leaders in corporations are judged first and foremost by their results. Having worked in a financial services one for many years(and being opinionated and, I hope, insightful) the influence of big macro trends was possible to see. A mediocre manager with a middling work ethic might be handed responsibility for consumer banking right at the beginning of a long term trend in which funding costs decline and aggregate credit demand picks up. The result, earnings improve substantially and it is "obvious" that this manager is just great, an exceptional strategist. On the other hand a gifted and hard working manager may be given resposibility for an operating services business(transaction processing and trust services) just at the point that the industry begins to change and new technologies need to be invested in and employee costs would significantly rise. The result, costs go up, earnings decline and the manager is "behind the eight ball" and just not tough enough.

The best recent political example is the credit President Clinton, his economics team, and the Democrats get, or take, for balancing the budget by 2000. Stop and think. He took office just as the technology boom began and left just before it crashed. During his second term the salaries, bonuses, capital gains, and stock options exercises related to the technology boom were unbelievably huge and tax receipts soared. With few significant new public initiatives in health care, energy, or infrastructure and their attendant costs passed during the Clinton administration and his refusal address the broken Alternative Minimum Tax burden, costs were controlled. Rubin, Summers, and company did not do anything to get in the way of the party, to their credit or not, and, voila, a balanced budget.

In stock market terms great performance by investment managers is often as little under their control as bad performance. Relative performance is therefore the measure used in the industry and in the short term The Big Unknown is kept in the closet. A few look for it and maybe a few of those actually find it. In 1993 I was with a senior executive at a meeting with investors and he explained in detail his strategy for managing his business, taking great pride in all of the nuances that he could see and the discipline that he would reinforce. When asked about his outlook for performance he was cautiously optimistic.

As we were leaving a young, and casually brilliant, hedge fund manager came up to him laughing and pleasantly said something like, "don't worry, you're going to make money hand over fist, everything's going your way no matter what your plans". The senior executive was befuddled and tried to start explaining his strategy and strengths again, looking to get some kind of affirmation or compliment. The hedge fund guy irreverently said, "You don't even know it. Have a great night." and walked on by.

This is by no means a new concept. It just happens to be on my mind these days.


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