A Prize For the Most Useless?

• Gary S. Becker

In 1992, Gary S. Becker won his Nobel Prize for extending microeconomics to a broad array of subjects, including discrimination, crime and punishment, human capital, family dynamics, and politics. He sounds, frankly, like a lot of the students I counseled at the Stanford Career Planning & Placement Center, who couldn’t decide between economics and political science. Most wanted the economics degree because they thought it might help them get a job after graduation. The job they most wanted, though, was President of the United States, so the political science gig might come in handy. Ultimately, the liberals ended up in journalism writing political essays disguised as economic analysis, while the more conservative grads went into investment banking and now own several Senators of their own.

Some things just aren’t taught at the undergraduate level.

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Becker spent most of his career as a member of the University of Chicago’s distinguished faculty. He was even considering leaving economics entirely until he met world renowned monetarist Milton Friedman who convinced him that economics was not a game played by clever academicians but rather a powerful tool to analyze the real world. A rejuvenated Becker began extending theories of rational choice to areas previously unblemished by economic analysis. Becker’s studies generated a great deal of criticism and many economists didn’t really consider him a student of economics at all, which (again) probably goes back to the fact that he wanted his research to be useful beyond the walls of the university. Becker even went so far as to agree to become a regular columnist for Business Week magazine, submitting his ideas and research to the general reader instead of just publishing in obscure journals.

Ultimately, Becker took the fundamental precepts of economic analysis (ludicrous assumptions obscured by complex mathematics) and applied them to other areas of debate. With a libertarian mindset and a fistful of equations, Becker proved things like legalizing illegal drugs and slapping on a tax would be more effective than prohibiting drugs like methamphetamines. And who wouldn’t question a study based on meth users doing what’s in their own rational best interest? Except, maybe, for anyone conscious of the paradoxical notion of a rational meth user. What exactly do they look like? Perhaps he’s really envisioning a young meth user with dentures, because the older ones couldn’t possibly be accused of having behaved rationally unless they’ve always harbored a secret desire to look like a pruned version of Gollum from “Lord of the Rings.”

Becker’s central premise is that rational economic choices, based on self-interest, govern most aspects of human behavior, and not just purchase and investment decisions that are traditionally the purview of economic analysis. Becker used charts and graphs and calculus to make assumptions and draw conclusions about racial discrimination in labor markets, job training, family size, divorce, criminal behavior and the role of women in the workplace. It’s going beyond the Peter Principle. It’s reaching beyond your own circle of incompetence and expanding into new service areas. It is the opposite of focusing on your core strength.

I know of several super regional bank trust departments which failed, year after year, to beat the market with their investment management model, which have decided they should tackle “both sides of the client balance sheet” and have begun offering a broader array of advice on a wider range of investment alternatives and decisions regarding both asset and liability decisions. In other words, since they didn’t do a very good job of investing client assets, they decided to expand their scope of services to include advising clients on how much they should borrow and invest in the new, probably also unsuccessful, investment strategies. All this is being done in the name of offering “wealth management services” to their affluent clients.

If an advisor can’t manage a long-only stock portfolio, how in the world does it propose to make competent real estate decisions as well? If it won’t take a stand on stocks versus bonds, how do they expect to offer expertise in deciding among complex hedge fund strategies? If running is a problem, try walking. Don’t start designing cars.

Becker is sort of like the carpenter for whom every problem requires a hammer. We all look at problems with our own biases and from our own point of view. Successful investors, however, find that when their view of the world conflicts with reality based on faulty underlying assumptions, it is their pocketbook which is incurs a sub-optimal result.

• Douglass North

Douglass North, a 1993 Prize winner, may be as important as John Maynard Keynes was to macroeconomics, the traditional branch of economics that deals with the performance, structure, and behavior of the national economy as a whole. These two branches, microeconomics and macroeconomics, form the core curriculum of many economics programs.

My roommate at Stanford and I would debate the key questions of economics, sometimes for hours – depending on whether or not we ran out of beer. The key question is, “which is the most worthless, micro- or macro-economics. There was no question, really, that they were both worthless. The only real point of contention was which was worse.

Micro focuses in on the smaller unit, such as an individual consumer or small business entity. Macro, on the other hand, considers the grand scheme of things. It looks at national statistics, international trade, and price and inflation statistics. I’ve always been a fan of entrepreneurs, so was somewhat sympathetic to the microeconomists I’ve met. Not because they are in any way useful, of course, but at least they seem to be rooting for the right team. My roommate argued that because the microeconomists were always assuming perfectly efficient companies and perfectly rational consumers, any conclusions drawn from their resulting charts and graphs must be fundamentally flawed. After all, when was the last time you met someone who worked for a perfect business? And let’s be honest, just how rational is your spouse when it comes to spending money?

I, however, always presented the case against macroeconomics. Economics majors, like Literature majors, are great fans of irony. Indeed, one of the big factors behind Arrow’s Nobel Prize win was the fact that he had a paradox named after him. Arrow’s paradox, also known as “Arrow’s impossibility theorem” examined various economic criteria, including the “independence of irrelevant alternatives.” I mean, doesn’t that phrase have “Laureate” written all over it? It doesn’t matter a whit that nobody understands what it means (and sounds like the definition of the word “trivia”). The phrase is steeped in so much cosmic irony that it practically demands that students do a word search in Shakespeare to see if Arrow lifted the concept from an old book. Economists delight in irony the same way that conservative pundits savor the fact that Al Gore, the inventor of the internet, received a C- in Natural Sciences and a D in Man’s Place in Nature during his stay at Harvard (where he spent much of his sophomore year shooting pool in the Dunster House basement lounge, watching television, eating hamburgers, and hacking his way into the Defense Department’s ARPA net to steal code). It’s that geekish sense of intellectual humor of a brainiac screaming “notice how smart I am!” In Arrow’s case, Alfred Nobel’s minions in Stockholm, Sweden chuckled at the irony of his famous phrase and voted him into the club. (In Gore’s case, they are said to have actually guffawed.)

Outside of the merry pranksters in Sweden, however, few people actually paid much attention to Arrow, North, or Becker, so not many people could be hurt. No harm. No foul. Things were done in the traditional spirit of Ivy League antics with no one really getting hurt except for the parents of underclassmen who were saddled with the tuition bills. The next four gentlemen to win were pushing theories that reached out and touched investors portfolios and proved to be a little more dangerous.

Next post: A Prize For The Most Useless - Part II

To start at the beginning of the Investment Heresies eMag, click here

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Irrational Instability

Since when is a rescue bad news?

AIG is a BIG insurance company. A couple of years ago, it had a market value of $190 billion. Last Christmas it owned over $1 trillion in assets, but was leveraged roughly 10:1. For every $1 in equity, it owned $10 in assets and had $9 in liabilities. This is not necessarily unusual for an insurance company, however it does leave them vulnerable in the event that irrational instability spreads like wildfire through the financial system.

AIG made a few bum investments, but the Q2 write-offs of around $10 billion shouldn’t wipe out a company with a market capitalization of $190 billion. Now the rumor is that write-offs for the company will soar to perhaps $60-70 billion, but even that shouldn’t take the company to the brink.

At the end of last year, AIG had $380 billion of “current liabilities,” which is usually defined as coming due within a year. By mid-2008, however, bond buyers went on strike. Though AIG was highly rated, the rating agencies no longer have any credibility. In fact, the rating agencies helped drive a stake through the heart of AIG just this week by downgrading the company in the midst of crisis, and even then the bonds remained investment grade. With no investors willing to buy their bonds, and $380 billion coming due through the course of the year, the clock kept ticking.

AIG, like hundreds of other companies in the financial services sector, have been forced to reduce the size of their balance sheet, selling assets at the worst possible time. This has caused the price of corporate bonds, junk bonds, mortgage-backed securities and all things paper to drop. Because new accounting rules implemented in November of 2007 require that these assets be “marked-to-market” (price) so with each succeeding wave of liquidations, prices go lower, more write-offs are required, and the problems spiral out of control.

Mark-to-market accounting makes sense for assets held in short-term inventory for sale, but not for long-term investments. Were individuals subject to mark-to-market accounting during the real estate boom, they would have been forced to mark up the value of their homes each year and pay income taxes on these phantom gains. Worse yet, now that home prices are sinking, homeowners would have to subtract the losses from income which would reduce your income tax burden, but leave you subject to having the bank step in and call-in your mortgage given that your negative income suggests that you can no longer afford the home you’re living in. Forget for a moment that your real (cash) income hasn’t changed. If the bank comes knocking on your door and forces you to refinance, but no one else will loan you the money because they also think you have negative income, the end result is that you’re out in the street with nowhere to live while the bank sells your house out of foreclosure for less than its worth, and next year it’s your neighbors who are out on the street because they had to mark their houses down in value.

Do you see how irrational this is? That’s the situation we’re facing in the markets today.

A modern day “run on the bank” doesn’t necessarily involve tellers pulling money out of an institution. Today the financial institutions are so dependant on the bond market providing liquidity that a buyers’ strike in the bond market creates havoc.

Who are these bond buyers? Many are pension funds. However, only a small portion of bond money is dedicated to the junk bond market. If a company (like AIG) is at risk of falling to junk status, most of the pension fund money will look elsewhere. Financial institutions, themselves, are major bond investors – but remember, these companies are shrinking their balance sheets, which only adds to the problem. Closed-end funds are sometimes buyers, but many of them are being forced to de-leverage as well, so they tend to be net sellers at the moment. You’re left with a few retail mutual funds with money to buy, but they finished spending their available cash in August of 2007, and shareholder redemptions are forcing them to liquidate as well. AIG has $380 billion of paper to refinance, but everywhere they go they get the cold shoulder.

AIG, and other companies like it, are reasonably sound entities being forced into the unwilling arms of the government because their short-term debt is maturing and no one is willing to buy their paper.

The government has been criticized for bailing out rich Wall Street shareholders. But the real end game is to bail out bond holders. AIG has lost $185 billion in market value, and that’s okay. Stock investors take that sort of risk every day – it’s just that it’s a rare day that they actually have to absorb that sort of loss. The Secretary of the Treasury is trying to protect AIG’s $900+ billion in creditors by making a bridge loan to help the company survive the credit crunch. Those creditors include annuity holders who are depending on AIG to provide them a lifetime income stream. They include retirement plan participants who bought bonds through their pension plan because until this week AIG had one of the highest ratings out there.

Is it fair that a run on the bank caused by idiots at Lehman Brothers, Bear Stearns, IndyMac and a bunch of independent mortgage company brokers that offered mortgages to deadbeats on overpriced rental condos in the vacation hot spot of your choice with little money down and no income verification --- is it fair that the credit crisis that followed imperil retirees depending on AIG for their grocery money?

Probably not.

We have reached the point where the credit crisis is unfair and probably irrational. The Treasury is doing whatever it can to restore stability. When trust is destroyed, however, a restoration of faith cannot be mandated by government fiat. The only credit that buyers trust, at this point, is the government itself. That is why the government now explicitly backs the bonds of Fannie Mae and Freddie Mac. That is why the government is able to raise $85 billion which is lent to AIG (at an 11% interest cost).

• What does this mess mean for stockholders?

For owners of financial services companies, it means that it will be a long time before you can get a meaningful rally in the sector. The stocks can pop 50% overnight (or lose as much), but the sector won’t really recover until the balance sheets are downsized, trust and credibility are restored (good luck with that!), and the companies have reinvented themselves as profitable and stable. We’ve said before that the next stock market rally won’t be led by financials, and the fact that they had been leading the market up (in August) had been troubling us.

The rest of the market can keep falling until it is so incredibly cheap that buyers come in even in spite of Wall Street’s lack of credibility. Drug stocks have reasonably stable earnings and sell at 12X earnings. Is that cheap enough? Big oil sells below 8.5X earnings. Is that cheap enough? Software companies are selling at about 14X earnings and have attractive growth prospects. When do buyers step in? At 13X? At 10X?

The May-Investments fund portfolio has 30% in bonds and much of the equity portfolio in historically defensive sectors like healthcare and consumer staples and pharmaceutical companies. The May-Investments portfolios did not sell-off today as much as the market, which fell 450 points (-4.7% today for the S&P 500 Index). Still, the market feels like it’s wound tight as a spring and could rocket down more, just as it could (and I hope will) rocket up.

To me, the government deciding to throw its support to AIG bond holders was a good thing. The stock market can go to hell, but if the bond market stops working the whole country is in a world of hurt. It seems to me that the Treasury understands that.

Rather than springing up, though, the market tanked some more. Not just financials, but across the board the sell-off was severe. Though I remain an optimist (…this too shall pass), at the end of the day when the mid-day rally failed to hold, we sold our position in industrial stocks and for a few days, at least, will let the money sit in cash.

We told investors that when the market is tanking, our philosophy is to take some steps to “get out of the way.” The sell-off in commodities and international stocks is consistent with a world view that says the U.S. recession (which still hasn’t been classified as such by the economists) has spread to the rest of the globe. I don’t know if I agree with this observation, but in a liquidity crunch the resulting irrational instability can even force good companies into bankruptcy, and cause prices to sink far below “fair value.”

We might be setting up another “once in a lifetime” buying opportunity, a la 1974, but if that is what’s actually happening the entry point will more likely come somewhere below 9,000. All we’ve got at this point is a run-of-the-mill attractively valued market.

If the market falls from here, we’ve got 40% in bonds or cash equivalents that we can redeploy in stocks at much more attractive levels.

If the market rockets UP from here – as I truly hope it does – we will have locked in a loss on our industrials and left a little more money on the table. That market, however, would mark the beginning of a new, rationally stable capital market, and I would welcome that outcome even if it means a little short-term underperformance up front.

Yesterday’s post admitted that I am optimistic, but have little confidence in my forecast. For that reason, we have shifted back to our most defensive position in the face of persistent selling. Though the Treasury is taking heroic steps to support the market, the bond buyers strike shows no signs of abating.

The good news is that I believe that the current bout of instability is irrational. The bad news is that the market doesn’t care one iota about what I think. Prepare for the worst. Hope for the best. Don’t freeze, but remain watchful. Keep your bearings along the way.

Volatility creates opportunity. This just happens to be one of those days where it isn't a very pleasant sensation.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Weekend at Bernanke's

Four different stories came out of Wall Street this weekend, any one of which would have made an interesting start to the week.

First, sub-prime mortgages brought down Lehman Brothers house of cards. Lehman closed its doors to forestall creditors. Like Bear Stearns, which experienced a run on the bank earlier in the year, Lehman was a major fixed income investment bank. Home to the popular Lehman Bond Indicies, the bank manufactured a large percentage of the sub-prime loans that have triggered the 2008 financial crisis. Apparently they weren't able to dump all of the toxic paper to clients, and retained enough that these bonds, for which almost no market exists, when "marked-to-market" were marked down to almost worthless. Lehman reported a $4 billion loss last week, but still was able to report assets, a positive book value, and positive cash earnings (the mark-downs are a non-cash charge). Thus, even though Lehman was probably profitable on a cash basis, the fact that buyers would no longer finance its operations was too much for it. Several last minute attempts to sell Lehman to foreign banks failed because the Fed refused to make another sweetheart deal, as they'd done in March for Bear Stearns.

By the time I read about it, late Sunday night, it was old news. As the clock passed the midnight hour, the reports were of Lehman employees going in on Sunday to clean out their desks, enjoy one last beer and pizza with (former) co-workers. Lehman declared its parent company bankrupt. Subsidiaries are still open for business on Monday. But a broker with no access to funding is necessarily in a liquidating stage. The asset management subsidiaries will be sold to others. Who knows what Lehman creditors will receive. Shareholders have lost everything, as should have been the case with the Bear.

The Lehman saga, however, was only part of the story.

With Lehman gone, attention was bound to turn to Mother Merrill. One blogger is said to have speculated that Lehman was brought down by big Wall Street interests at Goldman who were wanting to hedge their own positions in Goldman shares, but owned restricted stock and were thus prohibited from shorting their own stock. Lehman, it was speculated, was merely a proxy for GS. With Bear and Lehman now gone, Merrill would be the next best short, given that they couldn't short their own shares. Merrill knew that it could never withstand the sort of shorting pressure and intense market pressure that killed off the other two free standing investment banks, so it struck up merger talks with Bank of America after being encouraged to do so by the Fed.

Elsewhere in New York, ten major banks are said to be putting together a $70 billion pool to help financial companies in distress. The Federal Reserve, having spent a great deal of its balance sheet bailing out Bear Stearns, needs help. The big banks figure that if they don't hang together, they will hang separately.

Perhaps the real question is demonstrated by the fourth story coming out of the Big Apple, that the giant insurance company, AIG, has approached the Fed looking to borrow as much as $40 billion because it, too, is having difficulty rolling over debt. The Treasury allowed investment banks to tap into the Federal Reserve in March, in an attempt to keep Lehman and Merrill alive. AIG figures that would help them out, too, and would also like help from Uncle Sam. The question is, if it takes $40 billion to bail out AIG, just how far is that new bank pool of $70 billion going to go?

• How could this happen?

The good news is that most of this news is "old news," simply confirmation of what we already knew, that banks had lost their senses and the markets were going to discipline them severely, with or without help from the regulators. The regulators, it seems, have been much too cozy with these big Wall Street firms for much too long. When Congress passes "privacy laws" that are essentially meaningless, the big firms on Wall Street figured out a way to turn these new laws into a big stick to wield against brokers who try to change firms, which has nothing to do with the original intent of the legislation but is just another example of how the regulators roll over for Wall Street. Some of the biggest buyers of these problems loans and credit derivatives are the highly regulated big national banks. The Adjustable Rate Security crisis happened right under the nost of the Securities and Exchange Commission.

Investors need to realize that the age old joke about, "I'm from the government and I'm here to help" is as big a joke on Wall Street as anywhere else. The S.E.C. isn't going to protect them from Wall Street greed.

Only common sense can do that. Had Wall Street and its regulators demonstrated a bit more common sense in the past decade, the current episode of debt destruction might not have been necessary. Instead, the market is acting like a slow moving car crash and I don't have any idea how many times the car is going to roll. As one Minyanville blogger recently noted, "Rome wasn't burnt in a day."

• Has the May-Investments Outlook Changed?

We're still pretty much on the sidelines when it comes to owning financial stocks, and especially banks and brokerages. However, this sell-off has advanced to the stage where "safe havens" are few and far between. Not even our bond positions have been able to catch a bid. The biggest problem for our portfolios hasn't been Lehman going off the air, but oil prices crashing to below par ($100).

We're in a "no place to hide" market and the only good thing that I can say about that is that high volatility, "throw the baby out with the bathwater" markets are generally experienced more near a market bottom than a market top. Let's hope that is the case this time as well.

In January of 2008 we told clients to expect a difficult first half but that markets would recover by year-end. We observed that after predicting a recession in 2007 (starting with our October 2006 economic update) that we were happy to report that things were not as bad as we'd anticipated; the job market was not as bad and profits outside of the financials and consumer cyclicals sector were hanging in there. The tax rebate earlier in the year also helped keep the economy moving along. After all, it's now September of 2008 and despite this weekend's headlines, the economists are still debating whether or not we're actually in a recession.

Even at our mid-year Economic Update, I gladly announced that our rosy conclusion was that the glass was absolutely half full!

Unfortunately, the last two months of economic statistics haven't been encouraging and the unemployment situation has taken a turn for the worse. Consumer sentiment, which was starting to turn back up (from very depressed levels) will now probably roll over. I keep looking for some good news on the horizon, but it's harder to find than a non-partisan politician. Our prediction for a year-end upturn is clearly at risk and the last thing I want to do is hold on to my forecast just so I don't have to admit it was wrong.

Though I am still officially an optimist at the moment, my confidence level in that outlook is practically nil. The markets are very volatile and will likely "break" in one direction or the other.

Some major piece of good news could result in a strong move up that could turn things around. For instance, if the Federal Reserve would temporarily suspend "mark-to-market" accounting requirements for financial companies, some of the pressure to dump assets would be eliminated. The Fed might want to re-introduce restrictions against naked short sales to make it harder for short sellers to force these companies into a "bank run" sort of scenario where a collapsing stock price sends a signal to the bond market to stop buying a certain company's debt.

There is some good news lurking out there. Tomorrow morning would be a great time for it to make an appearance!

Only 15 days left in September. And counting....

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Divergence

Beginning in mid-July, at least for a month, the trends in the U.S. market diverged from market trends in others parts of the world. It is difficult to know whether to celebrate the recovery of stocks in the financial sector, or hide money under the mattress because the global economy is threatening to collapse.

On the U.S. side, in mid-July the markets concluded that Freddie Mac and Fannie Mae are going under, which is bad, but that the government will guarantee their bonds in order to prevent a financial catastrophe. The bonds of these heavily leveraged mortgage guarantors still trade at a modest premium to Treasury bonds. Shareholders of those two companies, however, have lost about $100 billion in market capitalization. The fact that the U.S. printing presses do, in fact, back the bonds is important because ownership of the bonds is spread throughout the banking sector and were the bonds to fall precipitously the banking sector’s “mark-to-market” accounting rules would mean a lot more banks would fall into the “troubled” category.

Major market players, (Bill Gross for example) are on record as saying that the Fed needs to take these entities over, sooner rather than later, before the mortgage market can return to any semblance of normalcy. In the meantime, Gross is trying to buy $5 billion worth of mortgage-backed securities which will likely rise in value once the spread between mortgages and treasury bonds narrow. He’s saying in effect that the Fed needs to step in to prevent a “financial tsunami” from spiraling out of control, but he’s not so pessimistic that he isn’t willing to step into the middle of the fray and buy distressed mortgage assets. Color him concerned, but not pessimistic.

I share both his concern and his underlying optimism about the U.S. financials sector. There is more bad news to come. California foreclosures continue to soar, though other parts of the country are starting to see foreclosure rates decline. To me, the financial sector may have bottomed, but its not going to lead us out of the slump.

From July 15 to September 4, the financials and consumer cyclical stocks have been appreciating while most sectors, and especially the energy/commodity complex, has experienced a ferocious sell-off. Why the divergence?

I think that the energy and international stocks are experiencing double-digit declines (since July 15) as investors worry that the U.S. recession is getting worse and spreading to the global economy. Though I don’t think a global recession is in the cards, what worries me most is that the market seems to be signaling this outcome. Our international investments, once more than 40% of our mutual fund portfolio model, have been systematically sold to the point where now it is almost down to 5% of the total portfolio. The fund strategies still have about 30% invested in the bond market. Outside of the consumer staples industry, it’s increasingly difficult to find any asset class anywhere that it working.

The last few months have this market feeling a bit more like 2002. Back in 2001, it wasn’t that hard to make money, even in a declining market. Simply by not owning technology, portfolio managers could dramatically outperform and it wasn’t that hard to find sectors with positive returns that year. In 2002, though, it was difficult to find anything that went up, with bonds and real estate being major exceptions to the rule. By the end of August, 2008, the market looked a lot more like 2002 in that it’s becoming increasingly harder to find any asset class going up.

As investors, consumers, and financial institutions de-leverage (reduce their level of borrowing), they are forced to sell assets to reduce the size of their balance sheet. Even strong asset classes are put on sale. At the end of the de-leveraging process is a great time to buy. The questions is, are we near the end?

The financials say yes, but keep in mind that a year ago the financials were saying that the sub-prime crisis would cost, at the most, maybe $10 billion. In reality, that estimate didn’t even cover half of what a number of the large banks ultimately had to write off. In my book, the financial market has no credibility as a forecaster. Though I do believe that mid-July might represent a bottom, and that by now most of the financial sector write-offs are already factored into current market prices, that doesn’t mean that the financials are a timely place to invest, or that they can lead the market up from here. It will take time for managements to re-gain earnings power and credibility. The write-offs aren’t over, but they will no longer come as a surprise.

The commodity and global markets are saying that the recession will spread as the de-leveraging continues. Fear has certainly replaced confidence in those markets. The steep declines are reminiscent of 2006, though, when Amaranth Advisors held a distress sale of billions of dollars worth of energy assets. I think that some over-leveraged hedge fund shops are being forced to sell assets. Once those funds have liquidated their books, hopefully the commodity markets will at least stabilize.

The signal we’re waiting for is for strength in the U.S. business sector, especially in the consumer cyclicals, industrials, technology and healthcare sectors. When these sectors start leading the market up, that will be a sustainable rally. The earnings power in these sectors remains intact, while the financials have diluted their earnings power because they’ve been forced to raise capital at a difficult time in the market. Even highly regarded Wells Fargo just completed a preferred stock offering that pays investors 9.75% in order to go out and make more mortgage loans that pay back 6.5%. These are tough times for banks, and forward earnings estimates have zero credibility at the moment. It’s hard to have a sustainable rally until we move beyond the current real estate bust. It’s hard to say that the sector is valued at an attractive level when book value keeps shrinking, dividend yields are being cut in half, and an earnings recovery is based on assumptions that have no evidence of being accurate.

Our fund portfolios are sitting on the fence, still defensively positioned in bonds while recently adding pro-recovery sectors like healthcare and technology. Intellectually, I’m fairly optimistic that consumer confidence will return, the recent spate of layoffs will be absorbed into a reasonably healthy manufacturing sector, and eventually stocks will rally because investors aren’t finding attractive returns in cash, bonds, or real estate investments.

Unfortunately, we can’t look to economists for an answer. They put out a lot of useful statistics, but by the time they declare that we’re in a recession, it will already be over. Portfolio managers have to make decisions before all of the economic data is in. Once the recovery has been established beyond all reasonable doubt, prices will be much higher than they are today.

Being a portfolio manager is the most interesting job in the world and it’s a lot like being an economist – except that you have actual responsibilities….

WARNING: Stolen joke alert – (Q) Did you hear of the economist who dove into his swimming pool and broke his neck? (A) He forgot to seasonally adjust his pool.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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