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Notes from the 2012 CFA Conference

The conference was opened on Sunday May 6th by James Montier of Grantham, Mayo, Van Otterloo (GMO) who came into Chicago (where the economic theory of efficient markets and the capital asset pricing model was formulated) with rhetorical guns blazing.  His main aim was to tear down CAPM by taking apart all of its assumptions (rational actors, similar objectives and time horizon, etc.) individually and then as a theory.  He accused practitioners of “physics envy” in the sense that in physics or math exactitude is possible because the variables are constants, but in economics no two entities are ever exactly the same.  Bad theories led to bad models which have had disastrous results time and time again.  The Chicago School is so impressed with the elegance of their models that they won’t see that they just don’t work in the real world.  Value-at-risk models assume that things that happen less than 1% of the time can more or less be written off, when it is exactly those <1% events that keep killing us. He took pains to impress upon the crowd that certain events (like the housing crisis) should be thought of as predictable surprises – things that if you are economically astute/historically knowledgeable you know not only can but will happen (you just don’t know when).  He had several recommendations: Never use the term “optimal”; it implies an exactness you cannot possibly ever have.  The best you can ever hope for is for your data to be “robust”. Define risk properly – as The Permanent Impairment of Capital Know the limits of your models Treat financial innovation with skepticism (just because it’s complicated doesn’t mean it’s brilliant). Study financial history; it will help you spot predictable surprises. For policymakers: Central bank policy should strive to be counter-cyclical instead of pro-cyclical Investors cannot expect markets to do the right thing (i.e. regulate itself) – Adam Smith’s “rational self-interest” doesn’t assure fair markets. Regulators must guard against being “captured” by those they are supposed to regulate. For his part on Wednesday morning Professor & Nobel Prize winner Eugene Fama attempted to rebut some of Montier’s criticisms.  Amazingly, he argued that the economic crash in 2008 caused the financial crash (instead of the other way around, as is widely believed).  He argued that markets are very efficient and that even where they aren’t, it does not profit you to bet against them.  If markets are irrational, he said, how can you model that?  The work that he has done, he believes, has enabled investors to achieve the best returns for their risk tolerance.  There will always be a value premium, so why be a growth investor?  Even if that premium were to go away, it would take decades before you would have enough data statistically to make that claim.  The only concession he made to the opponents of efficient markets was in the area of momentum, which shouldn’t exist in an efficient market.  He prefers Kenneth French’s three factor model to CAPM at this point. The Investor Roundtable held on Monday morning was also very interesting.  Four global strategists (Anatole Katesky, Barry Ritholtz, David Rosenberg, and John Mauldin) took on the big picture: Kaletsky: Markets are moved by UNEXPECTED events.  Much of which concerns us today (Europe, China) is a known, and therefore not likely to have major impact.  A slip back into recession by the U.S., on the other hand, would be a surprise and would have major impact. Only the European Central Bank (ECB) can save the “European experiment”.  That means Germany. They can and they will.  And they will soon be forced to. At best, Japan will be a trade from time to time. Expect a continual pattern of crisis and government response like we have seen over the last two years. Continue to be optimistic in the long run as long as economic freedom is growing globally (and it is). Ritholtz: Important to remember that we are still in a secular bear market.  It will last many more years. Austerity can work, but only if people perceive that is it being applied fairly.  Right now this is NOT the case.  Globally there is a feeling that the banks get socialism while the rest of us get capitalism. Agrees that Japan’s problems are deep and intractable. Don’t try to forecast the future.  Make the best “Now” decisions. Rosenberg: Believes we are moving into a new era of political change in Europe and is pessimistic about how it will play out. Very concerned about the health of Chinese banks. Concerned about the “fiscal cliff” in the U.S., in other words what will happen if tax cuts end and selected government spending cuts begin on December 31. Thinks bonds are still the safest place to be as world growth rates will continue to fall. Monetary unions always fail eventually – the Germans will say NO to Europe.  (disagreeing with Kaletsky) Negative short rates are bullish for gold.  Buy the dips. European banks issues will mean less funding of world trade – bearish for emerging markets. Mauldin: France is two years or so from being where Spain is now. Economic weakness breeds nationalism – security and peace issues will arise. Worries about the repercussions of changes in U.S. securities regulations. Bull long term on China, but bear short term - even powerhouses eventually have recessions.  Advice to China:  let it happen. Emerging markets will respond to financing crisis by starting their own global banks.  This is an example of the positives that crises can bring. Michael Pettis gave a fascinating presentation on the situation in China.  He is a professor at Peking University.  His thesis is that China has an investment-driven economy, similar to that of Brazil in the 1970s and Japan in the 1970-80s, among others.  This type of economy is characterized by very high capital spending.  When applied to sectors that were previously capital starved, the approach is initially very successful.  There are substantial productivity gains to be had, so GDP soars.  The country sees the program work and expands it.  Interest rates are kept artificially low to stimulate “borrow and build”.  After a while, the easy productivity gains are gone and the incremental benefit of new construction falls below the cost of capital.  The capital spending is politically popular because it creates jobs, however, so it continues.  Eventually the money runs out, and you are left with high debt and excess construction.  A recovery is extra difficult at that point because you don’t have the usual recession levels available (lowering interest rates, deficit spending, etc.)  If you are a heavy exporter like Japan and China, your trade surplus can help you keep this going a very long time.  In the end, however, there is always a bust and a long period of stagnation.  There is often quite a bit of political instability. Pettis argues that Chinese economists recognize this already, but western economists don’t seem to want to.  He sees the solution as moving from stimulating the production sector to stimulating the consumer (demand) sector.  He says this will be very difficult because the household sector has not benefited much from the government’s policies and wouldn’t be able to sustain a consumption boom even if the government wanted one.  China’s savers face negative real interest rates as bad or worse than U.S. investors. He then went on to discuss the nature of financial repression.  Every banking crisis is ultimately resolved by forcing an artificially low savings rate on savers to transfer money back to the financial sector so that it would eventually be healthy enough to make loans again.  This may also be achieved by taxes or bailouts, but the reality of the transfer of money from the citizenry to the banks NEVER CHANGES. Lastly, he made the point that right now the world desperately needs net demand.  Everybody can’t export their way to prosperity at the same time.  China is not a net consumer (no matter how much iron ore or copper they take in).  If China ever went to being a net consumer, this could have very positive implications for world growth. There were a few other very good presentations, notably Daniel Kahneman on Behavioral Investing and Randall Kroszner on Federal Reserve Policy, but I will save that for another post. 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