Is this a sign of what might happen in China?

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The bank analyst who had been most prescient and interesting about the Irish banks worked for Merrill Lynch. His name was Philip Ingram. In his late 20s, and a bit quirky—at the University of Cambridge he had studied zoology—Ingram had done something original and useful: he’d shined a new light on the way Irish banks lent against commercial real estate.

The commercial-real-estate loan market is generally less transparent than the market for home loans. Deals between bankers and property developers are one-offs, on terms unknown to all but a few insiders. The parties to any loan always claim it is prudent: a bank analyst has little choice but to take them at their word. But Ingram was skeptical of the Irish banks. He had read Morgan Kelly’s newspaper articles and even paid Kelly a visit in his university office. To Ingram’s eyes, there undoubtedly appeared to be a vast difference between what the Irish banks were saying and what was really happening. To get at it he ignored what they were saying and went looking for knowledgeable insiders in the commercial-property market. He interviewed them, as a journalist might. On March 13, 2008, six months before the Irish real-estate Ponzi scheme collapsed, Ingram published a report, in which he simply quoted verbatim what British market insiders had told him about various banks’ lending to commercial real estate. The Irish banks were making far riskier loans in Ireland than they were in Britain, but even in Britain, the report revealed, they were the nuttiest lenders around: in that category, Anglo Irish, Bank of Ireland, and A.I.B. came, in that order, first, second, and third.

For a few hours the Merrill Lynch report was the hottest read in the London financial markets, until Merrill Lynch retracted it. Merrill had been a lead underwriter of Anglo Irish’s bonds and the corporate broker to A.I.B.: they’d earned huge sums of money off the growth of Irish banking. Moments after Phil Ingram hit the Send button on his report, the Irish banks called their Merrill Lynch bankers and threatened to take their business elsewhere. The same executive from Anglo Irish who had called to scream at Morgan Kelly called a Merrill research analyst to scream some more. Ingram’s superiors at Merrill Lynch hauled him into meetings with in-house lawyers, who toned down the report’s pointed language and purged it of its damning quotes from market insiders, including its many references to Irish banks. And from that moment everything Ingram wrote about Irish banks was edited, and bowdlerized by Merrill Lynch’s lawyers. At the end of 2008, Merrill fired him. One of Ingram’s colleagues, a fellow named Ed Allchin, was also made to apologize to Merrill’s investment bankers individually for the trouble he’d caused them by suggesting there was still money to be made on shorting Irish banks.

Full article via vanityfair.com

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So, where are we now? Although “quality” stocks are very cheap and small caps are very expensive (as are lower quality companies), we are in Year 3 of the Presidential Cycle, when risk – particularly high volatility, but including all of its risky cousins – typically does well and quality does poorly. Not exactly what we need! The mitigating feature once again is an extreme value discrepancy in our favor, but this never matters less than it does in a Year 3.  This is the age-old value manager’s dilemma: we can more or less depend on quality winning over several years, but it may well underperform for a few more quarters. We have always felt we should lean more heavily on the longer term higher confidence.

As a simple rule, the market will tend to rise as long as short rates are kept low. This seems likely to be the case for eight more months and, therefore, we have to be prepared for the market to rise and to have a risky bias. As such, we have been looking at the previous equity bubbles for, if the S&P rises to 1500, it would officially be the latest in the series of true bubbles. All of the famous bubbles broke, but only after short rates had started to rise, sometimes for quite a while. We have only found a couple of unimportant two-sigma 40-year bubbles that broke in the midst of declining rates, and that was nearly 50 years ago. The very famous, very large bubbles also often give another type of warning. Probably knowing they are dancing close to the cliff and yet reluctant to stop, late in bubbles investors often migrate to safer stocks, and risky stocks betray their high betas by underperforming. We can get into the details another time, but suffice it to say that there are usually warnings, sometimes several, before a bubble breaks.  Overvaluation must be present to define a bubble, but it is not a useful warning in and of itself.

I fear that rising resource prices could cause serious inflation in some emerging countries this year. In theory, this could stop the progress of the bubble that is forming in U.S. equities. In practice, it is unlikely to stop our market until our rates have at least started to rise. Given the whiffs of deflation still lingering from lost asset values, the continued weak housing market, weak employment, and very contained labor costs, an inflationary scare in the U.S. seems a ways off.

Jeremy Grantham Quarterly Letter – January 2011

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But what concerns me more than this are some of the implications that proponents of the new normal seem to draw when it comes to investing.  For instance, Richard Clarida of PIMCO wrote the following earlier this year, “Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.”

This certainly isn’t the first premature obituary written for mean reversion.  During pretty much every “new era,” someone proclaims that the old rules simply don’t apply anymore… who could forget Irving Fisher’s statement that stocks had reached a “permanently high plateau” in 1929?

Mean reversion is in some august company in being well enough to read its own obituary.  Men as varied as Samuel Taylor Coleridge, Ernest Hemingway, Steve Jobs, Rudyard Kipling, and Mark Twain were all recipients of the news of their own demise.  Personally, I think Kipling’s response was among the best.  Upon learning of his departure from the mortal coil while reading a magazine, he wrote to its editors, “I’ve just read that I am dead.  Don’t forget to delete me from your list of subscribers.”  With respect to mean reversion, I can’t help but say, in the spirit of Mark Twain, that reports of its death are premature and greatly exaggerated.

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No. 2 INVEST—DON’T TRADE OR SPECULATE

The stock market is not a casino, but if you move in and out of stocks

every time they move a point or two, or if you continually sell short…

or deal only in options…or trade in futures…the market will be your

casino. And, like most gamblers, you may lose eventually—or frequently.

You may find your profits consumed by commissions. You may find a

market you expected to turn down turning up—and up, and up—in

defiance of all your careful calculations and short sales. Every time a

Wall Street news announcer says, “This just in,” your heart will stop.

Keep in mind the wise words of Lucien Hooper, a Wall Street legend:

“What always impresses me,” he wrote,“is how much better the relaxed,

long-term owners of stock do with their portfolios than the traders do

with their switching of inventory. The relaxed investor is usually better

informed and more understanding of essential values; he is more patient

and less emotional; he pays smaller capital gains taxes; he does not

incur unnecessary brokerage commissions; and he avoids behaving

like Cassius by ‘thinking too much.’ ”

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“The average per-person consumption rate in the first world of metal and oil and natural resources is 32 times that of the developing world,” says Diamond.  ”That means that one American is consuming like 32 Kenyans.”  The problem is not the number of Kenyans, the problem is when Kenyans or, more pressingly, big developing countries such as China, gain the ability to consume like Americans.

Can’t humans simply increase the supply of resources as they have done before? “We can change the supply of some things if there is only one limiting resource.  If it food, then we can have a green revolution and produce more crops,” he says.  ”Unfortunately, we need lots of resources.  We need food, we need water.  We are already using something like 70-80 per cent of the world’s fresh water.  So you say, ‘Alright, we’ll get around water by desalinating sea water.’  But then there’s the energy ceiling, and so on.”

Full article via FT.com

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To summarize what I have said: Aim for the highest; never enter a bar-room; do not touch liquor, or if at all only at meals; never speculate; never indorse beyond your surplus cash fund; make the firm’s interest yours; break orders always to save owners; concentrate; put all your eggs in one basket, and watch that basket; expenditure always within revenue; lastly, be not impatient, for, as Emerson says, “no one can cheat you out of ultimate success but yourselves.” I congratulate poor young men upon being born to that ancient and honourable degree which renders it necessary that they should devote themselves to hard work. A basketful of bonds is the heaviest basket a young man ever had to carry. He generally gets to staggering under it. We have in this city creditable instances of such young men, who have pressed to the front rank of our best and most useful citizens. These deserve great credit. But the vast majority of the sons of rich men are unable to resist the temptations to which wealth subjects them, and sink to unworthy lives. I would almost as soon leave a young man a curse, as burden him with the almighty dollar. It is not from this class you have rivalry to fear. The partner’s sons will not trouble you much, but look out that some boys poorer, much poorer than yourselves, whose parents cannot afford to give them the advantages of a course in this institute, advantages which should give you a decided lead in the race–look out that such boys do not challenge you at the post and pass you at the grand stand. Look out for the boy who has to plunge into work direct from the common school and who begins by sweeping out the office. He is the probable dark horse that you had better watch.

Full address via David Voelker  of historytools.org

One of the most remarkable things about the investing world is how (correctly) venerated Warren Buffett is and how completely people ignore his investing advice. Since Mr. Buffett has made more money than anyone in the history of the planet solely through investing, one would think that when he says quite clearly what to invest in, people would pay attention. I guess they do pay attention, they just do the opposite. In 1974, near the bottom of the market, he said stocks were so cheap he felt like an over-sexed guy in a harem. In 1999, near the top, he opined that stocks would see returns way below those experienced in the bull market up to that time. From the time of his comments in November 1999 to the end of October 2008, stocks fell over 2% per year. In October 2008, again near the bottom, Buffett published an op-ed in The New York Times entitled, “Buy American. I Am.” telling people to buy American stocks. They promptly accelerated their selling. On October 5th of this year, he said the following: “It is quite clear stocks are cheaper than bonds. I can’t imagine anybody hav- ing bonds in their portfolio when they can own equities.”The result: people pour their money into bond funds in record amounts, and sell their holdings in funds that invest in U.S. stocks. Why inves- tors persist in doing the opposite of what the greatest investor of all time does, is a greater mystery than the problem of consciousness, or the origin of life, or free will and determinism.Those at least are hard problems.

Full Commentary via leggmason.com