Thoughts from the Frontline Weekly Newsletter What? Me Worry? by John Mauldin April 20, 2007 In this issue: What? Me Worry? Past Performance Predicts Future Disaster The Surprise of the Black Swan The Boomers Break the Deal La Jolla, Moving, and Graduation This week I am in La Jolla for my annual Strategic Investment Conference, co-hosted by my partners Altegris Investments. This week's letter is the basis for the speech I will be giving Saturday afternoon on a few of the items in my long-term worry closet. What? Me Worry? It will come as no surprise to this audience that there are a few things that worry me. I often write about problems in the markets. Subprime mortgage contagion, earnings shortfalls, a slowdown in consumer spending are all on my worry list. But I am not just your average amateur worrier. I am a professional worrier. I get paid to worry. For a professional, worrying is an art form. The amateur worrier spends way too much time worrying about events that are likely to happen. A true professional worries about the unlikely events that create the most problems. It is the things we are not worried about which can cause us the most harm. For instance, I am not worried that the subprime mortgage debacle might cause a recession. I think it will bring us a garden-variety recession. I have lived through five recessions, a few market crashes, and other economic upheavals in my adult life and expect to live through that many more problems in the future. My portfolio and business are built to withstand a recession or two, so I don't worry about it. What worries me about the problems in the mortgage market is the possibility, however small, that we will see a credit liquidity crunch that will bring about more than a simple recession. I think it unlikely, but I can see a path that makes it possible. The capital ratio at US banks is at its lowest level since 2001, and with more losses coming from mortgage and consumer lending, it is possible that banks will tighten up lending practices. We are already seeing some anecdotal evidence of tighter lending standards and a reduction in consumer lending. Enough to throw us into a serious recession? While unlikely, it is something to pay attention to, because that would change things and maybe require some portfolio adjustments, as well as bring new opportunities. In what may seem like a contradiction, a professional worrier must be an optimist. Spending too much of your time worrying can lead to inaction and not getting into the fray. There are two types of people who lose in today's markets. First, there are those who are pessimists and do not get into any investments at all, staying in cash. That is a strategy that is guaranteed to lose you buying power, as inflation and taxes eat into your portfolio. Second, there are the unabashed bulls that chase the latest investment fad, often when it is coming to an end. $90 billion dollars went into mutual funds in January of 2000. I am told that 80% went into Janus funds, some of which went down by 75% or more. Sometimes they do ring a bell. The correct position is cautious optimism. At the risk of repeating myself, the way to be in the top 10% of all investors in 2017 is to simply be above average each and every year for the next ten years. That is harder than it sounds. Many investors create portfolios based on historical data that is unlikely to repeat, or choose investments which may well be outstanding in most years but have some awful years as well. The enemy of compounding is losing. You can and should be cautious, but you need to be in the game if you are going to be above average. Past Performance Predicts Future Disaster I was at Rob Arnott's Advisory Panel meeting last week, coincidentally here in La Jolla. I had the great pleasure of listening to Professor Harry Markowitz (who developed Modern Portfolio Theory and got the Nobel Prize for it) comment at length on the presentations. He told one story that I have to share with you, as it illustrates quite well the problems faced by professional worriers. It seems his son is an attorney (of whom Harry was clearly quite proud) and was defending an interesting client. The case involved the client, who had lost $100 million for a group of Indian tribes, and they were upset. However, they weren't quite the innocents. It seems they were not satisfied with typical returns and wanted to make a little more. They specifically instructed the money manager to invest in loans which paid 22%. Basically, these were loans to resorts and vacation spots. The manager, in an effort to protect the principle, diversified the loan portfolio by making lots of loans, thus trying to insulate the portfolio from the problem of any one or two loans going bad. 22% a year can make up a lot of losses if you can keep the losses small. What happens, however, if a majority of the loans go bad all at once? That would clearly be a bad thing, but how could that happen? Past performance of the loans suggested that the concept was sound. However, a bad thing did happen as vacation travel plummeted after 9/11 and the follow-on recessions. Evidently, projects were cancelled or halted and the tribes who thought they were diversified against risk found they were not. Whether it was property in the US, the Caribbean, or wherever, they all were hurt in the aftermath. Interestingly, there were five different expert witnesses (both for the defense and the tribes) that testified on diversification and modern portfolio theory. Evidently all were aware of the irony of being questioned by the son of the developer of the theory. Long Term Capital Management is another case in point. The Nobel laureates associated with that firm had run extensive risk analysis on all the historical data. These were not wild gunslingers. They were clearly convinced that they had covered the risks. And they had covered all the risks that were in the historical databases. However, there was one piece of data that was not in the historical numbers, and that was the effect of Long Term Capital itself. LTCM became the market and the connection between markets that had never shown any correlation. As they had to sell seemingly unconnected investments to meet margin calls, the pressure on all of the markets ratcheted up simultaneously. And the more they had to sell, the worse it got. The same thing with Amaranth last fall. They had PhDs running around doing analysis on risk, based on historical data, but someone forgot to factor in what it means when you become such a large part of a relatively small natural gas market that you can no longer meaningfully hedge or exit a losing position. They were averaging down into a losing trade, which is nearly always a mistake, but their market activities were of such size they distorted the market signals. Before they realized, they were getting margin calls, and the size of their own trades to raise cash was making the market move against them. Interestingly, the trader (Brian Hunter) and his team that lost $6 billion at Amaranth are now raising money for a new fund. According to people who have read their material, there is a great deal of emphasis on risk control. Imagine that. How special. Even more amazing is that he has reportedly gotten commitments for several hundred million dollars. As an aside, you will not see that fund on any platform offered by myself or my partners. Sometimes the best risk control is to avoid it altogether. A few years ago, I took the due diligence questionnaires for hedge funds from a number of firms (I think it was approaching ten) that analyze hedge funds, and then worked through them to compare the various documents. They all had different sets of questions. After a while I think I spotted a pattern. You could see that the differences were basically in things that had probably caused problems for the firm. They added a series of questions that were designed to make sure they never had those problems again. I can tell you that my analysis has more depth to it than five or ten years ago, or even a few years ago. Every time there is a problem, and you hope it is the other guy and not you having it, a new set of questions appears to try and deal with that risk in the future. And you can make book on the fact that in five years the questionnaires for fund managers will have even more questions. It is always the questions that you don't ask, the data that you didn't know about, that is the problem. The Surprise of the Black Swan This is what Nassim Taleb calls the black swan problem. You can have a database with 4,000 white swans. History and the data tell you that swans are white. But the absence of a black swan doesn't mean there isn't one. As John Kay writes in this week's Financial Times: "Every sophisticated institution has its own models back-tested against the experience of that institution. But this illustrates that the analytical problem is fundamental. The data used to back-test, of necessity, is drawn from a period when the institution did not experience the problems the risk models are designed to anticipate. The one thing we know with certainty about the banks, insurance companies and hedge funds that compete for our business is that they did not go bust in the period from which their historic data are drawn. "That, unfortunately, is the only thing we know with certainty. The risks models financial institutions use insure that it is very unlikely that these institutions will fail for the reasons that are incorporated into the model. That does not mean they will not fail, only that they will fail for different reasons."