Archive for February, 2010

Risk management in complex organizations

Tuesday, February 23rd, 2010

In 1999, Richard Bookstaber wrote a seminal article called Risk Management in Complex Organizations (Association for Investment Management and Research, March/April 1999).  I must have read this article over 20 times over the last ten years (I keep a folder of seminal articles for my continued education).  To a family, their goals and needs are complex and confusing.  To an investment bank, their trading operation is a complex organization.  Below are quotes for your consideration:

a) The paradox of risk management: “How can we manage a risk we do not know exists?”

b) “Precision and focus in addressing the known comes at the cost of reduced ability to address the unknown.”

c) “The root of the problem is not the complexity of the unseen risks.  The unforeseen events turn out to be simple.  The root of the problem is the complexity of the organization” in dealing with risks.

Bottom line:  Risk management is about having options.  Do you know your options?

Always Asking, Never Assuming™

Christopher Holtby

Reviewing a few confusing 2010 macro and market themes

Monday, February 22nd, 2010

Since January 2010, there has been a sharp rebound of the US dollar, fiscal tightening policies from China, and a debt crisis brewing in Europe.  Washington is following the example of the Japanese government by not allowing the real estate foreclosure process to proceed at a normal pace (partly due to low capital ratios at the banks).   What is interesting is that the investment strategists believe 2010 will see an earnings recovery, with the same intensity they believed 2009 would be a “tough year” and 2008 would be a “slow year.”  If my memory is correct, the economists believing the US economy would have soft landing in the summer of 2008, are now touting a strong recovery in 2010 (GDP growth of 5%).  Looking back to the 1940s, seven out of the last eight recessions saw two quarters of positive “headline” growth (source: Gluskin Sheff).  What makes an end to a recession is sustainability, such as increasing retail sales tax receipts. 

Any crisis creates a change in behavior.  There appears to be a disconnect between the actions of consumers and corporations and the forecasts of investment strategists:  1) home-ownership is no longer considered to be a stable asset, 2) lower gas prices and a strong stock market rebound in 2009 didn’t influence Americans to drive more miles for the second year in a row (source: WSJ), 3) consumers are spending less on non-essentials (source: NYT), and 4) households are paying down credit card debt in never-before-seen amounts.  Our government, in order to prevent an all-out-deflationary depression, has had to expand its balance sheet to offset the actions of the American household.  The question will be how these two competing actions balance themselves out over the long-term. 

Investors are piling into bond assets.  Over the last 25 years, investors have a had very low allocation to bonds, around 7%.   In 2009 stock mutual funds saw net redemptions of $4.1 billion (source: Gluskin Sheff) whereas bond mutual funds saw a $349 billion in-flow.  The grass is not always greener on the other side of the fence and nobody knows with scientific certainty why this change of allocation is occurring (I expect fear and not concrete thought).  According to Haver Analytics, stock mutual fund managers are at the low end of their cash allocation (around 3.9%) whereas bond mutual fund managers are at the high end of their cash allocation  (3.3% for government bond mutual funds and 7.7% for corporate bond managers). 

Bottom line:  As the American economy and financial markets re-calibrate to the new realities of a less leveraged world, investing will be a difficult process.

Always Asking, Never Assuming™

Christopher Holtby

What does Discount Rate hike mean to you?

Saturday, February 20th, 2010

Definitions:  Discount rate is the “penalty rate” for banks needing emergency funds from the Federal Reserve (normally around 1% higher than the Fed Funds Rate).  Fed Funds Rate is the interest rate at which banks lend their balances (known as federal funds) held at the Federal Reserve to other banks, usually overnight.  The Discount Rate is set by the Fed Board of Governors, and the Fed Funds Rate is set by the Federal Open Market Committee (FOMC).

Last week the Fed’s Board of Governors raised the Discount Rate from 0.5% to 0.75% inter-meeting.  The surprise was not the amount, but the timing.  Two weeks ago, Bernanke’s prepared text to Congress stated the intent to raise the Discount Rate soon (defined normally as “in the future”, and market didn’t really appreciate that would be in 7 days).  The Fed also reduced the length on discount window borrows to the normal overnight term (since the Fall of 2008 the term had been extended to 28 days).  Currently, only $14.9 billion of window borrowing is outstanding, compared with over $1 trillion of cash held in Federal Reserve funds.  The Dow Jones rallied 233 points with the first discount rate decrease (Aug 2007), and markets declined with the discount rate increase.  The effect on the economy, bank lending and non-bank company profitability has nothing to do with the discount rate over the long-term.  It took increasing the Fed’s balance sheet to almost $2 trillion to arrest the downward spiral in the economy and markets (current financial crisis was a credit crisis, not a liquidity crisis, so reducing Fed Funds Rate and Discount Rate had a negligible effect on arresting the downward spiral).

For months, the Fed has written and talked extensively about exiting from the various strategies used to stabilize the financial markets.   The raising of the discount rate means the exiting has started, even if done gradually.  Markets of any kind really dislike uncertainty.  The inter-meeting change created uncertainty about the market pricing of all financial assets.  Interest rates, foreign exchange rates, and implied volatility of all assets have now been priced into the market.  This is reflected in an uncertainty premium.  The dollar has strengthened and solidified it’s strong trend relative to the Euro, Pound and commodity exporting countries.

Bottom Line:  1) Uncertainty is now firmly entrenched into the markets, 2) Investors need to be very clear on the timeline of their investments – short-term, intermediate and long-term – and the acceptable level of uncertainty on those investments, and 3) Looking at over 200 years of financial and economic history, this is a normal process.

Always Asking, Never Assuming™

Christopher Holtby

Country risk and international/emerging market investments

Monday, February 15th, 2010

Beginning with the creation of the European Union through the Maastricht and Lisbon Treaties, a generation of investors no longer worried about European country risk.  German bonds and Greek bonds traded within a few basis points of each other up to late 2007/early 2008.  Economic historians will point to the periods between 1946 and 1999 as being very challenging.  Deciding which European countries to invest in and how was tough.  You had the Club Med countries experiencing several periods of currency devaluation.  The markets provided guidance on the risk between these European countries with credit spread differentials on corporate and government debt.   Since the creation of the European Union, German and Greek bonds traded based on interest rate differentials.  No longer.  They now trade based on credit differences.  Risk and return eventually come back into balance.  The only question is when.

One great aspect of capitalism is that it allows a society to get richer (source: Schumpeter).  Capitalism also brings about creative destruction.  The global stock and bond markets are in this current phase.  I experienced such a phase in Canada during the late 1980s through the mid-1990s (family businesses and investments).   There is opportunity in a crisis.  There is also the need to ensure one’s assets are intact at the end of the crisis or the creative destruction phase.

Money managers will need to avoid the pressure thrust upon them from pension consultants and the like over the last 25 years to base their country weightings on the EAFE Index.   Sometimes it makes sense to have a zero weighting to Japan (currently a 23.5% weighting in the MSCI EAFE Index).

Bottom line: Stock picking, not country allocation, has historically provided a balanced risk/return trade off.  Policy/political risk during a creative destructive phase is very real (US is especially included in this category).

Always Asking, Never Assuming™

Christopher Holtby