Ramblings of a Portfolio Manager 11-2-2009

Ramblings of a Portfolio Manager or “Beam Me Up Scotty!”

For those non-Trekkies, Kobayashi Maru describes a fictional test taken by cadets at Starfleet Academy--one with no possible winning scenario. The pyrrhic exam was only defeated once, by Captain James T. Kirk (then cadet), who reprogrammed the computer to allow a positive outcome. It is meant as a test of character rather than of skill or military acumen. It also describes current U.S. market sentiment toward the US economic recovery.

Wednesday afternoon, the market experienced a strong sell-off, primarily on the news that the well-known Fed Insider, Government, er Goldman Sachs, had lowered its projections for third quarter GDP expectations to +2.7% from the prior Street expectations of +3.0%. If Goldman said it, then, well, it must be true since they are the smartest guys in the room and, of course, have the “inside line.” Just like it was with their $150/bbl oil prediction in 2007 and $25/bbl prediction in early 2009. On Thursday, US third quarter GDP came out at +3.5%. Well, one of three ain’t bad… Goldman’s miss and the economy’s beat immediately spurred a round of short-covering and some genuine buying in the US equity markets, with the Dow ending the day up nearly 200pts on Thursday. Immediately, technicians who saw all sorts of chart breakdowns on Wednesday evening tripped over one-another to find bullish themes in Thursday’s market actions. The economist crowd, however, were not so sanguine.

Having been 50% correct all year (at a much greater cost than the quarter one could just as well flip), the PhDs found no cheer in the 3^rd quarter economic report. They were quick to point out that, ex-cash for clunkers, the real number was probably +2.7% (which would still be the best quarterly advance since the third quarter of 2007). Missing from their dour analysis was that consumption as a whole added 2.36% to growth with inventory restocking adding nearly 1% and residential construction adding 0.53 percentage points, its first positive contribution since the fourth quarter of 2005! Actually, many viewed the consumption component as a bad thing as it is seen as “volatile.” Gee, our math says that in an economy 70% driving by the consumer we are right on track (3.5%x.70%=2.45%), but then again we don’t have PdDs in economics or higher mathematics. The economists divided into two camps: the “skeptics” saw the data as bad, claiming that the economy is only being supported by the Obama stimulus package. Ignoring that fact that only 17% of the package has been spent on what most of their brethren argue are non growth-producing projects, they claim the only way the US experienced GDP growth in the third quarter was through government spending; i.e. growth was spurious and without the stimulus, we would still be in recession. Therefore, they argue, the market is ahead of itself. Of this camp we ask, what was the point of the stimulus package if not to produce this exact result? The second camp, the “believers,” were more forward looking. In their view, the growth data was bad as it was real and signaled that the Federal Reserve may withdraw liquidity ahead of current expectations. They argue that the market is not discounting a rate hike as early as they now predict and, therefore, is ahead of itself. All this “no way out” arguing helped the Dow to more than erase Thursday’s gains on Friday. Japanese sailing vessel analogies aside, we term this the “damned if you do and damned if you don’t” scenario. Just remember that it was a group of PhDs in economics who almost sunk the world economy in the last great financial crisis (with leverage) in 1998 with the last “too big to fail” bailout--Long Term Capital.

As we write this Sunday evening, news comes across that the Chinese PMI rose to a better-than-expected 55.2, the highest level in 18 months, signaling continuing expansion of manufacturing in that country. Chinese GDP is now expected to grow in excess of 9.5% this year—a number of which we should be envious…at least we think. What do our economists say? Well, we’ve yet to hear them try to convince anyone that growth in China is bad for a multitude of conflicting reasons, as they are attempting to do with growth here. In fact, no one questions that Chinese growth is stimulus-induced--as it should be--and that their Central Government will soon be tightening monetary policy. Instead, economists have been telling us just not to believe the numbers—that the Chinese Government is lying. Perhaps, but such “lies” can only continue for so long before a little dog exposes the man behind the curtain. By the way, the Shanghai Composite ended the day up 2.7%. Well, enough of the movie analogies. Our whole point in this Ramblings is to suggest that a lot of very highly educated folks can take the same data and arrive at the same market predictions for wholly opposite reasons if they have a prior bias. By the same token of course, many highly educated folks can take the same data and arrive at polar opposite market forecasts, also depending upon their priors. That demonstrates the pitfalls of giving credence to economists as market prognosticators. Our question is, who will be the Jim Kirk to reprogram some of these geniuses? Obama? Geithner? Bernanke? Our bet is on Mr. Market. In any case, whomever he/she is will rely on psychology rather than programming to resolve this intellectual no-win scenario.