Archive for September, 2010


For any American who travels in Europe or Japan, one of the more striking contrasts comes with the train system. The trains are a clean, efficient and even enjoyable form of intercity transport. The nagging question for decades is why we don’t have the same level of train service in the US.

French Train

There are many reasons (cultural, geographic, and political) but the one I want to zero in on is featherbedding because some of the issues tie directly to today’s financial industry and has implications for us as investors.

Up until the 1940s, railroads (passenger and freight) were every bit as prevalent in the US as they were in Europe. However, in the 1950’s, the technology of transport started to change once again. On the railway front, new safety and management techniques were developed and implemented to improve the efficiency of the railroads for both passengers and freight. At the same time, the airline industry, the long haul trucking industry and the interstate system were also developing quickly to compete for business.

By and large, the railway industry responded to the outside pressure by imposing barriers, complex work rules and unnecessary procedures to stem the employment losses which resulted from the productivity enhancing new technologies. Whether those rules were imposed from a federal level (Interstate Commerce Commission) or by railway unions (featherbedding), the results were the same. Cabooses rode at the back of every freight train with a full crew well into the 1980s in both the US and Canada, decades after their usefulness had been replaced by simple technologies. In one famous business study of the Union Pacific Railroad, it was found that 14 layers of approval were required to ship a product on a freight car even though the stationmaster on site had all the information and tools necessary. Featherbedding not only involved creating make-work schemes for unionized staff, it also meant creating overly complex procedures and overpaying for management as well.

Mainstream economists are not particularly bothered by the practice of “featherbedding” or at least not the bits that arise from collective bargaining rather than government regulation. The comfort with the practice rests on the idea of “economic rents” (profit in excess of what one might expect theoretically) and how the “economic rents” are shared. Whether it goes to the CEO, shareholders or the staff, it is income and is generally treated the same in most models. That is fine for a short time when an industry is making large profits (or even super-normal profits, if you subscribe to that notion). The car companies formerly know at the Big Three were able to sustain multiple layers of featherbedding for decades while European, Japanese and now Korean car makers chipped away at the US market. On the government side, the politically protected and overmanned US Post Office, with offices in every zip code, was unable conceive of much less offer overnight delivery. A small company called Federal Express operating after hours from the airport in Memphis invented a whole new business service in that gap.

What does all this have to do with Finance?

Well, the same things that happened to the Railroad, Automobile and US Post Office are happening now to the large financial firms. Just as people from the 40’s couldn’t imagine a world without the big railways, people from the 60’s couldn’t picture a car industry not dominated by Detroit and people from the 70’s could not imagine anyone but the postman delivering a letter, we are now faced with the TBTF (Too Big To Fail) financial giants.

There was a time before debit cards and PayPal when we depended upon bank tellers to get cash and checkbooks to pay bills. The need for solid banks with vaults in every town was obvious. Financial information was difficult to gather and analyze, so there was a significant premium attached to those firms which had the scope to do the job. Size was all important. With size comes complexity but also efficiencies which, in a fully competitive market, are passed as savings to the consumer. But stocks are not socks and bank accounts are not household appliances (despite an early to mid-80s diversification attempt by Sears). The industry, always piously invoking concern for the security of the public’s money entrusted to these same institutions, erected legal, statutory, industry and procedural barriers to entry in order to maintain pricing power. The fact that much of the excess profits thus created ended up in bonus pools has in no small way shaped the career trajectory of most MBA graduates in the last two decades.

Prior to the improvements in technology and information availability, there was nothing much one could do about the situation. Indeed, financial services grew from 4% of the US economy in the 1970’s to 8.3% in 2006. From a pretax profit point of view, growth was even more dramatic, rising from 13% of pretax profits in 1980 to 27% in 2007. Demand for financial services increased and the industry responded by doubling as a proportion of the US economy. Some of that growth was necessary but as the accompanying graph to the Stern Report shows, the future trajectory is far from assured.

From Stern Business School Blog

So, what will drive change? On the one hand, deleveraging should reduce the demand for financial services and products as the US consumer rediscovers savings and reduces risk appetite. On the other hand, the ability to access information and track investments on a personal computer is superior to what was available on the most high end dealing floors only a few years ago. The industry is already responding by offering financial products at significantly lower cost (low or no-load mutual funds, ETFs, low commission trading, online banking and other services). Although only time will tell, the initial indications are that the low cost products can be as good or better than the older, high cost products that they replace. We have already seen the exit of many hedge fund managers who were unable to deliver on the core promise to make money in all types of markets. Like the HELOC junkies in the residential market, it appears that most hedge funds grew primarily on the back of the loose money regime and benevolent markets that largely prevailed from the Asian and LTCM crises onwards.

How will this affect you?

Since long term investment returns can be severely impacted by costs (fees paid out are not available for compounding over multiple years of investing), the ability to find the right product at the right cost will be more important than ever. Mutual funds with 5% loads, insurance products with 8% fees baked in and 2/20 hedge funds will still exist. The question is whether they continue to offer value for money or whether the extra money you pay over a lower cost option is only going towards featherbedding someone else’s retirement.

The financial technology is changing and how you react as a consumer of financial products will have a large impact on the final result of your investment program. Companies and individuals who did not take advantage of the advances in long haul trucking, overnight delivery, air travel and efficient Japanese cars definitely missed out on opportunities. The same thing is happening today in the financial arena. Not all new products will be good ones and certainly some of the old ones deserve their reputations but a critical evaluation of those products will lead to better investment outcomes.

Many in the financial industry can’t or won’t see the shift. They are blinded by their own self interest which, when challenged, is recast as a greater societal interest. Over and over again, we have been told that America needs a strong steel industry, a strong auto manufacturing industry, a strong textile industry, a strong semiconductor industry, a strong pharmaceutical industry and so on. While these may be true statements, often the price for maintaining strength beyond what the market can bear comes in the form of protectionist barriers (in the manufacturing areas) , direct taxpayer subsidy (in the case of the TARP or the car companies) or indirect cost (in the case of the current quantitative easing program). The risk of massive financial failure means that we will never know what would have happened if a Resolution Trust regime had been imposed to wind down overextended bank balance sheets (certainly lending shrank anyway). The cash has been printed and doled out, the bonds have been issued and the debt will be on the books for us and future generations to pay as taxpayers.

But as consumers of investment services, we need not further subsidize the financial industry by continuing to buy overpriced product. With the information and technologies available today, the ability to pay for the investment value actually provided has increased dramatically. If you chose not to take advantage of these new capabilities, you certainly won’t hear any complaints from TBTF financial institutions. But don’t expect any “thank you” cards either. One critical element of “featherbedding” is the sense of institutional entitlement that drives the implementation and maintenance of such schemes well beyond their economic justification.

Light at the End of the Tunnel?

This is one of those classic glass half full or half empty metaphors. The optimist uses this cliché to point out that no matter how bad things seem, there is hope down the line. The pessimist sees the headlight of an oncoming train rushing forward to crush the observer.

Since the Global Financial Crisis started, we have certainly seen our fair share of Express Trains coming through the tunnel. Despite calming assurances that we were almost clear of the worst parts of the recession, we have had to cope with property busts, toxic assets, higher than expected unemployment, sovereign debt crises, bailouts and contradictory signals of inflation and deflation.

But this time the light at the end of the tunnel may be of the positive variety. Although the ranking orders have not changed dramatically in most of our portfolios, we are starting to see more positive numbers lower down in the rankings for the first time since April of this year. Since the Fund King System looks to capture the medium term trend, the uptick suggests that strength is building in select asset classes. Given the relatively limited upside available in government bonds, we would not be surprised to see some ranking changes in the coming few weeks. Whether Gold and Silver can maintain their leading status will depend largely on how much panic we have left in the system (panic has not been in short supply over the past few years). This is a good time to pay attention to the direction the Fund King System is indicating because most asset classes have been fairly directionless for almost half a year.

Are their downside risks? Of course there are and if you want to give yourself a good scare, check out some of the hyperinflation articles that have been running on the ZeroHedge Blog. There have been a number of good articles on hyperinflation lately which correctly point out that hyperinflation is not the result of really strong inflation but rather a loss of faith in the currency. Therefore, a bit of deflation beforehand is no inoculation against subsequent bouts of hyperinflation. This is a serious topic which does not seem to be on the agenda in Washington, Brussels or Tokyo.

New Feature

In response to requests and hopefully in time to take advantage of slightly better market conditions, we are taking the wrapper off our SPDR Component Stock Ranking Engine. The Ranking Engine takes 15 ETFs from the SPDR series that represent different subsectors of the US Stock Markets. It ranks the component stocks at the end of each day and presents the tickers in order of their ranking. We are still working all the last bugs out so if you find an error, please let us know. This feature is available to Gold and Silver members.


In the coming weeks we will show you several ways in which to use this function to help build a portfolio which should keep you invested in the strongest bits of the market at any given time.

Investment Website Reviews

We are also busy building up a library of website reviews. With all the choices available on the web, our goal is to provide a useful clutch of websites which can help inform your investment activities. Take a look at the Websource tab on the Fund King Website. Please feel free to leave a comment (positive, negative or otherwise) and please feel free to suggest other sites that we may have overlooked. If you see a review that you feel is useful, click the Facebook “like” button to share it with your friends on Facebook.


Taiwan Analytics

We are also taking the wrapper off of a new website that we have been plugging away at for several months. This website takes the data off of the Taiwan Stock Exchange Website at the end of the session and crunches it into usable information about what institutional investors are buying, selling and holding in the Taiwan market. As interest swings back towards Asian Equity markets, we hope this will help our institutional investors fine tune their Taiwan portfolios. If you have any comments, suggestions or criticisms, let us know.

Taiwan Analytics Website

Manual Transmissions

Driving a stick shift is fun.

Whether a sports car or a 4×4, driving with a manual transmission imparts a feeling of complete control of the car and a tight connection to the road (or the trail). On a beautiful empty stretch of road on a nice day with the windows and/or the top down, winding through the gears and downshifting around corners, it puts a smile on your face. Manual transmission enthusiasts can often come up with sensible and practical sounding reasons for their choice. In the case of gas mileage, their arguments even hold some water although the gap has narrowed significantly in the last 30 years. In the final analysis though, they drive a stick shift because they think it is cool, they feel in control and it makes them happy. It is mostly about emotional gratification.

But, the reason that most cars are equipped with an automatic transmission is because most driving does not involve tearing around coastal highways and scenic mountain passes in Italy. Most driving takes place in the cities and suburbs. In stop and go traffic, working the clutch and shifting the gears becomes tedious for all but the hardcore enthusiast. Despite the glamorous car advertisements, cars are utilitarian vehicles: commuting, shopping and ferrying children are the primary tasks. The automatic transmission is the “standard” option for almost all new cars because that is what the market demands.

The manual versus automatic transmission argument has very real implications for your investment program as well.

There is no doubt that a more “hands on” approach to investment “feels” right. Investments should be individually weighed up and they should pass the “gut check” test that has been finely tuned by years of experience. A seasoned market veteran can happily regale you about the big homeruns he or she has belted out over the years. All of these winners came by relying exclusively on the finely tuned senses that can only work through a “hands on” approach to investment. By exercising “full control” from start to finish, the pro is able to deliver stellar results.

But, the question to ask is: does all this extra effort produce better results? If “total control”, “hard work”, “hands on approach” and “gut feel” were the ingredients to building a successful investment process, then why does the financial literature show that active managers underperform benchmarks well over half the time (70-85% according to this Standard and Poor’s report)?

The automatic transmission equivalent (Index Funds, ETFs, Systematic Investment) actually performs better in the long run because investing is not just about hitting homeruns. Most investing is like most driving. Markets jerk up and down just like suburban and city driving can be described as stop and go. While there are times when it can be fun, for most of us, investing is just a vehicle to achieve one’s long term financial objectives.

As you evaluate your investment options, watch for emotional words. Watch for the financial equivalent of the sports car winding along a beautiful two lane highway on the northern California Coast. Is your investment advisor selling you a dream or a practical method for achieving your investment objectives? Wall Street spends as much effort building the mystique of the investment process as car companies spend on marketing cars. Certainly the rapid growth of the hedge fund industry is driven in no small part by the same glamour of exclusivity that drives Ferrari sales. But, given the recent performance of hedge funds, one has to wonder whether the expense and noise is actually getting one closer to one’s destination.


Full Disclosure: This is me out on the trail with my fully manual Jeep Wrangler (which I also drive in stop and go traffic).

For most of my career, I have prospered by selling the financial equivalent of manual transmission sports cars. We called it “bespoke research” and tossed around terms like “value added”, “corporate access”, “datapoints” and “mindshare” with gusto. There are managers who were able to turn that into index beating performance but as the numbers show, they are in the distinct minority.

Black Box or Automatic Transmission?

So, while a System like the Fund King System may seem like a Black Box, it actually is more like the automatic transmission in your car. With a lot of extra effort and under the right conditions, you might be able to squeeze better performance out of your portfolio with a “hands on” method than you would using a non-emotional systematic approach. But, you have to question the cost, your motivations and your ability to deliver. Every stick shift driver thinks he or she is an above average driver. Unfortunately, the numbers do not back up that assertion for drivers or investors.

How does this apply to current market conditions?

Our view is that the market conditions are more likely to resemble rush hour conditions than the open roads of the 80’s and 90’s. As such, we would recommend taking a serious look at how you invest. Most of your return will be due to your asset allocation process rather than your skill in bottom up stock picking. This is the time for a practical automatic rather than a heart pumping manual transmission.

Lack of Wind

I used to take a small sailboat out onto the Great South Bay in Long Island during the summer. It was fun to zip along the warm, protected waters. A good wind would take us miles away to other communities where you could pull the boat up onto a beach and have lunch. On the way back home, there was always the risk of an afternoon drop in the wind. The first few times it happened, we would jig the sails this way and that, pump the rudder back and forth and even break out the paddles in a vain attempt to recapture the glorious, almost effortless movement we had enjoyed for most of the day. When a little puff came along, we would scramble to get the boat and sails positioned, often just in time to feel it fade away.

Later, as the summer progressed, we got smarter. We would pack some extra drinks, snacks and cushions. When the wind died, we put our feet over the side and waited for the wind to pick up again in the late afternoon. It always did. The sails would fill, the boat would heel over and we would be back in the docks in no time.

The financial markets today remind me of my youthful sailing adventures and the experience helps put this week’s frantic market commentary into perspective. Despite a 5% pop in the S&P500 last week, we are still becalmed and no amount of fluffing the sails or pumping the rudder is going to bring back the easy times of the Great Moderation (1982-2000) just yet. The Global Financial System is suffering from a lack of wind: the markets (financial, property, good and services, employment, global trade) are finding their new levels. The American Consumer, the great engine of global export growth, is rediscovering the concept of savings. The exporting powerhouses of Asia and Europe are slowly coming to terms with the market shifts and even the value of the US dollars that they collected during the boom years. This will all take a few years to sort out.

What signs should we look for?

One basic reason for the range bound markets is the lack fresh money coming into the financial system. Much of the money that was “printed” by the FED’s quantitative easing program has stayed very close to Federal Reserve vaults because money center banks have mostly arbitraged the near zero overnight funds against short term Treasuries. Not much of this “high powered money” is finding its way into the real economy.

So, the first sign to look for is a return to M3 growth (currently running at negative 4% on an annual basis). M3 for the US dollar is no longer released by the Federal Reserve but this week we have a short review of a site ( that continues to track the broadest money supply series. Check in once a month to see how things are progressing.

M3 Chart

Source: Shadow Government Statistics

What is the Fund King System saying?

For the US only investor, the system continues to rank Treasuries (TLT), Investment Grade Corporate Bonds (LQD), Gold (GLD) and Utilities (XLU) at the top of the list. For international investors, the picture is not much different. Fixed income and metals funds hold the top ranking. One pocket of strength from earlier in the summer (South East Asia Equity) is still evident. In our ETF portfolios, we see India (EPI) and Turkey (TUR) at the top of the list but with low readings that do not suggest an abundance of confidence amongst investors.

We recommend staying reasonably risk adverse and liquid with your portfolio and waiting for the “winds” to pick up before picking up higher risk asset classes. How will we know when the winds have changed? Sign up for our PortfolioSelect feature (open to Silver and Gold members) and let the Fund King System do the heavy lifting with the assets that you want to watch.

Portfolio Select