Last week I had the chance to meet David Merkel
on Twitter). I have been a fanboy of his for a long time, much in the same way I had been of Kevin Depew, as Merkel was one of the finance bloggers I started reading years ago. No, I take that back. This is nothing like my admiration for Kevin; it’s completely different. But it’s still there nonetheless. [Editor's note: David Merkel runs an equity asset management shop called Aleph Investments and he blogs on The Aleph Blog. Merkel is also a Minyanville contributor
. Kevin Depew, former editor-in-chief at Minyanville, is now editor of Bloomberg's Economics Brief.
We swapped stories. We swapped ideas. We drank coffee. We swapped ideas about coffee. OK, I made that last part up. But we did have a number of things to talk about on finance, models, economics, and the world we find ourselves living in at the turn of a new millennium.
While we both appreciate the use of models, I think we get the sense that the risks and limitations of models are not generally understood or appreciated by many. Models can only do so much. And even if you can predict the direction of change in a variable (like equity prices, default rates, etc.), predicting the severity of the move is a whole other issue. There’s a difference between predicting a 0.20% move and a 5% move. Volatility is inherently unstable.
(^VIX) is the best expression of volatility at a given time, but at best it's a coincidental indicator. And coincidental indicators coincide with the environment around them. A leading indicator is one that starts to change before it becomes obvious to everyone and everything else. To paraphrase a quote David told me, predictive models are sort of like tangos: They're at their best when they're a little out of step.
If you spend any amount of time reading David’s blog, you’ll see he definitely follows a contrarian-based strategy. It’s one I definitely like and appreciate. His blog outlines his thought process and experiences as an investor, and to me it makes it clear that he definitely tries to adhere to the old Warren Buffett adage of selling when investors are being greedy and buying when they are fearful.
It sounds so easy, but the truth is, it’s really difficult. It’s difficult because you have to go against the crowd, and people do have the instinct to seek out safety in numbers. Buying on green and selling on red feel good because that's what everyone else is doing. But frankly, that won’t make you money.
As a contrarian, if you ever see people coming around to your point of view, you start looking for the exits. As David told me stories about his investing, it’s obvious a lot of people in the business follow the same herding impulses as the rest of us. Buying asset-backed securities backed by auto loans when there’s tons of issuance is really the same as buying a hot IPO stock.
On the Economy and the System
This is an election year, so there’s bound to be lots of discussion about elections and policy. But frankly, David and I see a system that is simultaneously deadlocked and on autopilot. Many expenditures for the federal government are determined formulaically. In the cases of programs like Social Security, the expenditures are simply governed by the number of people in various age buckets that qualify for a certain benefit level, which is again, determined formulaically.
But nobody has discussed if or how we need to change the formulas that govern these expenditures. As David put it, we’re in a world where everyone wants to be paid out at par but there isn’t enough money to do so. To put it in the vernacular of Peter Atwater
, we’re in a “me, here, now” world, but everyone still thinks we’re in an “us, everywhere, forever” one.
I told David I thought we’ve already seen the future, and it is Japan. We may kick and scream about how different we are from Japan, but the policy choices and demographic changes we’re seeing in this country pretty much seal our fate for the next 10-15 years. Zombie banks, aging populations, and declining birth rates are all powerful forces to counter. While many people say we’re more open as a society than Japan, all you have to do is look at the recent shooting at a Sikh temple in Wisconsin to see how darkening social mood and “me, here, now” impulses can reverse societal openness.
But we both share some optimism about change, which I think can be summed up in this quote I heard from Stephen Covey (although I’m unsure if he originally said it): "We change when the pain to change is less than the pain to remain as we are.” In other words, our system will do what it takes to survive. If that means making changes to carry on in some other similar, yet different form, it will. Because the other option is systemic failure. Where there is no choice, there is clarity.
For all of the debate about Glass-Steagall and the divide between commercial and investment banking, nobody has talked about systemic tipping points and concentrations of lending or investing. People refer to these as crowded trades, but with the last credit crisis, there was a systemic failure to avoid systemic increases in real estate lending, the proliferation of off-balance sheet structures that securitized all of that real estate lending, and the search for yield that drove all of that hot money into the space.
There are no silver bullets or panaceas, but there has yet to be a real discussion about how we got here in the first place. It will take reform on the part of everyone to build up a new system that’s vibrant and resilient enough to withstand the challenges of a new day and age. Pining for the way we used to do things because we felt better isn’t going to work.
I had a great time catching up with David and talking about all of these things. Neither one of us knows what the future will hold or how events in China or Europe will affect what goes on here. Indeed, the only thing anyone seems to be certain about is to expect more uncertainty.
No positions in stocks mentioned.
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