Wednesday, October 28, 2009

The inside vs. the outside view

I've known Bill Miller, Legg Mason's top equity manager, for a long time. He's had his ups (beating the S&P 500 for 15 straight years) and downs (especially last year when he was crushed), but I continue to admire his wisdom and insights (could it be because we both majored in philosophy in college?). I highly recommend reading his most recent commentary, since we are both thinking along the same lines these days, but coming from different directions. He starts with an insight from Michael Mauboussin's new book Think Twice (he's also a Legg Mason guy) which describes two very different ways of analyzing a problem: from the inside and from the outside.

The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view...asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.

Those who are pessimistic on the economy and the prospects for the market are using an inside view, according to Bill:

PIMCO’s Mohamed El-Erian is the most prominent advocate of the “new normal”, a term he coined to describe a recovery with real growth of 1-2%, persistently high unemployment, and much greater government involvement in the economy. He has recently warned of a big letdown from the “sugar high” we are now experiencing in the market and the economy as the effects of the abatement of the credit crisis and massive government stimuli, both fiscal and monetary, begin to wear off.

He may be the most prominent, but he is not alone. In fact, it looks like he is the leader of a not so silent majority. The current consensus growth rate for the U.S. economy in 2010 is 2.4%. This is way below “normal” for the first year of a recovery.

Projections such as these follow the classic inside view pattern: they look at current conditions, current trends, anchor on the most recent data, and adjust from there.
A variant of the argument has it that with consumption elevated at 70% of GDP and the consumer retrenching, growth must be sluggish, profits will disappoint, and it will be hard for the stock market to make any headway. 

He goes on to note that past periods of huge consumer deleveraging and increased savings have not prevented the economy from growing at fairly impressive rates. He borrows from another friend of mine, economist Michael Darda, who notes that "The most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period." I've argued quite a few times that deleveraging need not mean slow growth, because growth doesn't come from leverage, it comes from work and investment. Debt and leverage can facilitate growth, by helping to distribute spending power to the nooks and crannies of the economy, but debt doesn't create growth since the money that one man borrows must come from another man's pocket.

I have been arguing for months now that the stock market is not overpriced because the mood of the market is still very pessimistic. To back up my claim I've pointed to credit spreads which are still quite high, to implied volatility which is still quite elevated, and to Treasury bond yields, which are still quite low. Bill makes a similar point from a different approach:

As market veteran John Mendelson often points out, it is not what people say that matters, it is what they do. And what they are doing is buying bonds and selling stocks. Through the first 9 months of this year, domestic equity funds had net outflows of $8 billion. During the first week of October, another $5 billion was redeemed. Bond funds, in contrast, had inflows of nearly $300 billion in the first 9 months of this year. Of the top 10 selling funds in America this year, 9 are bond funds and only one is a stock fund, and that one is the Vanguard 500 index fund.

Finally, he notes that "every time stocks have performed poorly for 10 years, they have performed better than average for the next 10 years, and they have beaten bonds every time by an average of 2 to 1."

Both Bill and I agree that these days it pays to be optimistic.


Thomas B said...

Scott ... I have been puzzled by this dilemma. It is not just fear that seems to drive some but also myopia. The big picture is not all that complicated.

I also studied philosophy, so this may contribute to why I like your blog so much;-) I have learned an enormous amount from reading your posts over the last few months. Thank you!

(You don't happen to have a reading list on economics and investing? I want to become as smart as you are! No kidding! )

Public Library said...

Absolute returns are the true measure of investment success. Following someone over the edge to out-pace an index by 100bp is folly.

Besides, an investment in LMVTX since 2000 would lost you serious money.

Unknown said...

Big Picture from Netherlands Bureau for Economic Policy Analysis which says :"World trade growth is still on a sharp downward trend, when computed from twelve months’ averages over the
preceding twelve month’s average (twelve months ‘momentum’; see last chart in Figure 1). Trend growth was deeply negative in August: –13.0%, way below the record growth rate of +9.6% in November 2006. Twelve
months momentum is negative since February, after having been positive for more than six years."

Also take a look on a very last chart 2.

DaleW said...

Besides, an investment in LMVTX since 2000 would lost you serious money.

Bloomberg has the total return as 8.85% since 12/31/99 reinvested in the security vs. a 9.42% loss for the S&P 500. These are total returns with dividends reinvested, not annualized returns, all according to Bloomberg.

dr. j said...

Besides, an investment in LMVTX since 2000 would lost you serious money.

I am always interested to see statements that are obvious, presented as wisdom. Terms such as "From the top..." or the classic "if this keeps up, then..." typically misguide investors. What does this data lead you to conclude about what may happen next. If past performance is no indication of future results, we should buy what has gone down and sell what has gone up. But that will never happen!

alstry said...

Sorry Scott,

Somehow this got posted under the wrong article:

This is what confuses me when you state....

but debt doesn't create growth since the money that one man borrows must come from another man's pocket.

With fractional reserve banking, simply by changing the leverage requirement, can't we simply create money out of thin air by increasing ratios?

For example, with a 1 to 5 leverage ratio $1 of deposits could create $5 of lending versus a 1 to 10 ratio would create $10 of lending against the same deposit base.

How else could we have over $30 trillion of private debt and only a few trillion in savings?

If everyone tried to pay down debt, wouldn't deposits evaporate before debt was paid off.

Thanks in advance for clarifying something that has always confused me.

Public Library said...


Not sure what you are looking at but using bloomberg terminal beginning 12/31/99 through 9/30/09, the magic lady paints a far different picture.

-29.86% holding period return after reinvesting dividends which equates to -3.57% annualized losses.

Sweeet jumbalaya. Gimmie some of those returns with a side of apple pie!

Scott Grannis said...

Thomas B: Thanks, it's nice to be appreciated. Here are two essential books (I probably should post a list of my favorites, but later):

The Way the World Works, by Jude Wanniski

(great explanation of supply-side economics)

A Random Walk Down Wall Street, by Burton Malkiel

(an essential book for all investors)

Scott Grannis said...

Public: Check out LMOPX, the lesser known of Bill's funds, but with better performance than LMVTX. I'm not sure I would turn up my nose at 100 bps above the market year in and year out. That can really add up over time. As for absolute returns, how do you know they are decent? What is your standard of measurement? It's all very squishy I think.

Scott Grannis said...

Family man: Focusing on long term momentum is not necessarily the best way to look at things, especially considering the huge and likely temporary disruption to global commerce last year. It's better to look at changes on the margin and market-based indicators like commodity prices, etc. All of those suggest considerable improvement, even some of the short-term charts you reference.

Scott Grannis said...

alstry: Debt can be created by anyone, not just banks. If I loan my money to Bill, then I have not created any new money, and I have not multiplied the things that my money can buy.

Banks can create money through the fractional reserve system, but their ability to do so is limited by the reserves made available by the Fed. Since the Fed hasn't changed the leverage requirement in a long time, then simply tracking the growth of bank reserves tells you how much money in the system has been created out of thin air. Until a year ago, it was precious little. Even in the past year, as bank reserves have more than doubled, the amount of "money" in the US economy (e.g., M1 and M2 money) has not increased by an unusual amount. The aim of the Fed, as Milton Friedman always said, should be to allow the amount of "money" to increase by about the rate of growth of nominal GDP; as the economy expands it needs more money to support a growing number of transactions. Look at the growth of money and you will see that it has not been unusually large. Look at measures of "debt" and you will see that growth has indeed been rather strong. Is this inflationary? No. Has it created demand out of thin air? No. It simply represents one person lending money to another, and that person re-lending it to someone else, etc. No demand is created.

In any event, creating new money out of thin air can never increase the size of an economy. It may appear to create new demand, since the recipient of the newly-printed money can turn around and spend it, but the system will very rapidly figure out that this is phoney demand, not real demand, and prices will adjust upwards. In other words, printing money only causes inflation; it can never result in real growth.

On another note, don't get bogged down by "savings." No one has figured out how to measure savings. And even if we could measure savings, it wouldn't matter. If US savings increase, then money will be transfered to some country whose spending will perforce increase. Whatever we don't buy here will have to be bought by someone outside the country.

Cabodog said...

Scott, off-topic but I thought you might enjoy Martin Sosnoff's letter to Apple:

CFP, EA said...


I'm surprised that you listed Malkiel's book since you seem to be something of a market timer/stock picker. However, I don't think that being a passive investor prevents you from learning from your blog.

As my moniker implies, I'm a wealth manager (used to have the less self-important title of financial planner). I'm also a passive investor, with almost all of my clients' money in Dimensional Fund Advisors (DFA) funds. As you know, DFA, which I believe is headquartered somewhere in your neck of the woods, is the sometime of the Mecca of passive investors.

That being said, I still find your blog informative and enjoyable, even if I don't act on the knowledge. Although during the trying times of last year and earlier this year, your discussions did help me explain to my clients why it was possible that the world might not be ending.

So thanks from a passive investor.


Public Library said...


An investment in LMOPX since 1999, adjusting for inflation, would have yielded about nothing.

Risk adjusted and on an absolute basis, you probably would have been better off investing in a savings account.

Unknown said...

We don't really have an inflation problem right now, but back in the '70s under Jimmy Carter, for two years we printed too much money. We added 13 percent more money to our money supply for two years. Remember how bad the inflation was? And we started down a socialist utopia with Jimmy Carter.

To stop it, what did we have to do? Fed Chairman Paul Volcker came in and, in an effort to suck all the money back to the Fed and out of the system, he had to raise interest rates.

Remember, the banks have all of this money on the sidelines right now. As soon as they release it into the system, from that time, it usually takes about two years for the money glut to cause inflation.

After printing 13 percent more money for two years, we had runaway inflation of 12 percent. So Volcker raised the interest rate to 20 percent, because whenever you borrow, let's say, $100, you'll then owe $20 — the Fed then takes that $20 and destroys it to get it out of the system and bring inflation back down.

So we had to have a 20 percent interest rate for a 13 percent increase in the money supply for two years. In the last year or so since Lehman Brothers failed, we have increased our money supply by 120 percent.

How high will our interest rate have to be to pull all of that money back out of the system?

Scott . . .

The quote above is from last night's Glenn Beck show. Assuming his data is correct (a stretch?), could you or any of the CBP readers opine on the
mechanical steps required to forego hyperinflation?

Unknown said...

Maybe I missed it, but it seems neither you nor Bill Miller, have included the cost of energy into your thinking. Oil is near $80, and probably going higher. Non OPEC production and its ability to produce is declining. Non OPEC represents about 60% of world production. Any increase must come directly from the OPEC nations, but they too are struggling. Older fields that require large capital investment to maintain current production levels. New oil is difficult and technically challenging, requiring $50-$70 plus dollars/barrel to justify development. The point is, times have changed, and our world of cheap and plentiful oil is gone - -this must be considered, when looking forward.

Scott Grannis said...

Cabodog: Thanks, that was an excellent love letter to Apple.

Scott Grannis said...

CFP: Thanks for your comments. I have great respect for Malkiel, and I think everyone should pay close attention to what he says about markets and long term investing. You stray from passive investing at your peril--that is the message I take away from reading Malkiel. Active investing can be rewarding (it has been for me, fortunately), but it can also be very costly.

Scott Grannis said...

thudbear: I think Beck is playing fast and loose with the facts. You can't really simplify monetary issues the way he has done. So many things are different that it's very tough to draw parallels to the past in any event. And the Fed hasn't really increased the money supply 120%; M2 is not up by any extraordinary amount. Reserves have doubled, but those reserves are not really being put to work yet. So trying to guess what will happen when the Fed reverses course is anyone's guess.

Scott Grannis said...

Scott and Fran: I've had numerous posts on the issue of oil and whether today's prices are likely to be a big drag on the economy. So far I don't think prices are high enough to be a big problem. We'll just have to see how things play out.

Scott Grannis said...

Public: equities in general have been miserable investments since 1999. But there is no reason to extrapolate this kind of performance.

Public Library said...

I am not extrapolating, only offering rebuttal to the homage paid to Bill Millers prognostication abilities.

DaleW said...

Public Library,
I am quite mistaken. Your numbers are correct. I left Bloomberg's compounding on a daily basis and that cut off the calculation in 2005, which flatters the numbers. This happens occasionally with Bloomberg because it doesn't occur to me they lack the resources to cut off a 10-year compounding calculation. You are entirely correct and I am entirely mistaken.

Eccono-monkey said...


What makes Mike Darda such a great economist? I can see you too share some views I have watching on CNBC for some time now...great calls.


Scott Grannis said...

I've known Mike Darda for many years, beginning when he worked for Jude Wanniski at Polyconomics. He and I share a lot of supply-side views because we have similar backgrounds.

Unknown said...

Scott... Further, to my comment, yes, we will see how it plays out, but at the same time, we must be prepared, as clearly there is a tipping/break point in the economy relative to the cost of energy/oil. I am not a economist, but one must think about this, and at least attempt to calculate where that break point is, I suspect we are getting close, and the break point could be somewhere around $100 or so. To ignore the cost of energy, in my view is incorrect, unless, you and Miller, are assuming the economy/world economies will adjust as the price of energy increases? Not sure how this works.

Eccono-monkey said...

Interesting. I heard that Darda suggested a book that contained many leading indicators. Its called Monetary Policy, A Market Price Approach. Its a wealth of insights. Can you suggest some more books?

Scott Grannis said...

S&F: See my posts relating to the real price of oil and oil consumption per unit of output. One very important point is that even with oil at $70-80, spending on oil represents a fairly low fraction of total spending from an historical perspective. I suspect the tipping point comes somewhere above $100. But even then, expensive oil just slows growth, it doesn't stop or kill it.

Scott Grannis said...

Eccono: the book that Darda mentions, by Manuel Johnson and Robert Keleher, is very good.

DaleW said...

I like Mike Darda because he synthesizes data well, which is the hallmark of any good capital markets economist, he uses historical analogy well and caveats his analogies responsibly, and while he cut his teeth with some guys who are very colorful and can dig in on doctrine, he's not over-the-top dogmatic in his writings or in person. I like Mike's work.

Eccono-monkey said...

What I find lacking in his work is that he does not mention the theory of credit channel or the "financial accelerator" While this theory heavy it does help with the background info...What do you guys think.