China is a rapidly growing economy and it’s going to continue to grow. Later this decade it will be the largest on the planet. There are 1.3 billion people over there! Their economy is changing in a meaningful way. My concern about China is that of an investment and the concern is very specific.
I don’t want to be a long- or medium-term investor over there for three reasons:
- By definition, its economic model — producing cheap stuff and selling progressively more of it to the world — is not sustainable. The more China grows from this, the more successful their economy, the more expensive it becomes for them to keep using that model. This is the essence of what they’re bumping up against right now and it’s the reason why the latest 5-year plan, the “Twelfth Guideline,” has a very different direction.
- They seem to have made relatively little progress transitioning the economy to one supported by internal consumption. There isn’t much of a middle class in China, and both direct and tangential exposure to their real estate bubble is going to create some big problems.
- Its demographics are very troublesome. Their population is peaking. China’s population has doubled in the last 50 years and it should fall around 10% in the next 50. That doesn’t mean their economy will stop growing, because GDP-per-capita has plenty of room to run. But it does mean that the favorable demographic tailwinds will now act as a headwind. Their population is getting top heavy, too. Ask Japan how much fun it is when your population not only isn’t growing, but is also getting older.
Anyway, this latest bump in the road is more indicative of a global slowdown. It says more about the rest of the world than it does about China. But it is a reminder how leveraged China is to the economic health of everybody else. That’s what will move the Chinese stock market up and down on a cyclical basis, while the three factors I listed above will drive its longer term performance.
The Whale gets Harpooned
The other major story in the last week was JP Morgan. I doubt you missed it, but in case you did, their latest investor call created something of a fiasco in the marketplace. They revealed a $2 billion loss on some bad “hedges” going awry.
I’d been reading stories about the “London Whale” — a shadowy trader at a major bank who was making enormous bets, distorting the credit markets, and pissing off a lot of hedge funds — for a few weeks in the FT and Bloomberg. It was a neat story, kind of a cloak-and-dagger soap opera, but I had no idea it would lead to this! This is real money. Real news.
It vindicates just about all of the criticism of the banking industry in the last few years. With various bank stocks up 40-90% since last October, a lot of investors were excited that all was clear in the banking sector once again. Most banks have been making pretty good money since the bailouts. It seems we now have an answer to the question, “at what cost?”
We also have an answer to the question about whether investors can trust them.
For those that don’t follow the industry, JP Morgan has cultivated a reputation as being one of the leaders in conservative banking practices. The perception was that they were at the other end of the spectrum from someone like Goldman Sachs (classic risk lovers) or Bank of America (messy balance sheet). When you wanted to invest in a big bank but didn’t want to take a lot of risk, you bought JP Morgan. They were “Fortress Dimon!”
In the grand scheme of things, this isn’t the end of the world for JP Morgan, at least not their operations. Yes, the story did knock about $30 billion off their market cap and that’s a pretty big hole to fill. But a $2 billion loss isn’t going to kill their operations. They’re still plenty solvent. They still have a viable business. The question is how it affects their brand over time.
Idiosyncratic events like this always create opportunity. For those who know how to vet that sort of thing, JP Morgan is probably worth researching further. Since late 2007 I have had a categorical objection to the big banks. My objection will remain categorical until I can finally understand their balance sheets and when they are required to mark more of their assets to market prices rather than prices calculated by their own models. This JP Morgan blowup is exactly why I object to large banks generally as investments. In this sector (far) more than any other, crazy stuff swirls up out of nowhere. It’s always bad stuff too.
But if that doesn’t bother you, some more work on JPM could be worth your time.
An important dilemma
All of this raises an interesting question. Do you want your bank — you know, the entity you’ve entrusted to hold your checking and savings accounts — to be able to lose $2 billion because of speculative positions gone awry?
So what if these losses were incurred their “trading department,” which is different than the banking department and was technically illegal back in the Glass Steagall days. Did you know that your bank even had a trading department? What if the losses came from bad positions in synthetic credit securities, and what if these positions could cause another $1 billion in losses next quarter, or the one after that? If one bank is doing this, what are the other ones doing? What about the risky positions that you don’t know about? What if those go bad?
This story should get the Volcker Rule passed, the part of Dodd-Frank that’s supposed to limit how much proprietary trading normal banks can engage in. But I remain doubtful. JP Morgan’s lobbyists are much more powerful than mine.
It should also kill VaR as a credible measure of risk, which was how JP Morgan was supposed to catch stuff like this before happening. I’ve been on something of a personal crusade against VaR for years, and while I certainly don’t feel any satisfaction at seeing it fail, yet again, to prevent or even warn of a major shock, I hope that investors can at least draw an important lesson from this story.
Without getting too technical, VaR (Value at Risk) is a measure of how much you can theoretically lose in a given day. It’s perfectly fine when times are normal, times where you don’t really need a tool like VaR. But it breaks down when you really need it. It’s like having airbags that work until the second before your car slams into the tree.
The reason why VaR stops working right before an accident is is that all the calculations are based on a Gaussian distribution of returns. Like the alien spaceship in the poster that hangs on Mulder’s wall, the Gaussian distribution of financial returns doesn’t exist. So the exact environment where you need a tool like VaR is the exact environment where it falls apart and reveals itself as fantasy.
But this story won’t kill VaR either. Investors want to believe. They need to believe. They need something “concrete,” something quantitative, to point to in order to justify their investment. They need some numbers to give their risk department. Yet all they’re really doing is engaging in magical thinking. They’re telling themselves stories to help them sleep at night. The realities of risk management are really scary, and we need something to soothe us.
I watched a bunch of hedge funds blow up during 2007 and 2008. In every single instance the blow-up was way beyond what the VaR models always showed. I saw a lot of risk managers lose their jobs. And apparently, there are still plenty in the industry who haven’t learned their lesson.
In the grand scheme of things, $2 billion isn’t the end of the world, even for a company like JP Morgan. They can manage through this. But it shows a disturbing lack of judgment by the firm. Those patterns of behavior are difficult to quantify and measure. They’re exactly what you want to avoid, though. Jamie Dimon has a lot of work to do to restore trust, to help investors feel protected again.
On the subject of protecting yourself against disaster, I watched a terrific movie last week.
If you want to have a movie experience that will completely take your breath away, don’t read any of what follows. There are minor spoilers ahead, but nothing that the trailer doesn’t reveal. Anyway, skip or skim this section if you’re fussy about that stuff.
All you need to know today is that it’s about a guy who has visions of a coming storm and starts building a shelter in his backyard. I know that premise sounds kinda lame, but trust me, this is one of those movies where the brilliance is in how everything happens rather than what.
The film takes place during the post-crisis recession. This is very important because during that time, we all had — and to a certain extent, still do have — that feeling that everything is only barely being held together. Our economy, our jobs, our relationships with our friends. It all feels so tenuous, gossamer threads in a delicate web.
Take Shelter is very explicit in terms of setting. We know that the main character forsees a violent storm on its way. But that feeling that something dark is on the horizon — that feeling we all know so well — is our gateway into this character’s world. Who among us hasn’t felt that primal urge to safeguard our loved ones? And who among us didn’t feel that acutely back in 2008 and 2009?
This emotional resonance is critical, because the movie asks a really important question, a question that doesn’t matter unless we’re connected to the characters on screen.
Take Shelter asks: How far does one have to go to be truly prepared?
It answers it, too. And it’s not an answer that I was comfortable with. To be truly prepared, to really safeguard ourselves against the kind of risks that lurk out there, we have to go too far. It is the only way.
Michael Shannon’s character, a performance that is brilliant in range and nuance, goes to crazy lengths to build this shelter. He incurs tremendous expense and risks losing all of his friends and family on the way. It’s disturbing to watch because we understand so clearly that these steps are necessary, that going too far is what it takes.
The masterstroke of Take Shelter is that it juxtaposes all of this with mental illness. A movie about a guy who has visions of a major storm and builds a shelter in his backyard isn’t interesting. We’ve been listening to that story since Noah built that ark. But a movie about a guy that we can relate to who builds a storm shelter in his backyard and also has a family history of schizophrenia? Now that’s a movie.
If you haven’t seen it, I should warn you of two things:
This film had a major personal, emotional impact on me. I didn’t sleep well after I watched it. I’m one of those guys that worries a lot about a lot of things, and on occasion, takes those worries very seriously. Sometimes Mrs. Concord says I’m just being crazy.
Since I’m a man like many others, men who are content to suffer in silence, I felt a very personal connection to the character in the movie. He, for a variety of reasons, must wrangle all of these internal and external challenges on his own without disrupting the lives of those he cares for and without revealing any weakness. Not only that, I’m also a man who fancies himself something of a lightweight intellectual. My only above-average quality is my ability to think rigorously, reason, and problem solve — so I am simply terrified of mental illness. I quietly fear losing my mind the way professional athletes quietly fear tearing their ACL.
Your second warning is that the ending, and much of the second half, is very ambiguous. You’re either comfortable with that sort of thing or you aren’t.
So watch it with your partner. Just in case you need a little support and also so you’ll have someone to talk to about it. You’ll want to discuss it after it ends. It’s that kind of movie.
A Disturbing Reality
I never bring up movies or music or books just to talk about them. I mean, I love talking about this stuff, but that’s what my personal Facebook feed is for. I discuss certain cultural artifacts in this newsletter because they are relevant to finance and economics. You don’t get that kind of commentary in other newsletters and you don’t get it when you turn on CNBC. But I think it’s important to the act of investing. There are so many things important to investing that aren’t denominated in Dollars or Euros. Nobody else talks about them. So I try my best to.
For those of us that work in the investment world, risk management is one of our toughest jobs. It’s a difficult dance. We all have to do something to get a handle on risk, and once we start, we realize how slippery the ground is beneath our feet. Any measure to reduce risk costs us something in terms of return. How much must we pay before it becomes not worth it? Is it best to avoid the endeavor completely? Or on the other hand, if we’re going to do it, is it better to go all the way? Is it even possible to find a midpoint?
Risk is a natural and inescapable part of the world that we live in. For the most part, that’s OK. We can live with the risk of not finding a parking place at our favorite restaurant or losing a few percent in a a market sell-off. We don’t lose sleep over this.
It’s the risk of catastrophe that keeps us up at night. And the thing that few people understand and what a movie like Take Shelter makes very clear is that the cost of protecting ourselves against this catastrophe is greater than we realize. JP Morgan just reminded us of this lesson, that the flimsy measures they sold investors as risk management were a farce.
Sometimes we laugh at the gold bugs and their bunkers. We think they’re crazy to stockpile guns and ammo and a 6 months’ supply of canned food. Is there a normal situation in which owning a military grade gas mask is worthwhile? Surely those resources would be better spent elsewhere?
Yet the reality is that this is what it takes. If you want to truly protect yourself against the nasty events, the only ones that are worth protecting against anyway, you have to go too far. Most of us try to guard against these scary outcomes, but we don’t do anything near enough. We do that little bit because it helps us sleep, and when we have that stray rational thought and recognize that the 2 jugs of water and 6 cans of beans we have out in the garage won’t do the trick, we banish that thought and get on with our lives. Confronting that inadequacy seems almost as scary as confronting the disaster itself. This is one of a million existential realities that make life as a human so achingly difficult.
If you want to protect your investment portfolio — I mean really, truly, protect your portfolio — you have to go too far. Telling yourself you’ll just get out if it starts going down won’t do the trick. Simple, vague risk management doesn’t work. If you want to guard against market meltdown, you have to plan ahead and do things that are expensive: hold lots of cash (in different currencies), repeatedly buy insurance, diversify your way out of concentrated gains, say goodbye to duplicative positions, and work hard to understand new types of assets.
Few of us actually do that. And the rest of us laugh at the few who do, mocking their elaborate shelters and puny rates of return.
There isn’t a right or wrong answer here. We each must seek our own peace. We find the balance that works, that impossible-to-quantify symmetry between good returns and a good night’s sleep.
And God help us should we peek over our neighbor’s fence and see what he’s up to. We have enough insecurity as it is.