The Bear Trap

Foregone Conclusions
Yesterday, I ran across an article from a stock-fund manager about an alleged bubble in asset prices caused by the Federal Reserve's policy of quantitative easing, that is using cash to buy mortgage-backed securities. When quantitative easing ceases, the argument went, pop will go the bubble and down will go stock prices. The drop will be very fast and very steep.

That could be. Of course, it's only a view. That the manager implies otherwise, writing with great confidence about the likelihood of his prediction holding true, does not concern me. Brave fronts are expected from those who predict markets for a living, to pretend to know what nobody can truly know.

What does bother me, however, is my sneaking suspicion that the manager has no choice but to make such an argument. His funds have been conservatively positioned, with high cash stakes, for several years now, such that his funds have among the lowest total returns for their categories over the trailing three- and five-year periods. They are in net redemptions.

If you were an investment manager, how would you respond to this professional challenge? By getting back into the stock market? That would seem to be impossible. For one, it would be tacitly admitting a major error, in being skeptical of stocks when they sold at 10,000 and optimistic when they were priced at 16,000 only a few years later. Second, by joining the pack, the manager's funds would never be able to make up their lost ground. In 2018, they would inevitably have poor 10-year numbers.

As the cliche goes, this investment manager won't get back into the game by hitting a single. He needs a home run. He needs for his funds not just to beat the competition, but to thrash it, by dozens and dozens of percentage points, to make up the huge performance gap of the past five years. Realistically, there is only one way to achieve the desired outcome--if the fund holds cash when others hold stocks, and if the stock market takes a dive.

So, while I attempt to follow the manager's argument, I keep thinking that this particular game is rigged. He knew what answer he had to justify before he began the article.

This suspicion is heightened by the knowledge that when quantitative easing began in 2009, the manager had a different view. At that time, he did not believe that quantitative easing would inescapably lead to a stock-market bubble. Otherwise, he would not have positioned the fund more aggressively. That means that so far, the manager has offered up one prediction about the behavior of stocks under quantitative easing--and he was wrong. It's a small sample size, to be sure, but that he is already 0 for 1 on the subject does suggest that he might be overconfident in his second prediction.

The existence of the bear trap is unfortunate, as the higher asset prices go, the more bearish counsel needs to be heard and considered. Unfortunately, the higher asset prices go, and the more bearish managers are left behind, the less credible their arguments become. It's not that they are necessarily more wrong as time goes by--this particular manager might well be correct in the second of his quantitative-easing predictions--but they no longer have free will. They are stuck advocating the only position that they can advocate, from a professional perspective. They are in a bear trap.

This is why I only skim the stock-market predictions of perma-bears, rather than read them carefully. Yes, as I keep repeating, those claims might be correct and well-reasoned. So too might the arguments of an attorney who is hired and paid by a client, and who has the legal obligation of representing that client's interests. But I don't have much taste for legal arguments. I prefer articles by those who don't know the answer before beginning the work.

Bulls who become bears are another matter altogether. Those views are highly valuable because they come from independent thoughts--very independent, as typically they represent something of a reversal of course.

(If you run across such a bull-turned-bear, please send me the link in an email. Those arguments would be good material for future columns. At some point, the bears will indeed be correct. I'd like for this column to have given that view its due. It's very unlikely that I will recognize when a bear has it right, join in support, and jointly call the market's top. That ability is past my pay grade. I should, however, be able to surface views that deserve to be surfaced.)

Note that the bear trap can be a bull trap as well. U.S. stocks have performed well for three decades now, such that no bull has been placed into the position of calling for a stock-market recovery, year after year, only to see it never arrive. In Japan, the bulls were trapped long ago. Those who had aggressive stock positions in the early and mid-1990s, and who therefore fell far behind the competition, had no choice but to maintain and defend their aggression. They were trapped, too--before they became extinct.

Failing Grades
Today's Wall Street Journal reports that  Microsoft (MSFT) has dropped its dreaded "stack" approach to ranking its employees' performance. Dreaded was not officially part of the system's name, but it accurately describes the feelings of Microsoft employees. Under the stack arrangement, Microsoft managers ranked employees on a scale from 1 to 5, with mandated percentage ranges for each score. Employees, understandably, loathed a system that not only put a single number on their value, but which forced thousands to receive a failing grade.

This action can be interpreted as Microsoft giving outgoing CEO Steve Ballmer the bottom grade on his own employee evaluation, since the tough-talking Ballmer has long advocated the stack program. It is also, however, a failing grade for management gurus. After all, the stack system's popularity owes to its enthusiastic adoption by former  General Electric (GE) CEO Jack Welch. Many companies copied Welch's practices, and management consultants flocked to hear his advice, which turned out to be wrong on this key item.

Welch was very, very good at earnings management, though. Perhaps he'll be remembered as an accounting guru.

Rule Number 1: Show Up
I attended a junior high school that followed the Welch/Ballmer grading system. (Or the Morningstar star rating system, if you prefer.) In a class of 20 students, one each would get a grade of A and F, four would receive Bs and Ds, and 10 would be awarded a C. I didn't mind that approach as much as did Microsoft employees. The only time I was in danger was in wood shop. My effort was unfailing--my coordination, not so much. Fortunately, although I was the least competent student in the class, one other student didn't show up on a regular basis. I was given in D in the class, and I was happy to get it.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.