Madison Market Monitor Second Quarter July 1, 2016

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Brexit Bombshell

One week ago the United Kingdom voted to leave the European Union. The impact of this "Brexit" (for "British Exit") decision has been far and wide (if not nearly as much as the media might suggest), with global markets hit and U.K. Prime Minister David Cameron announcing his resignation.

The vote was wildly split across the U.K., suggesting that Scotland may well seek independence and Northern Ireland may seek reunification with the Republic of Ireland because they decisively desired to stay in the E.U. Significantly, the older and the less educated the voter, the more likely s/he was to vote "Leave."

Other countries may seek to leave the E.U. as well, now that the seal is broken, perhaps starting with the Netherlands. European banks will be asked to weather a big storm and may not be up to the challenge. However, the vote must still be ratified by Parliament and it will take at least two years to implement the leaving fully. There is even talk of another Brexit vote because so many voters have expressed "buyers' remorse," but that doesn't seem likely.

 "The people of the United Kingdom have spoken, and we respect their decision. The special relationship between the United States and the United Kingdom is enduring," said President Barack Obama in a statement. "The United Kingdom and the European Union will remain indispensable partners of the United States even as they begin negotiating their ongoing relationship to ensure continued stability, security, and prosperity for Europe, Great Britain and Northern Ireland, and the world." The U.S. Federal Reserve and the Treasury Department also sought to soothe nerves.

 Markets for risk assets around the world responded badly to the news as Brexit reactions rippled across the globe. Stocks in particular felt the brunt of the fallout, alongside the British pound. The British pound fell to 30-year lows against the dollar. Banks got hit especially hard. The major safe havens were U.S. Treasuries, gold and the Japanese yen. But by the middle of this week (and quarter-end) most global markets had recovered nicely.

 Economic professionals overwhelmingly held the view that the U.K. leaving the European Union was a very bad idea. And until voting results started coming in, the consensus of public opinion experts - at least if one uses prediction markets or polling data as a proxy - was that voters would in the end decide to stay in the E.U. The financial markets followed suit and, accordingly, were on the wrong side of the trade and were initially hit hard when the result was announced.

 The impact of the Brexit vote will likely be very substantial for Great Britain and for Europe. Indeed, the E.U. referendum is tearing the U.K. in half. Radical parties are making inroads at every level of government around the continent of Europe as well. However, I don't expect long-term negative consequences in U.S. markets to any significant degree. A stronger dollar will likely lower GDP a bit and perhaps push interest rates a bit higher, but there is no reason to expect a recession at this point. Brexit also gives the Fed more reason not to move on interest rates. But if we do ultimately suffer a correction, remind yourself that this is why diversification matters and that volatility is the price you pay for higher equity market returns as compared with other investment options.

 That said, the political volatility expressed and evidenced by the Brexit vote already seems at work here. The GOP Presidential ticket will likely be led by a deeply disliked man with no political experience and a highly volatile track record. Prominent members of his own party are refusing to support him. Meanwhile, the Democrats will likely be led by a woman almost as disliked as her opponent, who is widely regarded as a poor campaigner, and who has a political past for which to answer. The level of anger and vitriol at work seem much higher even than we've seen in the recent past, polarized and fractious as the political climate has been.

 David Brady, the Bowen H. and Janice Arthur McCoy Professor of Political Science at the Stanford Graduate School of Business and the Davies Family Senior Fellow at the Hoover Institution, was interviewed recently by Goldman Sachs about the political instability the world seems to be experiencing. In the developed world, he points to globalization and technological change as the factors driving the biggest upheaval for traditional political parties since the late 19th Century. That first great wave of globalization eventually moved farm workers and household servants into the American blue collar working class, but only after substantial political upheaval surrounding the fear of mass immigration, income inequality, the loss of low-skilled jobs and the alleged culpability of the banking class.

 Sound familiar?

 According to Brady, the key difference today is that this second great wave of globalization is more powerful because the world economy is much larger and broader, now including more of Europe and most of Asia. Roughly three-quarters of the world is now involved in the global capital-based economy. Technological change is also much faster. And whereas agrarian jobs were largely replaced with industrial jobs during the last transformation, many jobs lost today are disappearing altogether, which has impinged on people's sense of identity.

 What happens in the markets in the nearer-term will not likely turn out to be a very big deal over the longer-term. There is absolutely no reason to change a well-crafted financial plan or to change one's asset allocation based upon the Brexit news. But the politics? That bears watching.

Forecasting Follies

Before this past season started, English Premier League football club Leicester City were 5,000-to-one longshots to win the title. In fact, they were the odds-on favorite to finish at the bottom of the table and therefore dropped to a lower division. The team was largely made up of low cost acquisitions of has beensnever weres and maybe will bes. Their primary aspiration had been merely to avoid relegation.

Leicester's ownership was ridiculed for hiring the 64-year-old Claudio Ranieri as manager last July. Despite having managed some of Europe's top clubs, he had never won a championship and he had been out of work since the previous year when he was fired by the Greek national team after an improbable loss to the Faroe Islands. His only job in the Premier League had ended 11 years earlier.

But deft management, team spirit, a tremendous work ethic, surprising player development, nearly every transaction working out, nearly every player having his best year ever and a remarkable lack of injury combined to create what is likely the greatest longshot victory in the history of sport. The alleged "experts" - who picked the usual suspects to win it all - failed utterly.

History has provided a long list of similar forecasting failures. Analyst Clifford Stoll argued that "no online database will replace your daily newspaper." Bob Metcalfe, an electrical engineer widely credited with the invention of Ethernet technology, predicted that the internet would "in 1996 catastrophically collapse." Federal Communications Commission commissioner T.A.M. Craven stated in 1961 that "There is practically no chance communications space satellites will be used to provide better telephone, telegraph, television or radio service inside the United States."

Marconi predicted that the "wireless era" would make war ridiculous and impossible. Decca Records rejected the Beatles because they didn't like the group's sound and thought guitar music was on the way out. Every other studio in Hollywood but one turned down "Raiders of the Lost Ark" before Paramount agreed to make it and it became one of the highest-grossing films of all time.

Thomas Bell, president of the Linnean Society of London, summing up the year 1858 (which included the announcement of Charles Darwin's theory of evolution by natural selection), stated: "The year which has passed has not, indeed, been marked by any of those striking discoveries which at once revolutionize, so to speak, the department of science on which they bear."

In April 1900, the great physicist Lord Kelvin proclaimed that our understanding of the cosmos was complete except for two "clouds" - minor details still to be worked out. Those clouds had to do with radiation emissions and with the speed of light, and they pointed the way to two major revolutions in physics still to come: quantum mechanics and the theory of relativity.

At the World Economic Forum in 2004, Bill Gates predicted that, "Two years from now, [email] spam will be solved." And nearly every political pundit gave Donald Trump no chance to win the Republican presidential nomination.

Most of the alleged experts making market predictions are highly educated, vastly experienced, and examine the vagaries of the markets pretty much all day, every day, Yet they too are wrong a lot - pretty much all the time in fact. Why are we so bad at forecasting?

The great Russian novelist Leo Tolstoy gets to the heart of the matter when he asks, in the opening paragraphs of Book Nine of

War and Peace: "When an apple has ripened and falls, why does it fall? Because of its attraction to the earth, because its stalk withers, because it is dried by the sun, because it grows heavier, because the wind shakes it, or because the boy standing below wants to eat it?" With almost no additional effort, today's scientists could expand this list extensively.

As Daniel Kahneman and Amos Tversky so powerfully pointed out, we have evolved to make quick and intuitive decisions for the here and now ahead of careful and considered decisions for the longer term. We intuitively emphasize (per anthropologist John Tooby) "the element in the nexus that we [can] manipulate to bring about a favored outcome." Thus, "the reality of causal nexus is cognitively ignored in favor of the cartoon of single causes." In short, whenever we try to figure out complex future outcomes we enter dangerous territory with disaster lurking everywhere.

Even when we recognize the fallacy of thinking in terms of single, linear causes (Fed policy, market valuations, etc.), the markets are still too complex and too adaptive to be readily predicted. There are simply too many variables to predict market behavior with any degree of detail, consistency or competence. Unless you're Seth Klarman or somebody like him (none of whom is accepting capital from the likes of us), your crystal ball almost certainly does not work any better than anyone else's.

All that said, the idea that we can live our investing lives forecast-free is as erroneous as the market predictions that are so easy to mock. As Cullen Roche repeatedly emphasizes, "any decision about the future involves an implicit forecast about future outcomes." As Philip Tetlock wrote in his wonderful book, Superforecasting: The Art and Science of Prediction: "We are all forecasters. When we think about changing jobs, getting married, buying a home, making an investment, launching a product, or retiring, we decide based on how we expect the future to unfold."

It's a grand conundrum for the world of finance - we desperately need to make forecasts in order to serve our clients but we are remarkably poor at doing so. The key then, as Roche has argued, is that we should shun low probability forecasts. By contrast, Superforecasting points to (and laughs at) the general inaccuracy of financial pundits at CNBC, whose forecasts are low probability ones of the highest order. As Jon Stewart famously joked, "If I'd only followed CNBC's advice, I'd have a million dollars today - provided I'd started with a hundred million dollars."

The central lessons of Superforecasting can be distilled into a handful of directives. Base predictions on data and logic, and try to eliminate personal bias. Working in teams helps. Keep track of records so that you know how accurate (or inaccurate) you (and others) are. Think in terms of probabilities and recognize that everything is uncertain. Unpack a question into its component parts, distinguishing between what is known and unknown, and scrutinizing your assumptions. Recognize that the further out the prediction is designed to go and the more specific it is, the less accurate it can be.

In other words, we need rigorous empiricism, probabilistic thinking, a recognition that absolute answers are extremely rare, regular reassessment, accountability and an avoidance of too much precision. Or, more fundamentally, we need more humility and more diversity among those contributing to decisions. We need to be concerned more with process and improving our processes than in outcomes, important though they are. "What you think is much less important than how you think," says Tetlock. Superforecasters regard their views "as hypotheses to be tested, not treasures to be guarded." As Tetlock told Jason Zweig of The Wall Street Journal, most people "are too quick to make up their minds and too slow to change them."

Most importantly, perhaps, Tetlock encourages us to hunt and to keep hunting for evidence and reasons that might contradict our views and to change our minds as often and as readily as the evidence suggests. One "superforecaster" went so far as to write a software program that sorted his sources of news and opinion by ideology, topic and geographic origin, then told him what to read next in order to get the most diverse points of view.

The best forecasters are all curious, humble, self-critical, give weight to multiple perspectives and feel free to change their minds often. In other words, they are not (using Isaiah Berlin's iconic description, harkening back to Archilochus), "hedgehogs" who explain the world in terms of one big unified theory, but rather "foxes" who, Tetlock explains, "are skeptical of grand schemes" and "diffident about their own forecasting prowess."

But as Tim Richards has argued, we are both by design and by culture inclined to be anything but humble in our approach to investing. We invest with a certainty that we've picked winners and sell in the certainty that we can reinvest our capital to make more money elsewhere. We are usually wrong, often spectacularly wrong. These tendencies come from hardwired biases and also from emotional responses to our circumstances. But they also arise out of cultural requirements to show ourselves to be confident and decisive. Even though we should, we rarely reward those who show caution and humility in the face of uncertainty.

One forecast we should invoke, at least until the evidence demonstrates otherwise, is that the markets will generally trend upward. According to University of Oregon economist Tim Duy, "As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy."

Because of the many problems we have with forecasting generally, our portfolios should also be diversified. A diverse portfolio - one that reaches across market sectors - greatly increases the odds that at least some of a portfolio's investments will be in the market's stronger sectors at any given time - regardless of what's hot and what's not and irrespective of the economic climate.

At the same time, a diverse portfolio will never be fully invested in the year's losers. For example, according to Morningstar Direct, about 25% of U.S. listed stocks lost at least 75% of their value in 2008 but only four of over 6,600 open-ended mutual funds lost more than 75% of their value that year. Thus a diversified approach provides much smoother returns over time (even if not as smooth as desired!). On the other hand, a well-diversified portfolio will always include some poor performers, and that's hard for us to abide.

Next, make sure your time horizon is long enough. If you don't have at least a five-year time frame before using the money, stocks are almost surely a bad idea. That's because the chances of negative returns over shorter time periods are too high. But over the longer term, our investment prospects are reasonably bright.

Finally, recognize that there are limits to how precise even good forecasting techniques can be. No forecast should be seen as more than the roughest of outlines. Your mileage can and will vary. Keep your attention focused squarely on specific needs, goals and what you can actually expect to control about your portfolio and its results.

Forecasting is a necessary element of financial planning and investment management. Yet we tend to be really bad at it. Thus handle your forecasts and your forecasting process with extreme care.

The .400 Hitter and the Investment Superstar

More than 20 years ago, when I was still directly involved in the institutional sales and trading world, I was talking to a money manager client about a big global bond deal, managed by my then firm, that was about to hit the market. The manager didn't like the deal very much, but he was going to buy it anyway and in noteworthy size. His view was that since the deal would be a significant component to the index by which he was benchmarked, he wasn't prepared to risk being wrong on its value.

It was a classic trade by a closet indexer - a manager who claimed to be seeking active alpha but who was, instead, afraid to move too far from his benchmark. The last thing that manager wanted was to stand out, because the career risk to him of becoming a negative outlier was far greater than was the potential benefit of being right.

About 20 years before that, back in 1974, Paul Samuelson issued his famous Challenge to Judgment. In it, Samuelson challenged money managers to show whether they could consistently beat the market averages. Absent such evidence, Samuelson argued that portfolio managers should "go out of business - take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives."

In his view, investors were better off investing in a highly diversified, passively managed portfolio that mimicked an index than using judgment to pick stocks. Indeed, the idea behind indexing is to effect broad diversification within asset classes and broad diversification across asset classes so as to achieve market-like returns.

Unable or unwilling generally to meet Samuelson's challenge, "active" managers like my client have increasingly acted like indexers and, not coincidentally, have steadily ceded market share to passive or quasi-passive investment vehicles. In 1975, John Bogle launched the First Index Investment Trust (later renamed Vanguard 500), the first stock index fund for individual investors, which is now one of the largest mutual funds in the world, and with it launched a seminal market trend toward passive investment generally and indexing in particular. Although the idea took root slowly, passively managed funds now control roughly 40% of all domestic equity fund assets, according to Morningstar.

Moreover, most "actively managed" funds are actually highly diversified and thus cannot be expected to outperform. Even so-called "smart beta" portfolios are designed only to try to outperform marginally. That's because the more stocks a portfolio holds, the more closely it resembles an index. The average number of stocks held in actively managed funds is up roughly 100% since 1980, according to data from the Center for Research in Security Prices. (See Pollet & Wilson, "How Does Size Affect Mutual Fund Behavior?" Journal of Finance, Dec. 2008). Large numbers of positions coupled with average turnover in excess of 100% (per William Harding of Morningstar) effectively undermine the idea that such funds could be anything but a closet index.

As Patrick O'Shaughnessy of O'Shaughnessy Asset Management has recently and convincingly argued, managers today are much more interested in seeking assets than seeking alpha. A quality concentrated portfolio offers the opportunity for substantial outperformance. But such portfolios can significantly underperform for long periods and, even worse, a lesser quality portfolio might fall apart entirely. In either situation, the career risk to a manager is extreme. That explains the move to closet indexing pretty well, I think.

Since even before Samuelson's famous challenge, the Sequoia Fund has seemed to be exactly what a quality mutual fund should be. It is one of the last old-style funds with "conviction" - concentrated positions in stocks the fund managers believe in strongly. Since its inception in 1969, Sequoia has remarkably outperformed the S&P 500 by nearly 3% per year and has returned an average of over 13% annually to its investors. But recently the $4.7 billion fund was wrestling with heavy withdrawals as clients asked to pull more than $500 million in the first quarter of this year and more of late, largely due to a huge stake - roughly 30% of its holdings - in Valeant Pharmaceuticals International. The drug company's shares are down roughly 65% this year amid questions about its business and accounting practices.

Arguably, Sequoia is the only fund clearly to have met the Samuelson challenge. But as I write this, concentration and conviction aren't working so well for Sequoia as investors are aggressively questioning the judgment of Sequoia's managers and are taking their money elsewhere.

Accordingly, it seems beyond clear that the money management business today is dominated by indexers and closet indexers. Even the strongest advocates of active management must concede that, as a matter of simple arithmetic, the universe of active managers will underperform the universe of passive managers. Costs matter and passive management is a much cheaper endeavor. As Morningstar keeps demonstrating, in every single time period and data point tested, low-cost funds beat high-cost funds. Factor in the added tax efficiency of passive investing (much longer holding periods and far fewer transactions in general) and it is clear that active management bears a difficult burden in the contest to earn the trust and business of investors.

Perhaps even more tellingly, the performance of active managers and alleged active managers - in the aggregate - is astonishingly poor. A recent Bank of America Merrill Lynch analysis of mutual fund performance found that less than one in five large-cap mutual funds outperformed the S&P 500 in the first quarter in 2016, which represented "the lowest quarterly hit rate in our data history spanning 1998 to today."

"The average fund lagged by 1.9 [percentage points], marking a record spread of underperformance," explained equity and quantitative strategist Savita Subramanian and colleagues at Merrill. "And growth funds, for which our data extends further back, saw a 6% hit rate, the worst since at least 1991, with the average fund lagging by the widest margin we have recorded in our quarterly data: -3.5 [percentage points]."

As Bloomberg's Oliver Renick trenchantly pointed out, "It was a stock picker's market in the first quarter. Too bad about the stock picks." Active managers have gotten what they say they want so far this year: much lower correlations and much more breadth. However, the 50 stocks in which mutual fund managers are the least invested gained 5.3% in the first quarter compared with a 3.1% decline in a gauge tracking the most popular ones.

These findings are consistent with the regular SPIVA scorecards provided by S&P, which measure the performance of actively managed funds against their relevant S&P index benchmarks. During 2015, 66.11% of large-cap managers, 56.81% of mid-cap managers, and 72.2% of small-cap managers underperformed their respective benchmarks. Over the most recent five years, 84.15% of large-cap managers, 76.69% of mid-cap managers and 90.13% of small-cap managers lagged their respective benchmarks. Similarly, over a 10-year investment horizon, 82.14% of large-cap managers, 87.61% of mid-cap managers, and 88.42% of small-cap managers failed to outperform on a relative basis.

S&P's SPIVA Persistence Scorecard is even more depressing. Out of 678 domestic equity funds that were in the top quartile as of September 2013, only 4.28% managed to stay in the top quartile by the end of September 2015. Furthermore, only 1.19% of the large-cap funds, 6.32% of the mid-cap funds, and 5.41% of the small-cap funds remained in the top quartile.

Indeed, an inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status. No large-cap or mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period while only 7.48% of large-cap funds, 3.06% of mid-cap funds and 7.43% of small-cap funds maintained top-half performance over five consecutive 12-month periods. In part, that's because investors so often chase returns, swelling the assets under management of the recently "hot" firms and making future outperformance much more difficult (because size is the enemy of performance - being nimble helps a lot).

A key insight of Michael Mauboussin's excellent book The Success Equation is what he calls "the paradox of skill," simply defined as follows: "As skill improves, performance becomes more consistent, and therefore luck becomes more important." In 1941, Ted Williams had a batting average of .406, making him the last player in Major League Baseball to hit over .400 for a full season. Yet at least one batter hit .400 or better in nine of the 30 seasons between 1901 and 1930. How can this be, when overall skill has improved since then, in light of much broader access to talented players as well as superior coaching and conditioning?

As legendary scientist Stephen J. Gould has explained, as skill increases and moves toward human limits (the "right wall" of human achievement), the disparity between the average and the great narrows. As a consequence, although the mean batting average in the majors has remained roughly .260 since the 1940s, there are now fewer players at the extremes. In other words, "variation in batting averages must decrease as improving play eliminates the rough edges that great players could exploit, and as average performance moves towards the limits of human possibility and compresses great players into an ever decreasing space between average play and the immovable right wall."

In the same way, money managers can lose sight of the fact that while they may be improving their products or skills, others are too, thus reducing the opportunity for excess returns. The great Peter Bernstein made the right connection between baseball and money management: "Competition is too tough for somebody to hit .400. I watch baseball figures like a hawk, and it seems that's how the world has become. The market is full of smart, eager, highly motivated, highly informed people. It's hard to be a winner by enough to matter, or to stay a winner by enough to matter. There's also the whole benchmark problem, namely that there's tremendous pressure on managers to keep their tracking error down. There's no incentive to make the big bets that are necessary to hit .400. You can't beat the market by a lot unless you make big bets." See also: Peter L. Bernstein, "Where, Oh Where Are the .400 Hitters of Yesteryear?," Financial Analysts Journal, March/April 1999. Simply put, no money manager can expect to outperform by doing what everybody else is doing.

The hurdles that money managers must overcome to meet Samuelson's challenge and beat the market are high indeed. The vast majority of managers who try to do so will fail, even though many of them are extremely talented and dedicated. Many casual investors have no need or reason to beat the market, no matter what active manager marketing may suggest. Owners of an S&P 500 index fund generally own shares in 500 excellent companies. There is nothing inherently wrong with that. Nor is there anything wrong with utilizing market "factors" to try to improve investment performance. But investors in "smart beta" or similar strategies shouldn't expect outsized performance.

Investors who want or need substantial outperformance must look for and at managers with smaller accounts who use concentrated portfolios of quality assets that are held a long time to have a plausible chance of success. But these investors ought to understand that many such attempts fail and that the desired success is getting harder to achieve with each and every passing day.

Securities and advisory services are offered through Madison Avenue Securities, LLC, a member of FINRA and SIPC, a registered investment advisor.

This report provides general information only and is based upon current public information we consider reliable. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment or any options, futures or derivatives related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Diversification does not guaranty against loss in declining markets.