About jimhemphill

I am Chief Investment Strategist for an investment advisory firm in Radnor, Pennsylvania, just outside of Philadelphia. Our investment approach is globally-diversified, with our research focus on using relative-pricing and relative-yield information in historical context as a guide to optimal asset allocation.

Ponzi Redux

“What we mostly learn from history is that people are unable to learn from history.”

Warren Buffett

Back in the 1920s, Carlo (Charles) Ponzi got an entire class of financial fraud named after him, when he convinced greedy investors that he had a mechanism to double their money in a short period by buying international postal coupons at a discount and redeeming them at face value. Hundreds lost their life’s savings in his scheme.

A Ponzi scheme, also called a pyramid scheme, offers apparently superior returns through some kind of financial legerdemain, but actually pays early investors with the funds of later investors. Pyramid schemes inevitably collapse when there are too many early investors expecting cash flow, or demanding their money back, and not enough new money flowing in to keep the illusion going.

The financial press has just broken the story of the collapse of a Ponzi scheme based in New York City, in which investors were promised high returns from buying up blocks of theater tickets for hot shows, which would then be re-sold at higher prices. The big draw for many was the understanding that they’d be capitalizing on the success of Hamilton, one of the most popular musicals in Broadway history, with the highest ticket prices ever.

Of course, there was no actual buying of theater tickets. A money manager cooked up the scheme to reimburse investors whose money he had misappropriated in his investment firm. Three guys were arrested, one is pleading, and the other two will go to trial.

Who was taken in by this nonsense? Surely only credulous old ladies on Long Island or the equivalent?

Actually, not. Among the victims were billionaire computer titan Michael Dell, billionaire hedge fund manager Paul Tudor Jones, an executive at Och-Ziff Management Group (an investment firm) and 125 others.

The moral of the story is that simply following the crowd, even the famous and supposedly sophisticated crowd, is no guarantee of good results. Often it is precisely the richest and most sophisticated who are the victims of scam artists. (See Madoff, Bernie.) If it sounds too-good-to-be-true, it very probably isn’t, you know, true.

Transition

“What we witness here today is not a victory of party, but a celebration of freedom.”

John F. Kennedy, Inaugural Address, January 20, 1961

When I was younger I could recite John F. Kennedy’s inaugural address by heart. Like many of my generation, Kennedy’s life and death had a profound impact on my early life. While I no longer believe that Kennedy deserves a place among America’s great Presidents, the soaring rhetoric of his inaugural, penned by Theodore Sorenson, remains among the greatest and most consequential speeches of the mid-20th-century.

I just listened to Trump’s inaugural. What struck me most is how much it departed from the conventions of such speeches, and how uniquely Trump’s distinctive voice and viewpoint came through. As usual, Trump was Trump, for better or worse.

I have been thinking a lot about Obama’s legacy, and trying hard to find reasons to be optimistic about Trump’s rise to power. I’ll share some thoughts about both issues soon. Here’s my immediate reaction to Trump’s speech from the portico of the Capitol:

The phrase “America First” has powerful echoes in our history, and none of them are positive. If Trump used the phrase after consultation with his advisers, he needs different advisers. If he used it despite such consultation, he is willfully ignorant. If he used it in full understanding of its historical importance, we and the world are in big trouble.  I became a Republican, above all else, because the Republican Party under Ronald Reagan had clearly replaced the Democrats of FDR, Truman and Kennedy in recognizing the irreplaceable role of America in the world. Trump’s speech sounds to me like a clear rejection of that legacy.

The unequaled success of the United States is the result of our institutions, our traditions, and our people. The Founding Fathers recognized that no institutional framework could preserve our Republic if the people chose the wrong leaders, or if we abandoned the essential characteristics of our civil society. The Constitution limits the power of the President, but several Presidents have refused to recognize and abide by those limits. If we want better leaders, we need to be better voters. Especially in the primaries.

There is always majesty in the peaceful transfer of power. I will continue to pray for my country, and for our new President to find wisdom and humility in that high office.

After the Deluge


 

I went to bed last night at 2 a.m. I’d been sure of the outcome since about 11 p.m., and got tired of waiting for one network or another to announce it. I woke up this morning to Donald J. Trump as the President-elect. Not what I expected yesterday morning when I went to vote, though I had discussed the specific scenario by which he won several times in the days before the election.

So how do we find sound footing after being swept away in this historic flood? We don’t. Because there was no flood.

Donald Trump secured one of the most unlikely victories, in one of the most amazing upsets, in American political history. This is bigger than when “Dewey beats Truman” was wrong in 1948, because Trump won against the projections of a massive apparatus of scientific polling. He confounded the doubters and the critics. He has swept away one of the most powerful American political dynasties. (And good riddance.)

But astonishing does not equal overwhelming. Right now, Donald Trump trails Hillary Clinton by less than 200,000 votes. Yes, you read that right, he trails. Depending on which website I consult, he has a confirmed total of between 276 or 289 Electoral votes. (The most likely final count adds 30 Electoral votes to the lower of Trump’s totals.)

This is a huge upset. Trump won, Clinton lost, absolutely certain, almost entirely unexpected. But it is no kind of landslide, no kind of mandate. It is, for the fifth time in American history, an Electoral College victory combined with a loss in the popular vote.

President-elect Trump savors his victory amid the most bitter partisan divide since Abraham Lincoln took office at the beginning of the Civil War. Public anxiety is the highest since December 8, 1941, the day after Pearl Harbor. Confidence in government and our public institutions is at the lowest level ever. And over 60% of American voters believe that Trump lacks the temperament to be President.

Sounds like we have nowhere to go but up.

Eight years ago, Obama took office with high expectations that he would lead us into a bright, prosperous and post-racial future. That hope went unfulfilled, with the blame fairly shared between President Obama and Congressional Republicans.

Trump will take office with the lowest possible expectations, with Republican majorities in the House and Senate, but with Senate Democrats retaining the power of the filibuster. He’ll have the opportunity to replace a deceased, very conservative Supreme Court Justice with a new judge unlikely to be any more conservative.

Last night his victory speech hit all of the right conciliatory notes. Let us all hope that Trump governs effectively and inclusively, that he surrounds himself with capable men and women, and that America’s future is bigger than its past.

May God bless, protect, and strengthen the United States of America.

 

 

End of the Nightmare

“It’s amazing what one honest man can do. One honest man and a cause.”

General Lo Armistead

“I don’t think on that too much anymore. My only cause is victory. This war comes upon us as a nightmare. You pick your nightmare side. Then you put your head down and win.”

General James Longstreet

I’ve had the Longstreet quote above running through my head the last few weeks, unable to recall where I’d heard it. Today I was finally able to retrieve the context from my aging brain. When I located the entire passage from the 1993 movie Gettysburg, I realized the complete exchange was even more pertinent to the entire 2016 election, now coming mercifully to a close.

In the movie, a group of Southern generals are discussing the excellence of Robert E. Lee, while their commander General James Longstreet is reflecting instead on the brutal nightmare the Civil War had become in its third bloody year. The ultimate result of the Civil War was largely decided at Gettysburg, just two hours drive from where I sit in eastern Pennsylvania. In the event that Trump pulls off a surprise upset tonight, Pennsylvania will likely be a key part of his victory.

This entire election cycle has been a nightmare. Asked about their feelings on the final day of the campaign, voters most often identify anger, fear, and depression. Those negative feelings are especially strong among independents, a group with which I find myself identified for the first time. Most Americans have picked one of the two nightmare sides, and are hoping their side wins.

Our national angst at the election contest derives in part from the bitterness and divisiveness of the rhetoric on both sides, but even more from the absolute lack of confidence in the nominees of either party. These are the two most disliked candidates of my lifetime. Despite the apologies of partisans on both sides, I believe that dislike is entirely deserved, again on both sides.

During the Civil War, Americans literally killed each other, in numbers never equaled in any other conflict. Yet the fighting men of both sides were able to recognize the excellence of their opponents, their courage and commitment, despite the fact that they were fighting to the death.

We seem to have lost that ability. The bitterness of this election divides friends, families, communities. How is it possible that our ancestors at Gettysburg could treat each other with respect immediately after slaughtering each other by the tens of thousands, yet our candidates today are unwilling even to shake hands before a debate?

A central reason for the partisan divide is that we have lost the very idea of virtue in public life. This process really began in the 1990s, during the first Clinton Presidency. Conservative William Bennett wrote The Book of Virtues, desiring to instruct children in those qualities of character necessary in a democratic society. Democrat Ben Wattenberg responded with Values Matter Most, a book asserting that such liberal priorities as education or affirmative action should form the core of a more elevated national conversation.

The problem, of course, is that values are something that you are not likely to share with your opponents, especially if values are defined in narrow partisan terms. Virtues, on the other hand, are affirmative qualities of character and soul that you can recognize even across profound partisan, cultural, national or religious divides. At Gettysburg Union General Winfield Hancock, gravely injured, brought water after the battle to his dying Masonic lodge brother, Confederate General Lo Armistead. He loved his friend, even though they fought on opposite sides of the most divisive question in American history, whether men might hold other men as property.

This year, the nominees of both major parties are individuals of poor character. Both have lied about issues of material importance. Both have a history of treating ordinary people with brutal indifference. Both have ignored the law, the rules, and common decency whenever necessary to advance their own interests. Neither candidate possesses any visible humility or ability to admit error.

We once shared the belief that good character was a necessity in any candidate for high office, and we celebrated such character in the lives of great Presidents like Washington, Lincoln, Teddy Roosevelt, and Truman. The choice of these two individuals, Trump and Clinton, to compete for the world’s most important office represents a betrayal, not just of a commitment to character in our leaders, but also of the central values of each party. The Democrats chose someone who has used political influence to accumulate a vast fortune, mostly through relationships with powerful financial interests and authoritarian foreign governments. The Republicans chose a crude man with no understanding of American history, Constitutional principle, or the necessary limits of government power.

Both parties have failed us, in fundamental and obvious ways. Each party’s voters believe that a victory by the other party’s candidate poses a fundamental danger to the health of our democracy.

So my wish is that both parties, regardless of the outcome of today’s contest, will recognize the damage done, in choosing their standard bearers, by abandoning a commitment to basic decency and to the principle that the public interest must take precedence over personal gain . Out nation needs, and our history and principles demand, a better class of candidate next election cycle.

The Election and Your Money

In past years, I’ve written on this topic once the results of the Presidential election are known. This year, I’m posting prior to the election, because some of the potential short-term effects of the election results are worth considering, so as to be ready if market dislocation follows next Tuesday’s vote.

This is my eleventh presidential election, and surely the most contentious. I won’t tell you how to vote, or even touch the arguments against the two major-party candidates. Good luck to all of us when we step into that booth and confront the duties of our citizenship.

What I will comment on is the investment implications of this election. You can also watch a recording of our recent webinar, The Markets & The Election Season. How will the results affect our portfolios? Is there anything we should do in advance of the election, either to protect ourselves or to maximize our opportunities? Are there actions we should be prepared to take after the election, depending on the result?

As always, let’s start by examining the data. We have really good data going back to the presidential election of 1952 about how U.S. financial markets have reacted in the short-term, over the two months on either side of presidential votes, to different election outcomes.

Here’s a summary of some of the key points:

  • Markets usually go up slightly in the two months bracketing the presidential election.
  • They go up more if the election is close.
  • If the election is a landslide, they go down a bit.
  • If the party in the White House changes, they go down. If the White House remains with the same party, they go up.
  • If a Democrat wins, markets decline, while a Republican victory sends markets up by exactly the same margin.
  • None of these historical moves averages as much as 2% in either direction.

So the best scenario for the markets is if the Democrats retain the White House by a slim margin, and a Republican wins the presidency. Which is clearly self-contradictory, and thus no help at all.

Does either party have a longer-term advantage? Yes, there is a slight advantage for Democrats in long-term returns. But if you deduct the market crash of 1929-1932, the Republicans have a slight edge. As investors, we really have no reason to prefer either candidate based on historical market reactions to partisan outcomes.

Is there a more reliable metric we could apply?

As we often do, we fall back on valuation. Economist Robert Shiller of Yale University won the Nobel Prize in Economics for his insight, captured in the Shiller CAPE (Cyclically-Adjusted Price Earnings ratio), that when stock market valuations are high, future returns are lower, and when valuations are low, future returns are higher.

The last two times the presidency changed hands, in 2000 and 2008, we used Shiller CAPE to inform our broad perspective on the markets.

In 2000, when George W. Bush finally won, valuations were high, and we warned that risks were high and prospective returns likely to be low. We took a defensive posture. As the tech crash continued through 2003, our portfolios largely avoided the market decline.

In 2008, when Barack Obama won a compelling victory in the midst of the worst stock market decline since the Great Depression, we observed that stock prices were below average. With risks lower and opportunities higher, we pounded on the table in favor of buying stocks. At the market bottom in 2009, our stock holdings were the highest ever. We were ultimately well-paid for owning stocks, as Barack Obama’s first term was one of the most profitable for U.S. stock market investors in a generation.

Today, market prices are high. With Shiller CAPE at 26.5 times trailing earnings, we are in the top 7% of historical valuations (93.6th percentile). Our portfolios are defensive, just as they were in 2000 when Bush 43 was elected.

A little more than a week ago, a Hillary victory with limited “coattails” appeared to be priced in.[1] A sharply different result—either a Trump victory or a Hillary victory with big coattails, giving the Democrats control of the House and Senate, would have been surprising, and thus likely to lead to a short-term market decline. (For what little it is worth, historically market returns have been highest with a Democrat in the White House and Republicans in control of Congress, just as we have now.) As Trump closed the gap, the U.S. stock market declined for nine straight sessions, the longest losing sequence since 1980. We have done limited buying during this decline, mostly for clients who were over-weight cash.

There is an aspect of our portfolio strategy that may intersect in interesting ways with the election results. While U.S. valuations are very high, all foreign stock markets are cheaper as measured by CAPE, without exception. We are overweight foreign equities.

To evaluate how this positioning might perform after the election, let’s examine the reaction of markets to the British vote on whether to leave the European Union (Brexit). Immediately before the vote, the final polls predicted Brexit would fail and Britain would remain in the EU. Markets rallied sharply. But Britons actually voted for Brexit, against polling predictions. Markets fell sharply, both in the U. S. and in Great Britain. But within weeks, markets fully recovered in both the U.S. and overseas. So far, so unremarkable.

But one market fell sharply and has continued to fall in reaction to Brexit—the currency market for the British pound, which fell by 6.0% the next day and has fallen another 10.4% since, with no sign of recovery.

What is the similar scenario in the U.S.? It would be a Trump victory, against the indications of the majority of polls. If we followed the Brexit path afterwards (no guarantees of that at all), we would see a sharp decline in the S&P 500, followed by a full recovery in stock prices, but we would also see a sharp and persistent  decline in the value of the U.S. dollar.

That single, entirely speculative scenario would actually benefit our target portfolios, because we are strongly over-weight foreign equities. A falling dollar increases the price of foreign stocks. Of course, there are multiple other scenarios under which we would not benefit.

Our advice is to exercise your franchise in line with your moral, political, and philosophical convictions, and to expect markets to react to the election results in unpredictable ways. Know that our portfolios are defensive and diversified, that we have cash available to invest in the event of a large market decline, and that we remain committed to a global perspective on investing. As always, we are devoted to your lifetime financial success, and none of our personal political perspectives will ever deflect us from making decisions solely based on what we believe to be your best long-term interests.

[1] A President’s election is said to have “coattails” when it also results in large gains for down-ticket candidates for Congress, Governorships, or state-house races. Examples during my lifetime were Johnson in 1964, Reagan in 1980, and Obama in 2008.

Rolling Bubbles

I just ran across an article on the recent collapse of the “emerging art” scene, which revolves around works by young artists, many still in their 20s. An art dealer bought a work by a hot young artist for $100,000 back in 2014, and is now trying to sell it for $20,000, before it goes to zero. Here’s an excerpt from the article:

This week, estimates for three Smith pieces are as low as $7,000. One, from the series he made by spraying more than 200 canvases with paint from a fire extinguisher, is estimated at $12,000 to $18,000. A bigger spray work sold for $372,120 two years ago.

Who knew that one episode of spraying paint from a fire extinguisher could create art worth more than $74 million at the peak? If the nomination of Donald Trump was not enough proof, this seems like persuasive evidence of the apocalypse to me.

This is also a good reminder to every would-be speculator about the risks of buying any asset simply because it is going up, without regard for its intrinsic economic value. When bubbles burst, they do so without warning, and they can trap even the most sophisticated investors.

We have been defensive in our portfolio commitments for several years now. As a result, we’ve missed some of the apparently easy money, in emerging tech stocks in particular. Right now we’re observing a global tendency for some of the most over-inflated asset markets to head south. This broad decline has already affected some of Silicon Valley’s “unicorns,” the term for non-public companies valued at more than $1 billion, as well as real estate in recently red-hot markets like Vancouver, which was down as much as 17% in a single month.

When considering any investment, the two questions we always ask are:

Does this investment represent an underlying asset or business with real and enduring economic value?

Is the price I’m paying reasonable in relation to that underlying economic value?

If the answer to either question is “no,” our practice is to stay on the sidelines. This causes us to miss out on some apparently easy money, but also helps protect us from permanent and irrecoverable losses.

I’ve been in the investment business since 1978. Time and again, I’ve observed greedy individuals chasing over-priced nonsense, solely based on the fact that it has recently gone up. They always seem to believe there will be some sort of warning before the bottom falls out.

Let’s all consider ourselves warned.

A Choice, Not an Echo

Spoiler alert! This post will disclose my political affiliation, not that I believe most long term readers will find it a surprise.

I grew up as a Democrat. My first vote was in the Presidential election of 1976. I was a registered Democrat and had spent the summer working in the office of a Democratic Congressman. I actually met candidate Jimmy Carter in my office building on Capitol Hill. But that fall I cast my vote for Republican Gerald Ford, and against the candidate of my own party. I thought Jimmy Carter was a fool, and his foreign policy positions a collection of self-righteous platitudes.

Events proved me correct. Carter won the 1976 election, announced that the United States was “at long last free of our unreasoning fear of Communism” and then pronounced himself astonished at the Soviet invasion of Afghanistan. At that point in Carter’s single Presidential term, I switched parties. By 1980, I was a Republican, because it was the party of free trade, a strong military, and robust leadership in the international struggle against totalitarian Communism.

In the 1990s, I watched as the Democratic Party tied its fortunes firmly to the coattails of the Clintons, nominating for President in 1992 and then re-nominating in 1996 a man who was clearly a sexual predator, who abused his office to suppress legal scrutiny, whose campaign took money from foreign interests including the Chinese military, and who lied carelessly and deliberately about both issues of public policy and personal transgressions. Since their Arkansas days, the Clintons have been unable to differentiate their personal political, financial, and legal interests from those of the nation. Indeed, by using the Clinton Global Foundation as a personal piggy bank, they have conflated their personal finances with those of global progress itself.

In the 1990s, I gave meaningful dollars to the Republican Party. I attended both the 1996 and 2000 conventions. I’ve met the last three Republican Presidents, all but one of the last four Vice Presidents, even every failed Republican candidate for President except Mitt Romney. Heck, my oldest child’s middle name is Reagan. So an election between any Republican nominee and Hillary Clinton should be a slam dunk decision for me. Easy and obvious.

Except it’s not. In 1996, I said the Democrats had made a deal with the Devil in re-nominating Bill Clinton, definitively decoupling the Democratic Party’s fortunes from historically progressive principles–that public service is a higher calling, requiring the highest standards of integrity to command the nation’s allegiance to our shared purposes.

Now the Republicans have done the same thing.

Donald Trump, like Bill Clinton before him, and like Hillary Clinton today, has personal qualities that clearly disqualify him from holding high office. He is an habitual liar. He is a gross, childish bully. He has been entirely unprincipled, both in his past business dealings and in his recent political campaign. He is less intelligent than any other major party Presidential candidate of at least the last half century. He has less impulse control than the typical adolescent male, and he appears to be impervious to advice, instruction, or any form of self-correction. And at age 70, none of this is remotely likely to change.

I spent the first year of Trump’s campaign in denial that he could secure the nomination. And then got stuck there, as he won primary after primary and walked out of Cleveland as the standard bearer of my party. Like so many of my conservative friends, I’ve been confused and conflicted about what to do. Time and again, I’ve watched Trump give another speech, or lead another rally, hoping against hope that he’ll somehow rise to the occasion, always disappointed.

It might be tempting to overlook Trump’s character flaws if he was sound on policy. After all, Lyndon Johnson was one mean SOB. Richard Nixon was a paranoid tough guy, surrounded by similarly ruthless partisans. FDR and John Kennedy were both notorious philanderers. If being a nice guy was the criteria for occupying the White House, Jimmy Carter and George W. Bush would be among the great Presidents.

But Trump’s policy positions are a confusing and incoherent mash-up. The defining principles of Republican domestic policy since Reagan has been an informed skepticism about the effectiveness of larger government, coupled with an understanding of the Constitutional limits on executive power. There is no indication that Trump even understands that we have a Constitution, and every indication that he believes the President has the same kind of autocratic power as the owner of a non-public company.

On foreign policy, Trump is a protectionist and a quasi-isolationist. He has aligned himself with Vladimir Putin, who has stolen tens of billions from the Russian treasury, murdered hundreds of journalists within Russia, assassinated his political opponents overseas, and invaded two neighboring countries. Putin has been clear about his desire to revive the Cold War, and his belief that the United States remains Russia’s principal enemy.

Trump is not qualified to be President.

I remember when the racist David Duke secured the Republican nomination for governor of Louisiana, and the national Republican party endorsed the candidacy of corrupt Democratic Governor Edwin Edwards, launching the slogan, “Do the right thing. Vote for the crook.” Edwards won, and later went to prison.

I’ve always said that I am a Republican third, a conservative second, and an American first. So must I vote for the crook, Hillary Clinton, to keep The Donald’s hands off the nuclear codes?

After months of struggle, I have decided that rejection of Trump in no wise justifies a vote for Hillary Clinton, an individual herself disqualified on personal character criteria from the Presidency, even if I agreed with her policies (whatever they actually turn out to be), which I do not. (I will note in passing that Hillary Clinton is smart, very hard-working, and supremely disciplined, all fine qualities. Plus it would actually be nice to see a woman occupy the highest elected office. Just not this one.)

Fortunately, the range of possible choices does not stop with two lying, unprincipled, self-centered, super-rich liberals from New York.

For the first time in my adult life, I will be supporting someone other than the Republican nominee for President. I will vote for the Libertarian candidates, Gary Johnson and William Weld, for President and Vice President. As soon as I get a chance, I plan to put a Johnson-Weld sign on my lawn.

For all of my conservative friends still struggling with the Hobson’s choice of Clinton or Trump, let me offer you some hope.  Once I made my choice, my despair and confusion vanished, replaced with relief, optimism, and even excitement. I believe this is much more than a lesser-of-three-evils choice or protest vote. It is, at a minimum, a vital next step in an overdue national conversation. More on this later.

On this post, more than any other I’ve ever written, I’d welcome your comments.