A Comment on the Downgrade.

First of all let me just say that a large percentage of recent volatility has been the result of program and day traders taking advantage of the US Treasury downgrade and global debt crises via high frequency computer trading. Probably in upwards of 70 percent of the sell offs, these trades create and vindicate fear. The overnight news has been swinging the indexes upwards of 200-500 points in a day. There is almost no sensibility in these market conditions. Rather, investor activity is overwhelmingly reactionary.

I don't believe that on August 4th the US was fundamentally less risky than it became the next day following the downgrade. There is little risk of default because if need be (not without consequence), America  can print money! This being said, the lack of political cooperation, albeit frivolous budget cuts and looming future expenses such as Medicare/Medicaid and pensions are very real issues. As Bill Haas of PIMCO noted, the real present value of the projected debt is somewhere in the neighbourhood of 66 trillion. This is not to be made light of, but can and will be overcome. America works, and will prevail.

http://www.pimco.com/EN/Insights/Pages/Kings-of-the-Wild-Frontier.aspx

On top of the debt ceiling woes and political bi-partisan politics, it seems as though the general lag in the US economy is what has legitimized fear and as such this downgrade. These long term fears coupled with stubborn unemployment and poor growth have cast a large shadow over the economic future of the United States. The European debt problems are more fuel to the fire. However we should not forget that the US is in the middle of a recession; one stimulated by the second largest global market collapse in the last century. As Warren Buffett noted in his July 8 interview with Bloomberg, America had 1 million new home owners a year and was building 2 million homes in the same amount of time leading up to the recession. Naturally, when the bubble burst years of over production would beat down employment. When American construction is suppressed so heavily that spills over in to many industries. Let us not forget how massive the real estate market is in the US. When the equilibrium is reached, demand will steadily drive unemployment down and production and growth will resume their normal duties. This is capitalism; its cyclical and extremely powerful. It can make investors think the market will never again crash (1999 and 2007), and that the economic world will end - right now. This is why we also should not put too much expectation on the influence of fiscal and monetary policies. While useful, these are secondary to the waves of supply and demand. I encourage you to watch the whole interview here:

http://www.bloomberg.com/video/72140684/

There is one more bone I have to pick with the influence of the S&P downgrade. I cannot figure out how they regained their reputation so quickly. Following the 2008 meltdown, many people across the globe were calling for rating agencies to be punished.  Had they not AAA rated toxic CDOs, the house of cards could never have been built. Now, only 3 years later their ratings are the heralded crystal ball again? Sure they made a huge mistake before and this downgrade seems more sensible given the evidence, but they continually under cut their credibility. For example, they downgrade the US debt, Warren Buffett responds by saying it should be rated quadruple A (non-existent) and they turn around and downgrade Berkshire. Say what you will about the fundamentals, but this is childish and the reactionary/vengeful undertone is clear. Last, what about the other agencies maintaining their AAA? How come the UK or France werent downgraded? Its all too shaky. Besides, when push comes to shove investors should be doing their own diligence. Full Stop.

I guess in the end this global debt problem is only going to create some very good value opportunities. For this I am grateful. Be fearful when others are greedy and be greedy when others are fearful.

Precisely Inaccurate.

I just finished reading renowned investor Joel Greenblatt's latest book - The Big Secret for the Little Investor - on which I have a few comments.

First, this book is quite short and very easy to follow. There are some simple equations explaining financial such as discounted value, but the book is mostly a discussion on basic value principles. Appropriately, Greenblatt quotes Ben Graham and Warren Buffett  multiple times. All things considered, the bulk of the book is a pretty solid summary of J.G.'s investing strategies communicated very clearly with all readers in mind.

The Big Secret also serves as a very good introduction to the world of indexes. Greenblatt spends a good portion of the book detailing what indexes are, how they are weighted, their relation to market sentiment, and how their historical returns differ from other passive or 'hands-off' strategies for the small investor - such as mutual funds.

Where I believe this book holds it's true value to the small investor, though, is in the discussion of the illusion that financial models, in all of their complexity, are to be heralded as the crystal ball of the investing world. While it is true that the analysts on The Street are experienced 'professionals' who spend days working on a comprehensive financial model, with multiple spreadsheets linked together and daunting equations, it does not guarantee a more accurate prediction of what this company is worth or more importantly what the market will be willing to pay for it in the future. One reason, Greenblatt notes, is that a more complicated model with more segmented information and forecasting will certainly be more precise, but not necessarily more accurate. Ultimately, any model/valuation that is forecasting future earnings, cash flows etc is making some serious assumptions about what the future will bring. No analyst can predict the price of oil 10 months from now, let alone an earthquake in Japan or widespread political uprising in the Middle East. These things all affect uncertainty which humans naturally associate with fear and thus investment risk, and they are completely unpredictable. Again, precise assumptions don't guarantee accurate ones.

To illustrate the fragile nature of these models, Greenblatt discusses the valuation of a hypothetical company, whereby he changes growth rates by only one or two percent. When forecasted out 10 years, these assumptions can change the 'value' of said company by 80 percent in either direction. Wile Greenblatt himself, I'm sure, uses excel  and builds forecasts for future performance, he does not hold this practice to be most important. What he details as most important in investing (as does Buffett) is a thorough understanding of the business, it's industry, and a common sense approach to forecasting growth and market returns. Only then is building a complex model a justifiable use of time and energy.

An investor should therefore be cautious not to purchase any securities on the basis of a buy/sell/hold report coming from their local brokerage. Indeed, the analysts who create these forecasts and price targets are experienced and hard working, but likely this quarter's earnings forecast is just a prefabricated template which has been updated with the most recent financial results. Often, the price target and buy ratings will be adjusted according to the new output of the model. In my view, this is reactionary decision making and will not help keep you one step ahead of the market.

The bottom line is that seemingly comprehensive financial models can be misleading. While they are a great supplement to the investing process, they are by no means primary. An independent investor should take it upon his/her self to read up on the business, understand how it makes money, try to get a grasp on growth prospects, take a look at the financials and - most importantly - make sure it is cheap.

http://www.amazon.com/Big-Secret-Small-Investor-Investment/dp/0385525079/ref=sr_1_1?ie=UTF8&qid=1311165340&sr=8-1

Red Sky at Night, Investor's Delight

At work the other day - when CI Financial was doing their Q1 earnings call - I came across this new start-up capital management firm/hedge fund called Red Sky Capital Management (RSCM). The shop started in September 2010, has one fund called the "Red Sky Partner's Fund" and roughly $50 million in Assets Under Management. Putting aside an impressive 19 percent return since inception, there were two major things that grabbed me about the Partner's Fund.

First, is the investment style. The fund is headed by Tim Lazaris, who along with most of the rest of the team, worked as a portfolio manager at GMP before starting Red Sky. What he has brought to the table is in my opinion a very interesting blend of investment philosophies which (so far) are working very well. The team has managed to build an investment strategy which first focuses on long term fundamentals. Looking for deep value plays through a bottom-up analysis is a strategy that Benjamin Graham, Warren Buffett and the likes advocate. This serves as the core of the portfolio; the platform on which greater risks can be taken, if you will. To compliment (and contrast) this strategy, they also perform top-down macroeconomic market analyses. Where the first strategy focuses on finding long term investment prospects which may be out of Mr. Market's favour, and therefore cheap, the latter is based on market momentum and technical indicators. These types of trades generally have a much shorter life and as such require more constant attention. It appears that utilizing two near opposite strategies in the same fun might be a sign that the Red Sky team biting off more than they can chew, but the undertaking is noble, and it is clearly working thus far. In my opinion, this is a very interesting approach to portfolio diversification and risk management. If you want to read more follow this link: http://www.redskycm.com/pdf/Red%20Sky%20Investor%20Presentation.pdf. Red Sky outlines their investment strategy in this PowerPoint.

Second, mutual fund giant CI Financial owns a 35% ownership stake in RSCM. Since the early 2000s, CI has veered away from the hedge fund business and focused on building its equity, fixed income, and balanced funds. While the size of this investment compared to the size of CI is almost immaterial, the fact that it has invested in this start up hedge-fund-like firm exemplifies their faith in the team at RSCM.

Ultimately, Red Sky started up in the heat of a bull market coming out of the biggest recession since the great depression. Clearly the market has been on their side since inception. While they've still managed to beat the big indexes (see above), the real test of their creativity and investing skill will be through good, bad, and uncertain markets. So far, they certainly appear to be on the right track.

Author Disclosure: I do not have a position in any Red Sky products and do not intend to initiate one in the next 72 hours.