welling.weedenco.com listeningin january 23, 2009 … · 2009-02-13 · between economic conditions...

There’s nothing ordi-nary or conventionalabout the trio of DeanLeBaron, Walter Deemerand Mark Ungewitter;nothing to explain howthe three highly dis-parate professionalsmight have happenedto join forces to try tothrash out a way out ofthis enveloping eco-nomic miasma.Nothing that is, exceptabiding intellectualcuriosity and a certainshared spirit of innaterebellion against con-vention. That’s howDean, the founder and former chairman ofBatterymarch Financial Management, inventorof index funds and pioneer of quantitativeinvesting came to together with Walt, the leg-endary technical analyst who has published“Market Strategies and Insights” since 1980,capping a long career marked by stints with thelikes of Bob Farrell, Gerri Tsai and PutnamManagement. And also with Mark, a low-keyand buttoned-down VP and portfolio managerat Charter Trust Co. — a plain-spoken NewHampshire-type who specializes in “privatewealth management” and yet cheerfully admitshe makes his dough by reading charts. Thevenue was last fall’s Contrary Opinion Forum inVermont, held just as both the foliage and thelatest installment of the financial crisis werepeaking. The troika was stunned by the lack ofawareness they encountered all around and

resolved to write something; to shake things up abit in smug analytical circles, and to goad dis-course forward on the urgent topic of how to getout of this mess. Their paper, like its authors,has proven a mite, well, too unconventional, forits intended platform, an academic journal.When a copy found its way to my desk, howev-er, it did exactly what they hoped — provokedand intrigued. A conference call followed latelast week. Share the stimulation.KMW

How did the three of you happen to gettogether to write a paper on “The WayForward”?Dean: We were at the Contrary Opinion Forumin Vermont in the middle of last October, as themarkets were falling apart, and were struck thatnearly everyone there was bullish. So the threeof us got together and decided, hey, we had bet-

Reprinted with permission ofwelling@weeden JANUARY 23, 2009 PAGE 1

RESEARCHDISCLOSURES PAGE 13

V O L U M E 1 1

I S S U E 2

JANUARY 23, 2009

INSIDE

Listening InDean LeBaron,

Walter Deemer &Mark Ungewitter

PAGE 1

Unconventional CluesContrary Troika Looks At History Searching For A Way Forward

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ter think this through.

Walter: Somebody made a presentation oneday saying that the S&P might bottom around965 and, if not there, at 940. Then somebodyelse raised his hand, interrupting him, andsaid, “It just closed at 910.” It was the next daythat the Dow opened down 700 points as we satthere.

Dean: Mark was at the conference at my insti-gation and one of the hooks I had used to gethim there was the chance to meet Walt, so thethree of us were chumming around a bit–

And naturally, aftera few libations, youdecided to write up asolution to what’sailing the markets?Dean: There werecocktails involved atthe forum — but not inthe writing. I’m onlythe lead author, as Isay, by virtue of the factthat I’m senior in age.Other than that, theeffort was at leastequal; we bouncedeverything back andforth.

You can’t really besurprised that theFinancial Analyst’sJournal passed onthe opportunity topublish your paper, can you? Not when it’sutterly devoid of algebraic equations. Dean: No. I’m very sympathetic to them; I’mon their so-called advisory committee and I cansee their point. Our paper is different fromtheir normal stuff — but that’s why we did it, ofcourse. This isn’t the time for conventionalthinking. Besides, Walter and I have done some mischievous things in the past, so we thought itwould be fun to collaborate again.

You have? Like what?Dean: Going way back to when Walt was work-ing at Putnam Fund, we would meet from time totime under a foggy lamppost —

Wasn’t that high treason? Consorting witha rival?Dean: No, it wasn’t that. It was just that I was

on the so-called fundamental side of things andhe was on the technical side, so in both caseswe had to hide our collaborations from ourrespective communities.

Walter: But what we found was that we werereally talking about behavior, so we could talkto each other. Which is why I think Bob Farrell’srecent quote is so good, “History does notrepeat itself exactly, but behavior does.”

Dean: It is exactly on target, which is exactlywhat you’d expect, considering the source. Inany event, Walt and Mark and I didn’t get

together to write thatpaper just to make anacademic statement forthe sake of making anacademic statement.That doesn’t do it forus. We are practicalguys. We want to knowhow something is goingto affect investmentmanagement or whatdoes it mean for gov-ernment policy.

Then why doesn’tthe draft of yourpaper that I’ve readgo into those practi-calities?Just because wethought that, for thepurposes of periodicalslike the FAJ, thosepracticalities really

wouldn’t matter. By the time it came out, therewould probably be a whole new set of circum-stances.

Walter: What Dean is being too much of astatesman to say is that we really wrote thepaper because there are roughly 100,000 sub-scribers to the Financial Analysts Journal and99,750 of them – at least – were blindsided byall of this. What we are saying is that they hadbetter figure out why they missed it. Maybethey should even look at things they’ve beenignoring.

Dean: I think that’s fair. I mean, most bigthings are not big unless most of us miss themas they are developing. As Walt has told memany times, the most dangerous things to sayin the investment business is that “It’s different


“What Dean is being too much

of a statesman to sayis that we really wrote

the paper becausethere are roughly

100,000 subscribersto the Financial

Analysts Journal and99,750 of them – at

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this time.”

Walter: Right.

Dean: Something trulydifferent only happensmaybe once every 50years or so. But when itdoes happen — whenyou get a hurricane inNew Orleans — it reallyhappens. And then itis, indeed, different.This just may be one ofthose times. I guessthe point to make here,which we may not havehit as hard as weshould have in thepaper, is that a numberof the things that wemight do proscriptivelyas government policymay be harmful toother things that may be going on.

How so? Dean: Well, one of the things we hint at is thatwe could have deflation and inflation at thesame time. So if you fight deflation, whichappears to be what we’re doing from aKeynesian standpoint, you may actually be mak-ing things worse in terms of aggravating infla-tion later. When I first went to Russia yearsago, the Russians explained to me how they playchess. They play multi-dimensional chess, as iffour games are going on at once on the board ina single game. From their standpoint,Americans play checkers; they do one thing at atime in a series. This may be one of those occa-sions where you have to play multiple games atthe same time—and hope not to run into toomany conflicts from one level to another.

Walter: I don’t talk with many very academic,statesmanlike people, as Dean knows. But oneof my friends says that we’ll have to fight infla-tion and deflation at the same time becausewhat we have been doing so far is analogous togiving somebody who’s hooked on heroine a hitof cocaine as a “cure.”

Dean: What I guess I said to Walt and Mark lastOctober — at least Walt has repeated it severaltimes — is that this is not your father’s recession.I was drawing on the fact that over the course ofthe last two or three years, quite a few widely

known economists, whom I will let stay name-less out of respect, have said to me, “The num-bers that I’ve been using and the relationshipsand correlations that I’ve used in the pastbetween economic conditions and financialmarkets aren’t falling into place the same waythey used to.” And they’ve gone on to tell me,and I’m quoting these economists here, “I’mbeginning to get a little agnostic about what’sgoing on and I’m beginning to get a little agnos-tic about my ability to put these new piecestogether that don’t seem to fit the same waythey used to.”

So you decided to look for new ways to putthings together?Dean: Well, keying off those thoughts whichimply humility — something which doesn’toccur to many of us often — we’ve got to look forsome new relationships. Of course, I admittedlyhave a propensity to try different approaches.You don’t often use contrary opinion, but whenyou do use it and use it correctly, it is extremelyuseful. Likewise, you don’t often use complexityscience, which is essentially the dynamics ofarranging a number of things to occur simulta-neously and studying them together rather thanin synthesis. But I suggested, let’s combine allof these pieces together and see if we can comeup with something. We thought the world wasgoing off in one direction while most of theinvestment community continued to be quiteconfused by the fact that the U.S. economy


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seemed to be in a frozen stop. And the worldeconomy was not behaving differently in anyway through it all. It was almost perfectly cor-related.

Yes, all correlations went to 1. Dean: The U.S. currency was the mainstay ofeverything around the world, as we all know,and yet we were losing other people’s money. Ilive for part of the year in Switzerland, and theSwiss have been saying to me for a couple ofyears that they thought what was going on inthe United States was so bad that they shouldquarantine the U.S. so that they didn’t get thedisease. Well, they did get the disease; theydidn’t quarantine the U.S. But for the Swiss tosay something like that suggested, to me, thatthere were some severe forces at work. Andthat they weren’t just ordinary structuralforces, like an imbalance between inventoryand sales that you would see in a normal reces-sion, where you would sort of take a pause fornine months while they got caught up. It sug-gested to me that there was a lot more going onand that we should look at behavioral financeand examine the degree of confidence in theworld’s financial systems from fresh perspec-tives. Then again, it came down to the fact thatWalt and Mark were good soul mates in dis-cussing all this in October and out of thoseconversations grew the paper we sent to you.[Available atwww.walterdeemer.com/A_Way_Forward.pdf]We simply decided, let’s write somethingbecause we think we have something differentto say.

If this isn’t our fathers’ recession, what is

it? A depression?Dean: We don’t even know how to definedepression. There’s a prediction market that Ifollow, and Walt does, too, at www.intrade.com,which attempts to measure the likelihood ofthings like a depression or a recession by track-ing how much people are willing to bet on oneoutcome or another. You essentially put moneydown on one outcome or another. The lastforecast I looked at – which is a couple of daysold – was that the chances for a depressionoccurring in 2009 in the United States wasabout 65%. That number is outstandingly bad.

It sure is. How does intrade.com define“depression”?Dean: Well, Walt has correctly argued that thedefinition of a depression is something wedon’t really know very much about. We haven’thad enough of them. And Walt doesn’t like theway intrade.com defines depression — and Iagree with him. They have defined it as a 10%decline in GDP during calendar year 2009.Walt points out quite correctly that GDP hasalready declined by something less than 10%but more than 5% in the fourth quarter of2008. So it already had started down the slip-pery slope. Which means defining it as a 10%decline within the confines of calendar 2009 isnot a great way to measure it. Merely the dis-cussion is interesting, however, and goes toshow that there really is no widely acceptabledefinition. There is, in contrast, an accepteddefinition of recession because we’ve had somany of them. Depression, we don’t know any-thing about, which from a contrarian stand-point is a very nice hint that maybe there’ssome merit in thinking about it.

Mark: I’d like to interject some historical per-spective on the definition of a depression. Inthe course of my research for our paper, I wasreminded that when people talked about the“Great Depression” before 1939, they werereferring to the period from 1873 to 1895.People’s perceptions very much play into thelabeling.

Or vice versa. “Recession” was theeuphemism they came up with after the1930s to avoid scaring folks.Dean: Yes, the assumption is that we can havean economic decline now, which we’re having,but that we know how to solve economicdeclines. We solve them with some combina-tion of monetary and fiscal policy. In our case,right now, we’re using massive amounts of


both. That’s the oldKeynesian notion andmost working econo-mists don’t dare to beanything other than aKeynesian. Theassumption is that it’ssomething we knowhow to do and we knowhow to do it fast and sowe will do it. But whatwe’re saying is that itmay either not work oractually be harmful interms of inducingmonetary instabilitylater.

Monetary instabili-ty?Dean: Yes. On aninternational scale.There are a number ofcountries –Switzerland, amongthem – who have beensaying that the interna-tional monetary system is too dependent uponthe United States. And they may try to use thisinterval to try to figure out how they couldbecome less dependent upon the stability of theU.S. dollar.

You see this an opportunity to overhaulthe international monetary system?Dean: Yes, the system certainly could use anoverhaul. But the question is whether we, asAmericans, would like to have the overhauldone to us or whether we, as Americans, wouldlike to be leading participants in the overhaul.Those are two very different things.

I can’t see the U.S. standing by passively—Dean: There was an international meeting onmonetary conditions roughly a month ago,which didn’t amount to much more than aphoto opportunity. The next one is set for lateApril. But I hear stories every once in a whilethat other monetary meetings, in which theU.S. isn’t included, are going on. I don’t knowwhether anything will come of them, but Iwould much rather have the U.S. be a partici-pant in the solution.

Yet you said earlier that you’re afraidsome of the policy moves being made willonly make things worse?

Dean: That’s right. I mean most people whohave been in government for a while – and Iwas, for little bit – are extremely sensitive to theidea that they exert leadership. The one thingyou can’t do is to say, “I don’t know.” An exam-ple I’ve often used comes from the first chapterof the management manual for officers atAnnapolis. It says that if a decision comes to thecaptain on the bridge, the main thing for him todo is to be decisive. It doesn’t much matter if hisorder is full speed starboard, full speed ahead orwhatever. Because if there was a reason for mak-ing the decision on the basis of facts, it wouldhave been made before it came to the bridge.We are somewhat in the same situation today;People are exerting leadership right now and noone wants to stand back and say, “Hey, wait aminute, we’d better think this through careful-ly.”

Gee, just because the likes of Bank ofAmerica and Citigroup keep coming back tothe taxpayers for more bailout money?Dean: They are prominent examples. We makea plea in our paper for transparency. We don’thave the data available to us to tell us about allof the loans that are out, even though we haveput a whole lot of taxpayer dollars into them. Iwould make transparency a condition of receiv-ing bailout money. I don’t mean that you have


to have all decisions made by the government orthat we need lots of new regulations. But I wantmore data on what is being lent and what isbeing done with it. If anything, it looks likewe’re actually getting less data. The Bank ofEngland has just announced that it will nolonger publish weekly figures on how muchextra money it is printing. In this country, formore than a year now, the government hasn’tpublished statistics on M3. So we’re actuallygetting less data, rather than more, perhapsbecause it might lead us to conclusions that thegovernment doesn’t want to gain currency.Anyway, I’m a strong proponent of transparen-cy instead of regulation. With transparency, theend markets can find their own balance. Yet atthe moment we may be getting less transparen-cy amid pleas for more regulation.

Mark: I would add that the things that we aredoing, because our leaders feel the need to “dosomething” are likely to work with long lags. Sowe don’t know the consequences of these inter-ventions will be. I mean, the credit crisis reallystarted in early 2007, and yet, while the stockmarket topped out that October, it didn’t reallyreflect the crisis until last fall. And the stockmarket is supposed to be a leading indicator?

Dean: Well, markets and the economy have, forthe last two or three years, been graduallypulling away from one another. Historically,yes, the stock markets led the economy but werecorrelated to it. The market had its cycle, whichled, by about six months, the business cycle andeverything moved along in time. And theintended purpose of the markets was the effi-cient allocation of capital to business enter-prise. But over the course of the last severalyears, maybe five years or so, the markets andthe economy have seemed to be moving apart.The markets have become their own beasts.Certainly, derivatives on oil and the like seemto have rather little to do with the production ofoil but a lot to do with the production of deriva-tives.

Likewise, credit derivatives.Dean: And credit derivatives as well. If youbreak them up, they have nothing to do withwhat is underneath. I’m old enough to go backto my old Graham and Dodd, which is where Ilearned about debt. According to SecurityAnalysis, the purpose of debt was project-relat-ed and debt was to be paid off from the profitsof a particular project.

How incredibly quaint.Dean: It’s extremely quaint. The idea of therollover of debt, when I first worked umpteenyears ago, was seen as very strange. The ideathat debt would become a permanent fixture onthe balance sheet, or that you could break itapart and never put it back together would havebeen considered very weird.

Mark: Nixon made currency irredeemable in1971 — at about the same time that WalterWriston started talking about managing the lia-bility side of the balance sheet, and since thenwe seem to have evolved liability managementall the way to the consumer, in terms of creditcard debt.

Dean: From where I sit, we seem to be in some-thing of a “through the looking glass” situa-tion. We may be putting something back togeth-er. But it’s the old story, we’re looking throughthe glass and there’s another world on the out-side. And we don’t have the tools from our expe-riences of the last couple of decades to under-stand what we may be getting into. Yet those arethe sorts of tools our society is designed todepend on.

You mentioned some alternative tools,however, in your paper —Dean: And those unconventional alternativeswere why the paper was rejected by FAJ.

They definitely don’t fit into value-at-riskmodels, then again, VAR analysis hasn’texactly covered itself in glory.Walter: Part of the problem is that all of us, butespecially technical analysts like me, deal onpast experience and none of us have livedthrough something like this before. Even ourelders haven’t lived through it before. So wedon’t have experience to go on or to. Duringthe Crash of ’87, you could go back to the Crashof ’62. During the unwinding of the technologybubble, you could go back to the unwinding ofthe Nifty Fifty bubble. But in this situation, youhave to go back to the 1930s to find some simi-larities. And anybody who was around back thenand is still with us was in a crib in the 1930s. Sowe are all learning for the first time and thatmakes it a little tougher.

Not to mention that many modern ana-lysts simply can’t conceive of going backthat far, because the data sets on theircomputers stop well short. Mark: I actually would go back even farther


than the 1930s, but I have tosay that I start to lose someof the historical contextwhen I go back generations— unless I’m simply not dig-ging hard enough.

Dean: We joke that Markdoesn’t talk to any livingeconomists. He only talks tothe dead ones.

Mark: They can’t shootback.

Dean: But I talk to the livingones. It’s one of the reasonswe mesh well together.

Mark: I like to think that ifKeynes were alive today, hewould not be a Keynesian.

I’ll bite, why not?Mark: Because he was deal-ing with the times in whichhe lived. He was very bril-liant, very clever, as well,and he also famously said hechanged his mind because“the facts have changed, sir.” And because Ithink what are known as Keynesian economicshave been corrupted or politicized over time.

Dean: Keynesian economic solutions havebeen overused. They have been applied five orsix times since World War II, and the seventhtime, we may discover, they will have no effect.

Mark: Right. This time, only if the answer totoo much credit is more credit, can theKeynesian be right.

It does seem like prescribing “a hair ofthe dog that bit you” to cure a hangover. Mark: Well, you can argue that FDR’sKeynesian policies shocked us out of a situa-tion where the gold standard probably hadgone too far and probably had itself becomeharmful. So Keynesian policies, back then,were able to shock us out of a self-feeding prob-lem. Similarly, when Paul Volcker dramaticallyraised interest rates, he was able to shock usout of another set of self-feeding problems. Butnobody is talking about anything policy-wise,that would be similarly painful or wrenching orshocking here.

We need somebody to hold paddles and

yell, “Clear!”?Mark: I don’t know, but I am skeptical thatmore of the same is the answer here— and Ithink Dean and Walter would agree.

Dean, you publish something called the ComplexityDigest and consort with scientific theorists whowrite on levels that addle my brain. What are theysaying about our fine economic mess? Thisfoundering financial system was allowed to becomefar more complex and convoluted than almost any-one realized during the credit boom. Yet the“solutions” being proffered are pretty linear,whether Keynesian or Austrian. Dean: This is a perfect application, if thereever was one, for complexity science. Butunfortunately, the few complexity theoristswho are economists are engaged in otherthings; distracted for one reason or another. Sothere is nobody whom I know of who’s reallydoing a good job of studying this, at the SantaFe Institute or elsewhere. It’s too bad becauseit is a dynamic problem; it’s an interesting oneand it’s one that complexity theorists shouldhave a lot to contribute to. I can only do it inthe most superficial way possible, by sayingthat and trying to encourage a few friends tospend some time on it. But they’re engaged inother things and don’t see any way in which thepolicy makers would do anything with their



research, anyway. Of course, that shouldn’t be adeterrent. Anyway, this is a perfect example ofa mixture of a structural problem, an interna-tional problem and a behavioral finance prob-lem all mixed up in a stew that should be dealtwith together, so it would be perfect as the sub-ject of a convocation or conference of complexi-ty theorists. But as far as I know, none isplanned.

It sounds like a failure to engage with thereal world to me. Dean: Yes, I think so. And the failure is mine.I’ve tried to stimulate something, but I haven’tbeen very successful. But it should be donebecause we should be playing chess rather thanplaying checkers.

Among the things that tell you that, youpointed out in your paper, are the volatilityextremes we’ve seen in the market?Walter, I assume you did that technicalwork —Walter: I did the digging and then Mark didthe interpreting. He may not admit it, but Markis a gifted technical analyst.

Mark: I’m proud of it; it’s the only way I canmake any money. There are many ways you canlook at volatility, but they all show pretty muchthe same thing. What we wanted to show in thechart [page 1], though, is that while elevatedvolatility is clearly a bear market phenomenon,extremely elevated volatility is not an unam-biguous signal. That’s because the most recentexample (before last year) of extreme 20-dayvolatility on our chart was in 1987, which was atthe beginning of the Greenspan era; when hefirst got into the practice of “liquefying” a cri-sis. And that volatility, and crash, we know inretrospect, were “just” cyclical corrections,dramatic though they were, in what was still avery young secular bull market. We also looked[in the table inside the chart] at the market’svolatility expressed as a standard deviation ofdaily closes in excess of 5% over an averagetrading month. It was striking that the autumn2008 decline had 12 days with greater than a5% move, either up or down, in the Dow JonesIndustrial Average, versus 11 of those days inOctober, 1929.

You also looked at some other marketcycle indicators that have long been allbut forgotten—like Edson Gould’s “Senti-meter.”Mark: Yes, and later we point out where we inthings like the Dow/gold cycle and where weare in the Kondratieff cycle. We can go into all

of the details, but the bottom line is that themarket has given us a behavioral signature that,to be very honest, is very similar to the initialdecline into the 1930s bear market. As weacknowledged early in this conversation, it’svery dangerous in markets to say, “It’s differentthis time.” On the other hand, we started ourpaper with that quote from Bob Farrell abouthistory not repeating, but behavior doing so.Which is why we wanted to look at these behav-ioral signatures in the market.

Dean: And we reached back a little bit fartherthan most people have been in the past year or so.

I’ll say, Edson Gould.Mark: Did either of you know Edson Gould?

Walter: I did. When I worked at Manhattan Fund,Gerry Tsai was very taken with Edson, so he sentthe other technician and me downtown oneafternoon a week so that Edson Gould couldexplain all his stuff. So not only did I know him,I was taught by him.

Mark: He evidently got an awful lot of mileageout of his “Senti-meter” model [chart, page 4].Am I right?

Walter: Yes. It worked really, really well until itstopped working in the late 1990s. But that wasafter he’d died, I believe.

It stopped working when the S&P blew wayabove its channel, and it’s only recentlycome back to touch that long-term chan-nel’s top again. Kind of makes you wonderwhere reversion to the mean will take it.Your chart says 505 would only be thebottom of the channel.Walter: Yes, the problem with reversion to themean is that the mean is an average of a highand a low. So when you revert to a mean, thatdoesn’t mean you’re going back to the middle ofa range and stopping. The mean is halfwaybetween a high and a low or halfway between awhole series of highs and a whole series of lows,so the risk is not reversion to the mean butreversion to the lows.

Exactly. Overshoot to the upside, thenovershoot to the downside and the meanis the middle.Walter: Yes, except everybody is yapping aboutreversion to the mean rather than to beyond themean.Mark: Are you suggesting, Walt, that Gould’sband changes as it moves?

Walter: No, I’m suggesting that the mean isbetween 3% and 6%, so you’re not likely to stopat 3%; the odds say you’re more likely to stop ata 6% yield.

Mark: You also can come back to commonsense and say that a 3% yield is arguably a mini-mum hard yield acceptable on a residual claim;a yield that’s a real return of capital. The thingis that in the 1930s, the S&P went a hell of a lotfarther down. When I looked at that data, I alsonoted that the dividends were also decliningback then. Which is why it’s worth explainingthat the 505 level we have marked on that chartwould represent a 6% yield if dividend payoutsremain unchanged. But in the 1930s, they did-n’t, of course. Payouts, if I recall correctly,declined by a third.

Hardly surprising, considering what washappening to earnings. So Gould’s charttells you—Mark: Look out below.

Which I take it is also the message of yourDow/Gold chart and your various S&P val-uation charts [page 5]. Mark: Right. As you know, the Dow/gold ratiomeasures how many ounces of gold it takes tobuy the DJIA (currently 12) and, according toits followers, reveals long pendulum swingsbetween financial asset and hard asset eras.One interesting thing about the Dow/gold ratiois that you can see that — even if you’d been try-ing to interpret it in real time — back in 1987 itcould have given investors real help in navigat-ing the astounding short-term volatility experi-enced in the Crash.

How so?Mark: Well, you can imagine what people werethinking in 1987. They had this volatility thathadn’t been seen since late 1929 and, at thesame time, the P/E ratio was as high as it hadever been, which was 20.

I don’t have to imagine. I remember it well.Mark: Well, if you would have looked at theDow/gold as a proxy for valuation, you wouldhave found reason to doubt that the top was in. It was only at a five multiple and you would haveseen that prior cycles had gone much higher. Sorecognition of a rising Dow/gold phase couldhave helped keep investors in the still-youngbull market. By the same token, today'sinvestors should be very cautious becauserecent volatility has taken place in a Dow/golddowntrend.

Dean: There’s one measure we didn’t put in ourpaper which may be among the best of all as amarket forecaster, and that is the number ofpeople engaged in financial services. The num-ber of CFAs, right now, is approximately100,000 around the world. The total is growingfaster globally than in the U.S., but the lastnumber I saw had it still growing on the order of18% annually. We have yet to see any substan-tial decline in that number, as far as I know, butI assure you, we will see mean reversion in thatseries, too, to a lot fewer than 100,000. Thatmay end up being one of the best indicators towatch.

Walter: How many fewer 100,000?

Dean: I don’t know. But services in theUnited States now contribute about 45% ofGDP. That number is going to be a lot less thanthat because we can’t all be providing services.

Walter: Would you like to repeat the numberthat you mentioned to me at the ContraryOpinion Forum?

Dean: Go ahead. I’ve conveniently forgotten it,but you evidently haven’t.

Walter: Well, you predicted that the total willbe cut in half.

Dean: That’s a modest forecast. I’ll stick withit, sure.

Mark: Why not? Have you heard the bad jokecirculating among traders about what CFAstands for now? “Can’t Find Alpha.”

That’s pretty good. But I like the namethey quickly came up with for the combi-nation of Shearson and J.P. Morganbetter—“Citi-Morg.”

Mark: I’m writing that down.

While we’re on dark topics — whatevermoved you guys to add a discussion ofKondratieff wave cycles to your paper?Walter: No discussion of long-term marketcycles would really be complete without delvinginto Kondratieff-wave theory, even if it is prettywell shrouded in mystery because its creator,Nikolai Kondratieff, died at age 46 in a Russiangulag. That was in 1938, when Joseph Stalin atthe peak of his power and Nikolai make the mis-take of predicting that capitalism would, onceagain, revive and flourish.


Dean: He was a real victim of the sort of“career risk” everyone in Wall Street worriesabout these days.

But why get into Kondratieff waves? Mostmodern economists tend to sniff that K-cycles are unscientific and wide open tovastly different interpretations.Walter: We make a point of saying that weremain skeptical of the theory as market practi-tioners but find its descriptive power interestingat this juncture. We believe that its descriptivepower is more important that its lack of timingprecision.

Mark: I’ll be a blabbermouth. Obviously, it waswritten in Russian and it really wasn’t written todescribe the stock market.

Dean: It was written to describe commoditiescycles back then, because economies in his daywere agricultural. But basically, we think K-waves deserve attention as an interesting histor-ical construct. And we point out that dismissingthem as unscientific hasn’t helped economistsavoid repeating historic mistakes.

Walter: One stumbling block for economistshas been that as originally postulated, theKondratieff wave was a generational phenome-non. But maybe it is really a lifetime phenome-non. If so, the longer life expectancy we havenow, compared with the 1930s, may be what hasapparently lengthened the old 50- to 54-yeartimeframe of a K-wave cycle. Maybe we’re notlikely to repeat the excesses of earlier genera-tions until we lose the personal guidance ofthose who lived through the last K-wave downcycle.

Dean: It’s not in any sense a precise tool; as K-waves go from one phase to another the pacingis not absolutely exact. But it’s a helpfuldescriptive tool as to what kinds of things youmight be looking for when you think that you’reat a shifting point from one very long termphase to another. When you look at the chart[page 7], you can see that the financial marketsare doing something unlike anything we haveseen since the 1930s, and that we are likelyworking our way down to a Kondratieff trough.In K-wave terms, we are moving from Autumnto Winter. Just as the current decline is unlikethe declines of the past 60 years, the ultimatebottom is not likely to resemble the bottoms ofthe past 60 years, either. This, in turn, meansthat the next bull market is also not likely toresemble the bull markets of the past 60 years.So this is not your father’s bear market, just like

it’s not your father’s recession.

Mark: I have to say that I used to be somewhatdismissive of K-theory, because I didn’t feel Icould trade it. But the more I’ve worked with itand contemplated it, the more I’ve discoveredthat it does open your mind to potential out-comes that you wouldn’t otherwise be open to.It’s unfortunate that it’s regarded as a bit of athird rail in the industry.

Dean: Well, one of the things that we’d hopedto do if the FAJ published our paper — was toopen up pathways to look at data when it is con-sidered very dirty (as in, before the 1930s);open up pathways for exploration. As Waltersaid, very few analysts using conventional tools,had any idea this crisis was coming. The longterm cycles we explored all have one thing incommon: a message that the ultimate lows inthis cycle may be considerably lower thanNovember’s scary lows. Based on the historicalevidence, what’s more, we are likely to experi-ence either painful debt deflation or highlydestructive monetary inflation— and perhapsboth at the same time. (Yes, it’s possible to havedeflation from asset destruction on a monu-mental scale at the same time as inflation fromthe ultimately successful increase in the moneysupply engineered to combat the deflation.Tools to fight the negative effects of one mayaggravate the downside of the other.)Meanwhile, we expect governments to continueto follow the seemingly easy path of heroicintervention until forced to confront the issueof sound money.

What you’re implying, then, is that we’refacing not merely a winter of discontent,but several winters of discontent?Dean: The artful tool of the Kondratieff theoryactually gives us guidance that the declinemight last another 5-10 years — or longer. Andmeanwhile, we question whether governmentintervention, which works in batch-processingtime, can fix major structural problems in mar-kets that adjust in real time. We worry, too,about interventions that could underminethings like fundamental property rights, inter-national cooperation and personal freedomsthat were crucial to capitalism through much ofthe 20th Century. I haven’t kept very close tabson this, but my impression is that almost everytime we have announced a stimulus package oran enhancement of a stimulus package, the U.S.stock market has gone down. Now, you mightsay that the markets have already discountedthe news, but there may be something elsegoing on. We might be doing something harm-


ful in those stimulus packages — and that iswhat the market declines could be reflecting.

Mark: This gets back to an earlier point Deanwas making. There seems to be almost a cava-lier attitude on the part of policy makers.They’re not worried, as we are, about unintend-ed consequences. Just imagine how different itwould be if a policy maker sat down and startedwith the idea that this may be a long-term situa-tion — and that whatever he does might make itworse. Somebody should be worried about theconsequences of these interventions.

Are you suggesting that Washingtonshould have just stood back and watchedthe credit system ice over?Dean: No. We’re not that Austrian. But wedon’t think tired Keynesian prescriptions willwork either. To repeat, we need to play multi-strategy chess, not checkers. I can’t speak forWalt and Mark on all of these points — and evenwe don’t claim government policymaking as acore skill. But if pushed, my Rx would include12 or 13 elements: 1) Targeted spending, a neg-ative sales tax and government participation innew loans. 2) An open invitation to foreignersto invest in the U.S. 3) Transparency every-where, but especially where government moneyis spent or lent. 4) Having the Treasury borrowin foreign currencies now, before we have to. 5)For its symbolic import, dedicating ourselves toan advance paydown on foreign debt. 6) Puttingthe government, wherever possible, on a pay-ment for service basis. 7) Cutting the defensebudget by 50%. 8) Promoting internationaltrade to blunt the growing anti-trade sentiment.9) Eliminating agricultural subsidies. 10)Forgetting ethanol. 11) Reorganizing the UNwith teeth. Bring Brazil and India into theSecurity Council as permanent members. 12)Signing the Kyoto and International Courttreaties to signal internationally that there real-ly is a new administration in town. 13)Realigning the monetary system to create back-ing for the U.S. dollar along the lines of thetrade-weighted Singapore system.

Those are some mighty tall orders. Dean: Well, the first thing government policyshould do is do no harm. That’s where trans-parency comes in. If we want to give some bank$25 billion, we should do so at the price that theycompletely open their lending books. That way,the market would be allowed to assess the risk andthe reward. It’s interesting, Bob Schiller says thatthe real estate market overall is approximately40% overpriced now, in relation to nationalincome—and national income is falling. Well, if

that be true – and it doesn’t sound like bad analy-sis to me – then attempting to stop foreclosures atthis level is a mug’s game. The market has got40% to drop, just to get to even. Trying to hold ithere artificially just can’t work.

What would you do instead?Maybe even something as wild as buying uphousing stock that is likely to be foreclosed andturning around and renting it to the occupants.The United States is one of the very few coun-tries that predominantly has owner-occupiedhousing. In Switzerland, for example, very fewpeople own their own houses. Almost every-body rents.

Mark: Trying to revive the market that was theproblem, if it has gone to an excess, is usuallyhopeless.

Walter: There was that famous attempt duringthe Crash of ’29, when the bankers’ pool camein and started bidding for stocks. It stopped thedeclines for an afternoon and that was it. Thenthe prices went to where they were going to go.

Mark: Right, despite statements from John D.Rockefeller that sound a lot like the onesWarren Buffett was making back in October orNovember.

So Humpty Dumpty is kaput; nothing isgoing to bring back the Goldilocks environ-ment of the late bull market and billions ortrillions of debts have to be liquidated?Dean: I am afraid so. I do have a crazy idea, ifyou want to stimulate consumer spending,which I’m not sure is a great idea here. I dothink too much consumer spending, and debt,were parts of the problems that got us here —and added to the trade deficit. But if you didwant to stimulate spending for a while, the gov-ernment could institute a negative sales “tax.”Just reset every cash register in the country toadd a subsidy, instead of deducting a sales tax,on each transaction. Again, I’m not sure it’s agood idea in our present circumstances, but itwould be a more efficient way to encourage con-sumer spending than income tax rebates.

So suppose President Obama called andasked you to help rescue the Treasury—Dean: We’d have some suggestions, althoughI’m sure we wouldn’t agree on everything. I waspart of a World Bank group that went to LatinAmerica in the ’70s and lectured Brazil andArgentina and Chile about how to behave finan-cially to rejoin the world’s markets. We hadseven looseleaf notebooks, and we went


through them one-by-one. We were terriblyobnoxious.

You didn’t start by warning, “Beware ofAmerican bankers bearing gifts?”Dean: No, but we should have. They werevery polite and listened, even though a lot ofthe advice that we gave them was contradictory.I mean, we said pay off some loans to demon-strate that you are aware of the importance offiscal prudence. But you can’t pay them all off.Tighten up your economy but at the same time,stimulate through government projects andclean up corruption and improve transparency.How often have I thought that those prescrip-tions for Brazil should have been applied to theUnited States, as well. Brazil is in much betterfinancial shape today than we are.

Thanks very much to the commodities boom.Dean: That’s right. It was serendipitous, tobe sure.

Transparency is a lofty goal, Dean. ButWall Street always wants it limited to theother guy. Dean: That’s true. I’m horrified by the idea,by the way, that there are all of these so-calleddark pools. Where, essentially, 20% of all stocktrades take place but never get reported, any-where. There’s no history on them. It is utterlycontrary to the things that I believe about howyou should have price discovery over a period oftime. We have been moving away from trans-parency in the equities markets.

Trying to match, perhaps, the opaque natureof the credit markets, where people blithelyplaced billions of dollars of derivative bets in“dealer markets” in which they were essen-tially making side bets with the croupier. Dean: All of that has to be cleaned up. But youknow, poor old Chris Cox has been beaten up forbeing a bad SEC Chairman. But that’s not true;he did exactly what he was told to do. Theadmonition was, “Now, Charlie, you sit here fora couple of years but don’t touch anything.”

True enough. But “I was just followingorders” isn’t a defense. Dean: I’m just pointing out that it’s too easy tofind scapegoats instead of fixing the structuralproblems that got us into this mess.

Mark: I don’t have expertise here — but I sus-pect you will see major reforms of the over-the-counter derivatives markets. Exchange-tradedderivatives have a pretty good track record.Margin clerk works pretty well, as do standard-

ized contracts. Besides, how many derivativescontracts do we need? I have all the risk I canhandle in the cash markets.

But that was the beauty of it all, thederivatives provided immense leverageand were supposed to hedge those risksinto oblivion. Mark: Even better, the over-the-counter deriv-atives could be kept off balance sheet, so therewas all sorts of room for nonsense in internalmarks and valuations, because there were nomargin clerks.

Walter: See, these are the problems we are try-ing to get our hands around with theKondratieff analysis. What we are saying is thatthe markets go from wild and woolly, unregulat-ed, to a clamped down and heavily regulated.You can’t quantify exactly how wild and woollythey got, but we know they were wild and wool-ly, and we also know the pendulum is swingingthe other way. The same thing happened in the’20s and ’30s, when we swung from wild, woollymarkets to the formation of the SEC, and allsorts of other regulations.

So you’re not at all sanguine that we’veput in a bottom?Walter: The rule is that financial stocks gener-ally bottom and start generating relativestrength before the market bottoms, which weobviously have not seen yet. That’s the scarything.

You’ve been skeptical of the November“bottom” pretty much all along —Walter: That’s true. And the fact that some ofthe key bank stocks are breaking theirNovember lows is not a good sign.

Dean: On another level, the close cooperationwe’ve been observing between the Fed and theTreasury isn’t really a good thing. Centralbankers around the world like to think of them-selves as very separate and independent ofpolitical influence. When they meet monthly inSwitzerland under the auspices of the Bank ofInternational Settlements, they almost alwaysgrouse about having to correct for mistakesmade by their governments. If the U.S. Fedstarts to be seen as the Treasury’s partnerunder Bernanke as it was under Greenspan, itsposition among the other central banks will becompromised. Foreign central banks will beless likely to speak openly, and less likely tocooperate with the United States at the centralbank level.


If October demonstrated anything, it’sthat we need far more coordination andcooperation in international finance. Andquite possibly a new international mone-tary regime. Dean: Right. It’s very unfortunate that theU.S. Fed is the only central bank with a com-bined mandate for both monetary stability andeconomic growth. The other central banksonly target economic stability.

You make no bones in your paper aboutharboring some Austrian leanings and docall for monetary reform, but not for theclassic Austrian solution of a gold stan-dard?Mark: We’re not that cynical. We believe thatpeople will use fiat money. We aren’t Austrianeconomists, however interesting and useful wefind some of their economic principles, asinvestors — things like it’s the boom that causesthe bust; the bust is proportionate to the boom;major intervention is likely to cause major unin-tended consequences and that sound money isalways the preferable policy. The problem withthe Austrians, from my/our perspective is thatmany of them are too rigidly dogmatic: Noinductive reasoning; no fiat money; no fraction-al reserve banking.

Dean: As practical investors, we’d rather payless attention to lofty principles and more atten-tion to what is going to work. The attitude ofthe world toward the U.S. too long has been oneof disdain for its aggressive and self-destructivemonetary policies. Now, with new leadership,there will be a new assessment. I am worried,though, that expectations are vastly too high.

Isn’t some disappointment natural, whenthe honeymoon wears off?Yes, but I’m concerned that in this case whatwill follow is a drive for “anything but dollars”on a global scale, a drive that the U.S. won’t beable to control. I can see global system beingimposed upon the U.S., in which each countrysupports its currency by holding reserves inproportion to its trade balances – somethingakin to what Singapore does today. Should thathappen, you’d have to hope that Kondratieff'sWinter is not an icy blanket of “beggar thyneighbor” protectionism. But that seems to becoming to the fore in a number of advancedcountries and even gaining political popularity

in the United States. If so, the Winter could be adecade or two long. To forestall that, I hope tosee the U.S. taking a generous step forward, andasking its trading partners, “What can we do tohelp you with your dollar problem?” At themoment though, very few people in the U.S. areacknowledging that the rest of the world has amajor stake in how the United States solves itscurrency problem.

Mark: All the talk here is about granting for-bearance, when we really need to seek forbear-ance.

Dean: Exactly, and that’s what the othercountries are saying. They’re saying, “The newU.S. administration says it will listen, but wedon’t hear you asking the question.” Granted,it’s early yet, but I don’t see Larry Summers, forexample, talking to his counterparts in othercountries. It will be very interesting the firsttime that the U.S. has to borrow money in some-thing other than it’s own currency.

Mark: Shocking, you mean.

Dean: Yes, which is why I’d be inclined to do iton a voluntary basis, before we are forced to doit because no one shows up at a Treasury auc-tion. I don’t see that as likely, but it would reallysend a message to the rest of the world that theU.S. is ready to take the risk of somebody else’scurrency the same way they have been taking arisk on ours for the last 25 - 30 years.

That would be a show stopper. Let’s closeon a more practical note, though. Walterhas been counseling caution and holdinginsurance for some time. What are youdoing, Dean, to try to cope with all of thisas an investor? Dean: My recommendation is what I call adumbbell strategy. Gold on one side and cashon the other side. One of the two will be rightand, hopefully, both sides are mispriced in rela-tionship to what the actual risk and return arelikely to be. It’s a complexity portfolio strategywhere you’re doing two things in roughly equalbalance; one side is wrong, but you don’t knowwhich one. And the name, dumbbell, applies toboth the strategy and the originator.

Right. Thanks, gents.

Weeden & Co. LP’s

Research DisclosuresIn keeping with Weeden & Co. LP’sreputation for absolute integrity inits dealings with its institutionalclients, w@w believes that its ownreputation for independence andintegrity are essential to its mission.Our readers must be able to assumethat we have no hidden agendas; thatour facts are thoroughly researchedand fairly presented and that whenpublished our analyses reflect ourbest judgments, not vested pocket-book interests of our sources, col-leagues or ourselves. Neither Weeden& Co. LP nor w@w engage in invest-ment banking; w@w’s mission isstrictly research.

This material is based on data fromsources we consider to be accurateand reliable, but it is not guaranteedas to accuracy and does not purportto be complete. Opinions and projec-tions found in this report reflecteither our opinion (or that of thenamed analyst interviewed) as of thereport date and are subject tochange without notice. When an unaf-filiated interviewee’s opinions andprojections are reported, Weeden &Co. is relying on the accuracy andcompleteness of thatindividual/firm’s own research disclo-sures and assumes no liability forsame, beyond reprinting them in anadjacent box. This report is neitherintended nor should it be construedas an offer to sell or solicitation orbasis for any contract, for the pur-chase of any security or financialproduct. Nor has any determinationbeen made that any particular securi-ty is suitable for any client. Nothingcontained herein is intended to be,nor should it be considered, invest-ment advice. This report does notprovide sufficient information uponwhich to base an investment deci-sion. You are advised to consult withyour broker or other financial advi-sors or professionals as appropriateto verify pricing and other informa-tion. Weeden & Co. LP , its affiliates,directors, officers and associates donot assume any liability for lossesthat may result from the reliance byany person upon any such informa-tion or opinions. Past performance ofsecurities or any financial instru-ments is not indicative of future per-formance. From time to time, thisfirm, its affiliates, and/or its individ-ual officers and/or members of theirfamilies may have a position in thesubject securities which may be con-sistent with or contrary to the rec-ommendations contained herein; andmay make purchases and/or sales ofthose securities in the open marketor otherwise. Weeden & Co. LP is amember of FINRA, Nasdaq, and SIPC.

W@W Interviewee Research Disclosure: Dean LeBaron is the founder and former chairman of Batterymarch Financial Management. Walter Deemer is a technical analyst who has published“Market Strategies and Insights” since 1980. Mark Ungewitter is Vice President and portfolio manager at Charter Trust Co. This interview was initiated by Welling@Weeden and contains thecurrent opinions of the interviewees but not necessarily their respective companies. Such opinions are subject to change without notice. This interview and all information and opinions dis-cussed herein is being distributed for informational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or invest-ment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. In addition, forecasts, estimates and certain information containedherein are based upon proprietary research and should not be interpreted as investment advice, or as an offer or solicitation for the purchase or sale of any financial instrument. No part ofthis interview may be reproduced in any form, or referred to in any other publication, without express written permission of Welling@Weeden. Past performance is no guarantee of futureresults.


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