– 09 Jan 2007

Rear view syndrome

In a great book “Five Eminent Contrarians: Careers, Perspectives and Investment Tactics” the author, Steven L. Mintz, writes about Michael Aronstein of Comstock Partners.

“On the links at the Westchester Country Club, Michael Aronstein is nearly as awesome as the giant clubhouse-hotel that is a throwback to the 19th century. He’s a scratch golfer who might have earned a spot on the professional circuit if someone has taught him the proper way to grip a golf club. As it is, he has had to settle for top golfer at the keenly competitive country club and a volatile career on Wall Street, where an unorthodox grip fosters his iconoclastic outlook.

Golf magazine’s former instruction editor argues that profligate use of credit ultimately breeds deflation, not inflation as conventional observers suppose. That is not good for owners of financial assets—the last bastion to withstand the tidal force of worldwide deflation. The current credit cycle will end the way every previous cycle has ended for 2,000 years, says Aronstein, with a default by the biggest borrower. It’s unthinkable until it happens, and then it happens. When the wave hits, prices of financial assets will plummet. Contracts tied to these assets, from home loans to multi-billion dollar commercial loans, will transmit ill effects to the rest of the economy just as ill-conceived commercial loans played havoc with banks and thrifts.

Prices, therefore, are pinned to nothing more palpable than expectation of what prices will be tomorrow. This is as true today, he warns, as when frenzied Dutch investors bid prices of tulip bulbs to stratospheric levels in the 17th century Tulipomania. Not only can it happen here, he says. It will. The wrecking ball is already in motion.

Critics consider Aronstein unduly pessimistic about the prospects for financial assets, but they acknowledge that the argument has merit. “Though it seems almost contra-intuitive, there is a chilling logic to it,” Barron’s reported in August 1989.

On the strength of his convictions, Aronstein surrendered most of his interest in Comstock Partners in 1992 to launch his own firm, West Course Capital—named for one of the Westchester Country Club’s two golf courses. “The whole premise is to give people an alternative to forms of wealth storage that are now popular,” he says. If the crowd wants financial assets, Aronstein reasons, then real value must lie somewhere else, namely, in commodities. So West Course Capital invests in commodities, but not in the fashion that commodities have come to be viewed by traders.

To Aronstein, commodities markets in 1994 resemble the bond markets in 1981 and 1982, after a thirty-year bear market drove out all players except hard core bond traders who live and die with each uptick or downtick. They focus on supply; Aronstein watches demand.

When intuition supported by exhaustive research persuades Aronstein to anticipate an upsurge in demand for a commodity—say lead, or cotton, or coffee, or even hemp—Aronstein invests long term, rolling contracts over at maturity rather than taking profits or losses at frequent intervals. It is a sort of Graham and Dodd approach to commodities, using many techniques of fundamental value investing. That this sounds odd to modern ears supplies one more piece of evidence that Aronstein is on the right track. Fundamental analysis with no companies? Says Aronstein: “Commodities are the most fundamental things. There are no treasury departments, no threats of tax increases. Commodities are the original concept of money.”

Initial results support this offbeat concept. “So far, so good,” offers Aronstein with characteristic respect for the vagaries of market behavior. In its first full year, 1993, West Course Capital generated a 15 percent return on investment, net of fees—outpacing the S&P 500 (adjusted for dividends) by five percentage points. Aronstein’s biggest single investment was in coffee, which he predicts will reverse a decades-long decline in consumption as baby boomers’ increasingly forgo soft drinks—a conclusion supported not least by the rapid proliferation of cappuccino makers. More convincing still, the price of coffee chalked up a 90 percent gain soon after Aronstein began to accumulate contracts. Nevertheless, Aronstein’s investment style won’t ever win over most investors. It can’t by design. “I just hope the wind is at my back,” Aronstein says, “and then try not to do what other people in my business are doing.”

Aronstein fell out of step with other folks in his business almost as soon as he arrived on Wall Street in 1979. Small surprise, for a Yale graduate who wrote his senior thesis on the poet Wallace Stevens. “Michael Aronstein, of the famed Comstock Partners, is extraordinarily bright, reflective and articulate,” Barron’s gushed in April 1992, “which always prompts the question, ‘What in the world is he doing on Wall Street?’”

Aronstein gives this explanation for an investment career: “The whole process of financial analysis didn’t intimidate me,” Aronstein says. “I didn’t see in reading the Wall Street Journal and Barron’s that there was a Wallace Stevens, where I would say, ‘Jesus, that’s fantastic, but I can’t write that way.’ I didn’t see a Stephen Hawking (the acclaimed author of A Brief History of Time). I looked and said I could compete in this field. It just seemed to suit my way of looking at things.”

He took his first job at Merrill Lynch, the giant wire house that is almost a proxy for the crowd, after friends urged him to join IBM, the only other employer willing to train him for a management role. Merrill paid about half the starting salary, but Aronstein soon found ample compensation in a small group of like-minded colleagues. With Merrill veteran Stan Salvigsen as tutor, Aronstein expanded his intuitive understanding of the way financial markets operate. “[Salvigsen’s] work in 1970-1980 was seminal,” Aronstein says. “It agreed with things I had thought, but it was the first really rigorous exposition of long term credit cycles and long wave bond prices. It was instrumental in opening my eyes to how things worked.”

As their collaboration progressed, Aronstein emerged as the expositor. His flair for expanding and articulating implications resulted in a series of economic analyses that were as fresh as their wacky titles: The Big Enchilada; Homesick; Bingo, Bango, Bongo; Little Shop of Horrors; Snouts, Lips & Tails; Twin Peaks; 32ds Over Tokyo; That Ain’t Mud on Your Boots, Partner, to name a few. It was splashy marketing if nothing else. And from someone who lasted only six months in the public relations business before being fired for coming to work late.

Once it became obvious that their bearish outlook didn’t jive with Merrill’s bullish image, Salvigsen, Aronstein and a third Merrill colleague, Charles Minter, formed their own firm, Comstock Partners, in 1986. “We knew we wouldn’t be able to talk about out view of the world,” Minter says. “There is no way to run a large brokerage firm with a negative point of view.”

Never mind that Comstock’s contrarian analysis was grounded in the work of classical economists like J.M.Keynes and Ludwig von Mises, or that Salvigsen and Aronstein published dead-on predictions that sky-high prices for oil and commercial real estate were due for comeuppance. Or, for that matter, that they said that inflation was not as intractable as it seemed after almost two generations.

On their own, they quickly drew a following. They polished Comstock’s fledgling image by pulling clients’ money out of the stock market in August 1987, on the very day that the Dow Jones Industrial Average touched a high that it did not surpass again for several years. And then they weighed in with a timely prediction that spiraling prices for residential real estate would come to an abrupt end.

Visions of Armageddon suit Aronstein, an affable worrier with a poetic bent. In an era where most of his peers tend to trace their roots to Paul Samuelson and Milton Friedman, Aronstein is more of a renaissance type. Armed with a photographic memory, he has attacked the library of modern and classical economics without ever having taken a survey course in the subject. But he puts as much or more faith, at times, in lessons from literary giants like Wallace Stevens, whose treatment of disorder and renewal has plenty of resonance in modern finance.

These intellectual bearing seem odd if not wholly irrelevant on Wall Street today—in sharp contrast with past eras when finance was nearer the world of letters. Maybe, however, the kinship between finance and letters remains closer than most observers believe. Time will tell.

Deep-seated pessimism separates Aronstein from fellow contrarians, who usually are optimists as a necessary condition of their out-of-favor investment strategies. But if the last vestiges of wealth do go down the tubes, he is not likely to rub his hands and gloat. Like a modern-day Cassandra, who warned to no avail that tragedy awaited Agamemnon, Aronstein bears ominous tidings with considerable dread. He does not expect most people to pay attention. Nor, in any event, will paying attention reverse the trend. Fate has handed Aronstein a nasty job. The only question is, when to launch the lifeboats.

That’s a tricky question, especially for contrarians. Lowering the life boats late is disastrous, of course. But lowering them too early also carries a stiff penalty, a lesson that Comstock Partners learned only too well in 1991. Convinced that bloated financial assets were in imminent danger of shrinking, Comstock stayed out of the stock market. Meantime, April 1991 saw the Dow Jones Industrial Average roar past 3,000 for the first time in history. Standard & Poor’s 500 stocks gained more than 30 percent while Comstock barely eked out half as much for its investors. From a lofty berth in the universe of top tier institutional investment managers, the young firm crashed to less-than-average performance. The excruciating plunge highlights the soul-searching that sometimes lurks in wait for investors who chart a contrarian course.

Aronstein’s dire predictions about looming deflation are linked to wealth creation, a core concept in capitalism. Each time a bank lends, it creates a new asset for itself and corresponding liability for the borrower. But it does not create the means to pay interest costs. In early stages of a credit cycle, wealth resides in the hands of suppliers of commodities. Over time, the interest burden drains wealth from suppliers of commodities to suppliers of labor. Then, in the terminal stage, wealth ends up in the hands of the holders of financial assets. It’s what Aronstein calls Bingo, Bango, Bongo. After inflation’s final hurrah, the much touted magic of compound interest turns diabolical, working its effect on the liability instead of the asset. Instead of creating wealth, deflation destroys it.

Countries dependent on commodities in South America and Africa felt the deflationary wave first, as commodities prices swooned. The means of paying interest costs evaporated, but the accumulated debt remained—as if the balloon burst and left a corpus of debt resembling an indestructible Plexiglas block, too heavy to lift.

After toppling governments on southern continents, deflation moved north. It hastened an end to the Soviet Union, a giant, inefficient, third world-esque system highly dependent on commodities. “It starts with the weakest ones first,” Aronstein says. “That’s why I couldn’t understand people here celebrating the collapse of the Soviet Union. It was like a miners’ canary dropping dead when gas begins to leak in the coal mine. It should not be a point of amusement.”

From the time he landed at Merrill Lynch, Aronstein sniffed something potentially explosive. Hired to become a stock broker, selling stocks made him uneasy. He could not persuade himself to cash in on investors’ stunning capacity for overindulgence and self-delusion when it seemed clear to him that economic calamity lay straight ahead. No sooner did one pie-in-the-sky expectation come crashing down than another took its place. “It was amazing that this was the heart of the American financial system,” he says, “and it was essentially run off grand misconceptions.”

Misconceptions have centered on boundless expectations at every turn, from the Dutch tulip frenzy to clamorous demand for oil, real estate and common stocks more than 300 years later. Investors act as if booms go on forever, propelled only by insatiable appetites unmoored from common sense.

In 1980, energy groups at major banks took on projects anchored by the flimsy assumption that oil prices would climb 10 percent to 15 percent a year for the next decade. Hardly had that bubble burst when home buyers and mortgage lenders persuaded themselves that home prices would climb ad infinitum, while commercial real estate developers produced spread sheets showing how commercial rents would increase for the next decade at 12 percent a year.

Aronstein often sat dumbfounded in the early eighties as “pretty smart people” on Wall Street jumped blithely on the milk wagon, saying “do you understand what you can do with these new conditions? That you could go out and just set up a savings & loan, pay an investment banker to raise $3 million, and then lend it to yourself to build condos?”

When banks unloaded those properties for 30 cents ton the dollar, not an uncommon outcome after prices collapsed, it meant that initial projections were off by more than 300 percent—hardly within the bounds that anyone could call a reasonable mistake. The system works this way, Aronstein says, because repeated observation validates anomalies, no matter how far outside the pale.

This simple wisdom is rarely attractive when the crowd gets good and lathered. If investors had pondered seriously the implications of oil at $100 a barrel, they’d have concluded that Saudi Arabia would outstrip Japan as an economic force and Mexico would soon possess more wealth than Germany. Warning in 1987 that stock prices were vulnerable to the same deflation that swamped the oil business, Aronstein described the madness of crowds with his distinctive aplomb, in That Ain’t Mud on Your Boots, Partner.

When the oil boom neared its peak, companies in the business were paying young geologists fortunes to find and produce more and more oil. This is a little like the fellow assigned to shovel out the stables paying someone top dollar to come in and cook Mexican food for the horses. The inclination on the part of businesses that are enjoying good demand and pricing for their product to produce more of it at higher and higher cost is the mechanism by which supply eventually overwhelms demand and brings down prices and profitability.

Viewing stocks in light of the oil collapse was not a casual comparison. Extremes do not occur in isolation, according to Aronstein. They are linked over long spans of time. In the closing decade of the 20th century, for example, society is captive of a credit cycle with reflections in the era after the U.S. Civil War and roots in the Great Depression.

In A Short History of Financial Euphoria, economist John Kenneth Galbraith described the bull market that followed the War Between the States. It sounds eerily familiar, a post-war tale of speculative boom that featured “pyramiding values and generally euphoric conditions in manufacturing, farming, and public construction.” Speculation focused in those days on railroads, which seemed to enjoy limitless horizons. Lenders forgot about defaults a few decades earlier, when canals and turnpikes captivated investors’ imagination. Once more, harsh reality restored them to their senses. “The new railroads, and some old ones, could not pay,” Galbraith wrote. “The respected banking house of Jay Cooke & Company, heavily involved with railroad financing, failed in September of 1873. Two large banks also went under. The New York Stock Exchange was closed for ten days. Banks in New York and elsewhere suspended payment in hard coin.”

This post-war tumult also featured double digit interest rates (which did not recur until the 1970s) and a rolling recession. Severe economic distress rippled from one economic sector to another, leaving in its wake a scorched trail of deflated prices. Some citizens enjoyed a boom while others muddled through a depression. Yuppies and poverty proliferated, side by side. It ended with the panic of 1873, from which the country did not recover for twenty years.

The credit cycle racing toward calamity a century later, in Aronstein’s view, was born in the aftermath of the Great Crash. Hobbled by awful memories of 1929, the economy crawled or lurched through the thirties. By a long stroke this was Wall Street’s most volatile decade. World War II brought a bull market, after which fear of depression resumed, fanned by the prospect of millions of unemployed servicemen.

So great was the angst in 1949 that common stocks yielded two and one-half times as much current income as bones. Yet suggesting larger investments in stock would have cost most trust officers their jobs. Convinced that collapse was imminent, Montgomery Ward chief executive Sewell Avery reportedly refused to embark on an expansion-minded strategy. As a result, the once great retailer fell far behind its more adventurous cross-town rival, Sears Roebuck. Three decades later, Ward was a humble subsidiary or Mobil Oil Company.

Yet, in the late forties, actual conditions all but ruled out sliding back into depression. Liquidity and risk aversion prevailed, legacies of depression. Balance sheets were clean, swept free of frivolous investments. The government began introducing safety nets that would support economic growth. Bank loans amounted to a mere 20 percent of deposits. Everything consumers needed or wanted, including credit, was in abundant supply. With production operating at full tilt, the postwar era confounded expectations and produced unprecedented prosperity.

The government’s increasing activism bestowed wonderful effects on the economy. The tax code stimulated borrowing. People took out loans for the first time to buy houses, cars and everything else that came with suburbanization. It was a wonderful confluence of forces, giving birth to the notion that credit was inexhaustible. Under President Johnson’s administration, prevailing wisdom supposed that the government could use its access to credit to do whatever it wanted, without limit. But, as Aronstein sees it, expansion accelerated by the Viet Nam war and Great Society programs started to drain stockpiles of raw materials, including energy. Cars in 1968 went 120 miles an hour on four miles to the gallon of gasoline. Auto makers advertised their products by the size of the engine and horsepower.

The national attitude toward consumption began to erase initial benefits of inflation. As the seventies approached, inflation became a problem. Credit expansion and price appreciation started to accelerate, unaccompanied by real shifts in the economy. Instead, growth reflected shifts in investment. Performance stocks dominated the late sixties, followed three years later by the Nifty Fifty. Aronstein dates the start if the last gasp of the inflationary trend to about 1974, the year that the Organization of Petroleum Exporting Countries (OPEC) delivered a coup de grace in the form of an oil embargo. Sharp increases in oil prices goosed inflation. President Ford sallied forth with his Whip Inflation Now program. The government distributed millions of WIN buttons. But aside from employing workers in button factories, the effects were negligible, says Aronstein. As the price of everything from crude oil to Coca-Cola increased, inflation returned with a vengeance.

Cheap credit accommodated price expansion. The real interest rate—the difference between the rate of inflation and nominal interest rates—was very low in the seventies. At times it was negative, meaning that savings accounts lost money. “Savers were much, much too credulous,” says Aronstein, using a favorite adjective. “After forty years of losing purchasing power, they finally got the message by 1979 that a host of changes had taken place.

Never dreaming that interest rates would go stratospheric before the seventies were finished, lenders began the decade by lending at long-term rates that were much too low. People invented new ways to pay for things they could not afford. Consumer credit exploded. Between 1970 and 1980 credit card receivables grew several-fold. Fifty years ago few people took out mortgages, which matured anyway in less than five years. So people did not buy houses that cost four times their incomes and pay them off over 30 years. That was a natural restraint on the price of residential real estate.

Rules changed once credit began to dominate the picture. Home buyers put down less and less cash. By the early eighties, lenders were accepting five percent down and lending customers the closing costs. It went largely unnoticed that money and credit were becoming interchangeable. “People weren’t buying homes,” says Aronstein. “They were buying mortgages.” Instead of goods, people were buying credit to acquire the goods. The cost of the credit, not the price tag, determined affordability.

Nothing could beat letting individuals put down a tiny fraction of the purchase price for a house, the bedrock of American life. Ancillary to that were office buildings and shopping centers. America was becoming a gigantic real estate bazaar, rife with speculation. The accumulated credit worked itself to a point where it had to expand even more rapidly in order or keep what had gone before from imploding. And the door was open to using credit as anybody saw fit. Credit intended for building soon embraced less tangible activities, like taking over companies.

The trend just played into lenders’ hands. After forty years of getting killed financially, they finally began to wise up. The first important step was aimed at stanching disintermediation, the flow of assets from banks to unregulated financial institutions. Deregulation of deposit rates made the banking system more fluid. Interest rates soared to nearly 20 percent, a major factor in the so-called “misery index” that helped defeat President Jimmy Carter’s reelection bid in 1980.

Afterwards, lenders could apportion credit by price rather than strictly by availability. They could make credit too expensive for most people, but they could not make it unavailable. There is a big difference. Too expensive requires judgment on someone’s part. That was the problem through much of the eighties. The genesis of recent banking crises lay in the ability to borrow at almost any rate as long as borrowers could convince themselves and a banker that there was some chance of repayment.

The biggest new way to exploit credit availability was to boost the federal deficit. Despite the rhetoric of cost conscious, conservative presidents in the eighties, federal spending heaped coals on the fires of profligate borrowing, worsening the swollen credit burden. State and local governments also jumped into the borrowing business to an unprecedented extent, until states like Massachusetts and California started showing symptoms of severe indigestion. In mid-1992, California handed out IOU’s to its employees in lieu of paychecks. Municipalities defaulted on debt obligations.

When loans pinned to crashing oil prices soured, serious faults appeared in the banking system. But instead of letting go when Texas banks were cooked and others were in deep trouble because of loans to oil-producing countries, especially in Latin America, the Feds added a turbo charger. The 1981 Tax Act, accompanied by enhanced deposit insurance, created, in effect, a Real Estate Speculation Act. It became almost unpatriotic for Americans not to speculate in commercial and residential real estate with federally insured deposits.

As if that wasn’t bad enough, Wall Street discovered slick ways to disguise debt products of dubious credit quality that they were selling to eager consumers. A raft of hybrid instruments entered Wall Street’s argot, terms like collateralized mortgage obligations (CMOs), collateralized bond obligations (CBOs) and real estate mortgage investment conduits (REMICs). The magic of diversification and federal guarantees transformed sows’ ears into silk purses. Aronstein wrote Comstock’s cocky broadside, Snouts, Lips & Tails, in February 1991.

Of the many advances in the long history of commerce, the advent of sausage stands out as one of the greatest. The idea of taking something which, in pure form, would be repellent to potential customers, and by thorough grinding, mixing, reshaping and adulterating, creating an entirely new entity that could be marketed free from the taint of its original ingredients, marked a milestone in the annals of business thought.

Sausage making is it the prototype for an entire class of merchandising technique that has become particularly common in modern finance… The financial marketer who uses commingling as an approach is responding to the same general conditions that drive the sausage stuffer: an abundance of lower grade ingredients along with a hungry and credulous public.

Maybe hubris precipitated Comstock’s rude shock in 1991. Or, perhaps, it resulted from obsessive fine tuning of a strategy that should have employed more flexibility. Fixed income strategies fizzled along with investments in sectors already flattered by the deflationary trend—commodities, precious metals and the like. Surveying the damage afterwards, the partners counted themselves lucky that they closed short positions in time. Had they been waiting to buy increasingly expensive shares to cover sales of shares they did not own, Comstock might have been forced to close its doors. But it was small compensation to be able to say that gloom had not completely run away with their senses.

Aronstein still wonders about the lapse that kept Comstock from going a bit further and buying stocks in time for the subsequent surge. He admits ambivalence. “I knew in my heart that we were making a mistake. I just thought it was going to be a small mistake.” The answer may lie partly in Comstock’s heady success as a bearish prognosticator. Hard-fought credibility rested on that position. “It had become too easy to just answer the queries and rattle off a story,” he says. “It flowed too smoothly, and we didn’t have to put up with so much ridicule [that] gets tiresome after a while.”

This kind of situation is pervasive on Wall Street, says Aronstein.

Causes aside, the blow to Comstock in 1991 shook Aronstein’s rugged confidence for the first time. “This was the first big mistake,” he says.

Events did not cause the partners to abandon ship, however. Their contrarian strategy had weathered skepticism before, it just was never accompanied by such a sharp financial setback. In the final analysis, being too early is an endemic risk in their line of work, especially when forecasting economic upheavals that occur only once or twice in a century. “I don’t know how to change it,” Aronstein concedes. “Things that seem patently absurd to me, I assume other people can see. And I assume they are going to behave accordingly.”

Concluding that their methodology was still intact left Minter, Salvigsen and Aronstein to mull a daunting puzzle: When would everyone else wake up to what was staring them in the face? “Sometimes things in here look so clear to us,” Aronstein said at the time, “that we look out the window and say, ‘Are we crazy? Are we looking at a different world?’”

Inscrutable forces will decide ultimately whether Aronstein is remembered as a gifted analyst or as misguided prophet of doom. But as he guides West Course Capital along a contrarian path, Aronstein is sticking to his guns and his golf clubs. For him, that’s the only rational choice in a world where most people fail to recognize what lies beneath the surface.”


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