Sunday, March 13, 2011

Initial Conditions

Sitting in his comfortable leather chair in front of his wide desk in his contemporary office, neatly and tastefully decorated with bright lower walls and light wood panelling, Harold Garland detected an uncharacteristic feeling in his stomach. The report he read was written by Enlightened Capital’s new associate, a graduate of Harvard who had taken a class by Kenneth Rogoff himself. Granted it had only been Economic Theory, and Prof. Rogoff had not taken her under his wing, but Darlene Padmore still had a Ph.D. in Economics from the institution. Garland believed in networking with Enlightened’s new associates once hired. Making them feel important and valued was one of those touches that made its business model work.

There was an official mission statement, but Enlightened’s unofficial mission statement was “Beat Goldman to the new opportunity and subtly point out you were there first.” Wall Street collegiality being what it was, it meant Goldman might throw them some business. Being first meant that they were not mere followers in Goldman’s wake. By necessity, that had encouraged Garland and his partners to cultivate skills more appropriate for trend-chasing industries like fashion and celebrity reporting. He himself was wryly aware of the similarity, but kept that observation to himself. It was best layered over the practice of solid professionalism.

Garland was a handsome man, with wide blue eyes and a somewhat puffed mouth underneath greying hair with distinguished styling. He was not overweight, and had not gone so when too many of his old school peers had. He had taken his MBA when Modern Portfolio Theory had been at its height; he still believed in it. Granted that business necessity had impelled him to accept the presence of anomalies before the academy had, but those anomalies fit in to his belief. MPT was an elegant creation; it truly was the smart and educated person’s answer to common sense.

Investment-theme trend-chasing cohered with his mental model perfectly. Vanguard dominating the index fund industry, there was no way to make a real splash in that field. MPT being the truth, there was no way to build a business through superior analytic capabilities. Garland had heard about value investing, but the field was full of old-fashioned carpers who knocked around MPT like they were old watchdogs growling at a new and better-trained rival. It’s true that Warren Buffett was one of them, but he was a genius. Harold Garland was no Warren Buffet. Nor was anyone else.

And besides, Harold thought to himself using the other skills he had learned in business school, old Buffett only became famous just before he became eligible for Social Security. He had spent a quarter of a century at Berkshire in near obscurity. It wasn’t exactly the career path that would be expected from the only man to get an A+ from Benjamin Graham himself. By the time Harold Garland had gotten to B-school, Benjamin Graham had passed away. There was no sense in emulating an old man when the advantages he had couldn’t be recreated.

Instead, Enlightened Capital had joined forces with progressive finance academics and became a rocket shop. Granted that there had been periodic embarrassments, starting with sovereign bonds in the mid-late ‘90s. Granted that Enlightened had been ensnared in the real estate collapse with all the other firms that counted. But that came with the territory. Everyone would like to keep their alphas high and their betas low, but sometimes beta snuck in and festered until it sprayed its pus all over the returns. Correlations in a bear market did approach 1. Since ‘08, Garland and the rest of his partners had pledged to keep an eye out for black swans. After all, it was fashionable to repent – and it did tie in with what Garland was sure to be the next fashion. The trouble was the obvious clash, which was souring his midriff.

Fighting the ill in his stomach, he put down the report and realized there were moments when even fashion turned ugly. The thought of blaming Darlene didn’t even occur to him; she had done a creditable job. Taking it out on her would have shocked him. Enlightened was a progressive, collegial shop.

“I don’t see how we can do this,” he said to Todd Myers in Myers’ office. Both offices were the same size, although Garland’s was in the corner of Enlightened’s space. Garland himself was the executive partner; Myers was the managing partner. In corporate terms, they were CEO and COO respectively. After Myers had read the executive summary, both looked like dogs that had found their bowls full of broccoli. Which was a feat for both of them, as their demeanours tended to invite the word “catlike.”

The “broccoli” was gold. Stealthily rising since 2001, the metal as an investment had a lot to recommend it. Even someone who had bought it in a rush, consequently overpaying, was bailed out by a rising trend. Corrections and consolidations were followed by spurts up, suggesting the payoff potential of a rational timing strategy. Better yet, there was an indicator that was the product of genuine academic research. As long as real interest rates were negative or unusually low – easy to quantify – gold went up because the opportunity cost of holding it was low. When real rates returned to reality, it was time to get out of gold and into something else. With this model, they could see the black swan coming!

Trouble was, the people with the expertise were real loons. Bringing in someone with the appropriate intellectual capital would have been like inviting a dog into a house full of cats. It was de rigueur for a so-called goldbug to spend half the day cursing the Federal Reserve. Everyone at Enlightened believes that America was fortunate to have the Fed. They said so, to great profit when Alan Greenspan was heading it up. Granted that there had been recent embarrassments, but they had only shifted to sotto voce. The Fed had been truly responsible for preventing another Great Depression.

Enlightened needed that cachet; the firm would have been dead without it. It had had a horrid five months after October ‘08. A CNBC panel with Doug Kass had saved them. When he said that the market presented “the buying opportunity of a lifetime” right at the March ’09 low, everyone at Enlightened had swallowed the nervous feelings in their stomach. Tim Geithner’s admittedly maladroit press conference a month earlier had given them the frights. Stoutly, they had recommended - even pleaded - to clients to buy with both hands. Leaning on the Fed had been a vital part of that strategy. It had paid off, but not without a lot of hand-holding and sceptic-soothing at first.

Todd, a triangular-faced man who was also handsome, now looked glum. “It’s either this or alternate-market private equity. And the SEC put the lid on that option once Goldman got in.” He didn’t have to say they would be reduced to the indignity of following in Goldman, Sachs’ wake.

For the first time in his life, Garland felt defeated. The only option that made sense for the firm meant bringing in a near-lunatic who would cut into a lot of Enlightened’s other business. Being tight-knit was a competitive advantage for a small firm that couldn’t afford tolerated satrapies.

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