Dr. Michael Burry saw the mortgage crisis coming from miles away. He was featured in Michael Lewis’ “The Big Short”, along with others who also saw the debacle coming. This year, Dr. Burry was keynote speaker at the 2012 UCLA Dept of Economics Commencement. It’s a speech well worth listening to. Dr. Burry is quite pessimistic about the future of U.S. as the debt-to-GDP ratio rises to levels higher than that of Greece. And the problems are no longer in the future, he says, but they have already begun to manifest themselves throughout society.

Perhaps most shocking to some (unless you’ve already gotten used to the TSA groping children)… he describes what happened to him after he wrote a New York Times op-ed criticizing the actions of the government and the Federal Reserve ( I Saw the Crisis Coming. Why Didn’t the Fed? – NY Times ). Within weeks all 6 of his funds were audited, he was compelled to provide Congress with every email he wrote since 2003, and the FBI showed up at his door. He wasted thousands of hours and over $1 million in legal/audit fees defending himself against a frivolous witch hunt against someone with clout who dared stand up and say “I saw it, why didn’t you?”

While not one bankster has ended up in jail, banks have collectively been given $$ TRILLIONS more of our money. And instead of consulting with truly smart and insightful people like Burry (instead of the crooked bankers themselves) as to how such events can be avoided in the future, our government offensively attacks those who predicted the crisis well in advance.  Instead of seeing people like Burry as able to offer true wisdom and insight, they treat him as if he had somehow played a part in masterminding all the pervasive and massively over-leveraged mortgage fraud that went on.

Another great quote from his speech: “As it turns out, information is not perfect, volatility does not define risk, markets are not efficient, the individual is adaptable.”

As a final note, here’s another great bit of Burry’s insights I’ve kept on hand since reading “The Big Short“:

‘ In Dr. Mike Burry’s first year in business, he grappled briefly with the social dimension of running money. “Generally you don’t raise any money unless you have a good meeting with people,” he said, “and generally I don’t want to be around people. And people who are with me generally figure that out.” He went to a conference thrown by Bank of America to introduce new fund managers to wealthy investors, and those who attended figured that out. He gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions. “By and large,” he later put it, “the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below-average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents presents opportunity, not risk, and that the dollar is still worth a dollar.” He was greeted by silence and ate lunch alone. He sat at one of the big round tables just watching the people at the other tables happily jabber away. ‘

(Interloper) “Outside of the entertainment factor, the primary differences between the two archetypes is that the first has risen to their position by attracting new money while the latter holds their position by effectively managing money. Type One*, with a travel schedule encompassing 150 days annually is dependent of their model for performance because they have much less time for specific analysis – hence the preponderance of more black box, momentum strategies. They are also much more dependent on their analysts and traders back at the office who must make the majority of the day-to-day decisions. Type Two* on the other hand, only really cares about the analysis. They are pissed when the marketing department drags them put of their cave before they’ve finished investigating a fishy footnote in the last quarterly statement. (Don’t think I’m exaggerating with that, btw. I personally know PMs that will spend weeks on a single footnote).”

“Here’s the important part: the industry loves them some Type One PMs. Momentum managers trade a lot more than value managers and this keeps the trading desk commission train rolling. The accommodating Type One manager is, unbelievably, available for evening functions where Financial Advisors can bring their top clients who, inevitably will be running around with blank checks by slide eight. Everybody makes money.”

“If you’ve read this far you have probably guessed where my preference lies. For my own money, I would much rather have the plodding, boring manager who obsesses about every aspect of a potential or existing holding, rarely straying from a concentrated portfolio of companies they are completely comfortable with. Like Buffett, they do not feel compelled to make changes (and thus rarely get referrals from capital markets) and will literally wait years for a stock to drop to valuation levels they find attractive. Type Twos will also avoid hot sectors and thereby escape the attention of the individual investor until the market craps out, and they don’t feel like putting more money into the market anyway. I pay Type Twos, in other words, to exhibit the discipline that I don’t have.”

” .. it remains important to understand the industry’s bias in this regard and that ‘best manager’ may mean something much different to the average investor than on the trading floor.”

* “Type One: Physically attractive, Ivy League (Harvard or Wharton, almost always), momentum-based investment strategy. .. They will be compelling, energetic, will pause and answer your question in a non-patronizing way. They will linger after the presentation until everyone has left, happily chatting about markets or whatever else the fellow-lingerers want to talk about. .. They are, in short, marketing machines.

Type Two will be older, having spent far more time as a senior analyst due to a dearth of personal charisma. They will likely not be Ivy League. Type Two will execute a more fundamentally-based investment process. Their longer performance track record has a better chance of being stronger, beating the index by a few percentage points per year by holding value during bad years. Type Two’s presentation will be so dull that you’ll want to gouge out your eyes after half an hour.”

Full Story: PORTFOLIO MANAGER SEARCH PRO TIP: FIND THE WORST PUBLIC SPEAKER POSSIBLE (Interloper)

And finally, this short passage from Michael Lewis’ book “The Big Short” seems to perfectly capture the essence of these points:

“In Dr. Mike Burry’s first year in business, he grappled briefly with the social dimension of running money. ‘Generally you don’t raise any money unless you have a good meeting with people,’ he said, ‘and generally I don’t want to be around people. And people who are with me generally figure that out.’ He went to a conference thrown by Bank of America to introduce new fund managers to wealthy investors, and those who attended figured that out. He gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions. ‘By and large,’ he later put it, ‘the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below-average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents presents opportunity, not risk, and that the dollar is still worth a dollar.’ He was greeted by silence and ate lunch alone. He sat at one of the big round tables just watching the people at the other tables happily jabber away. ”

How I wish I had been there that day to sit with him.

Upon speaking with many traders and investors over the years, I found it rather surprising how many of them had almost no clue how the Dow Jones Industrial Average ($INDU) really works, or even less how it is calculated.  If you want to succeed, you better know the subtle rules and intricacies of the games you’re playing.  Understanding how an index as critical as the DOW is calculated would certainly fall into that category.  Ironically, it is so shockingly simplistic, you will like have an “aha” moment as you understand why (besides inflation), the DJIA tends to exhibit such a strong upward bias.

While most broadly followed market indices today are “cap-weighted”, such as the S&P 500, the Nasdaq, and the Wilshire, the DOW is a “price-weighted” index (as are all of the DOW indices).  In a “cap-weighted” index, large price moves in the largest components have a much more dramatic effect on the value of the index.  So, if you have a company such as Apple that now has a market cap north of $300 Billion, you can see how much greater an effect that one company can have on an index over many other components.  However, you can make a point that such size brings clout, huge liquidity, and a huge shareholder base, so this potentially justifies its extra weight.

Regardless of any criticism you may have on the “cap-weighted” approach, the “price-weighted” method used to calculate the DOW will leave you with even more room for question.  Equal importance is placed on all stocks in the index, with each company’s stock price adjusted by a divisor, then added together.  The net effect of this is that share price alone becomes the most important criteria for maximum effect on the value of a “price-weighted” index!  For example, if you have a $10 Million company trading at $200/share, and a $100 Billion company trading at $20/share, the $10 million company will effect 90% of the value of the index, and an equal move in the $100 Billion company will effect a mere 10% of the index value.

The DJIA divisor is updated periodically and adjusted to offset the effect of stock splits, bonus issues, dividend payouts, or any changes in the companies that form the index.  When the DOW was originally created back in 1896, there were only 12 initial components that were simply divided by 12.  In 1928, the number of stocks was raised to 30.  Now, let’s say that our most expensive stock is currently trading at $100 and it has a 2:1 split to $50/share and causes the index to drop by 10%.  The divisor is used to readjust the index to its pre-split level.  This is all well and good, except for the fact that all these changes over the years have reduced the divisor to miniscule levels that now have a HUGE multiplier effect.  This dramatically increases the overall volatility of the index, especially with a large price move in a high-priced component.

For example, in June, 2009, General Motors and Citigroup were removed from the index, and Cisco and Travelers took their place.  With so many splits and changes over the years, the current divisor value is now a tiny 0.132129493.  In layman’s terms, for every $1 change in the price of a stock in the average, you can expect to see a 7.57 point change in the DJIA index (1 / 0.132129493).  So take a moment to think about this in terms of the 30 DOW stocks.  Most of the movement you see on a daily basis is caused by the top few highest price stocks, which currently include IBM (leading way ahead at $175/share), followed by CAT (at $107/share), and then CVX (at $105/share).  Bank of America is at the bottom of the list at around $10.50/share.

Now think how much easier it is to get a $1 price move on a $100 stock versus a $10 stock, and it’s pretty easy to see how index volatility can explode when a high-priced component exhibits a large change in price.  In addition, the more component stock prices increase, the more volatile the index becomes, and the greater the likelihood we will routinely see moves that average several hundred points a day.

You may have figured that with this technique, the DOW also seems inherently rigged to continually move higher.  For those pundits who’ve called for DOW 1,000 again and again, take a moment to think about this possibility.  Besides the obvious effects of inflation, how could that really ever happen?  Every time a few stocks in the index fall heavily out of favor (or are on the verge of bankruptcy), they are replaced with much more solid companies, trading with much higher stock prices, and generally at a time when the market has already experienced a large correction.  In fact, had you simply bought the DOW after the component-change announcement was made in June 2009 (or even better, a few of its highest price components), you would have fared quite well in the market since then.

Back in February 2009, with the markets plunging relentlessly day after day, after day…  I still recall how many traders were waiting in anticipation for some sort of crazy, panicky, high volume day to mark a capitulation bottom.  This latest market downswing took the DOW down nearly 30% in just over two months from 9,088 to a low of 6,470 on March 6^th, 2009.

Many traders whose market analysis and insights I respect seemed to be waiting for some massive “fireworks”-type event that would all but shout “THE LOW IS HERE”;   a sign that all the weak hands have most likely thrown in the towel, and that it was now time to BUY BUY BUY hand over fist.

Of course, Mr. Market will never make it quite that easy, even for its smartest participants to figure out what its current “jig” will be.  The DOW closed below 6,700 for several days before breaking out higher and closing above 6,900 on March 10^th, 2009 on a bit higher average volume.  It also marked the first day since this leg of selling began in early February that the DOW was able to close above its downward-sloping trend-line.  However, that super-charged high volume capitulation day we were all looking for and expecting to occur never materialized.  While in September and October 2008 the VIX volatility index hit highs just over 80, in February and March 2009 the VIX topped out in the low 50’s.  This peak was 35% lower than its earlier spikes, even though the market was now trading at lower price levels.

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