Monday, March 06, 2006

3/6/06 Book Comment: Cramer's "Real Money: Sane Investing in an Insane World" 3090 words

"Real Money: Sane Investing in an Insane World" James J. Cramer, 2005

Jim Cramer is almost a stock market cult figure right now on his tv and radio shows and web site,, with stocks immediately jumping upon his recommending them. Regardless of one's opinion of Cramer's personality, style, and/or clout, his many fans seem to worship him.

From following Cramer's voluminous posts on his web site off-and-on for a number of years, I believe that he is genuinely, sincerely well meaning and interested, perhaps as much as anyone, in trying, from his viewpoint, to help individual investors understand and beat the stock market game as played today by big money.

I also believe that Cramer's latest book gives the best feel for the current equity market environment dominated by aggressive hedge funds. It very clearly describes exactly how a certain type of very successful equity hedge fund manager, which Cramer was, actually makes big returns over many years in the financial markets, which Cramer did.

Although it is not his purpose, Cramer's remarkable candidness, after a slow start he really does tell how he makes money in stocks, also exposes how the vaunted U.S. equity market, often held up as a model for the rest of the world, actually allocates capital by the herd mentality, often seemingly out of whack with the fundamentals. (1) footnote quoting Cramer's book at end of article.

However, even as Cramer perhaps is at the height of his popularity, the fact is that his type of equity market speculating has been less significant in the overall financial scheme of things than it was in the late 1990s.

(This does not rule out even greater fame for Cramer should a slowing housing market, which is currently in a price standoff between buyers and sellers as inventories of unsold homes rise, induces some foot-loose capital to re-find its way back into the equity markets, after the massive asset shift out of equities into real estate that took place starting in late 2000.)

During the 2000s all sorts of trades in much more esoteric credit and derivative markets (the latter now on the order of $300-400 trillion in notional value) have exploded as the main speculative vehicles of choice by the major financial players.

Their importance is usually not popularly understood, because they are largely private transactions (the close to the vest big players would probably blanche at the idea of becoming popular tv personalities), deliberately hidden from both Cramer's main audience of aggressive equity fund managers and individual investors in publicly traded stocks, whose transparency has increased, and even from the monetary authorities, to the latter's increasingly professed uneasiness.

This is one reason why most stock market players today, including most equity hedge fund professionals, don't have an adequate understanding of the potential systemic risks in the current market, imho.

CFA and MBA programs notwithstanding, stock market professionals simply can't be expected to have a daily working familiarity with the markets, such as credit derivatives, that key players, such as NY Fed President Timothy Geithner, have recently expressed the most concern about. (A former NY Fed President, Gerald Corrigan, now at Goldman Sachs, chairs the Counterparty Risk Management Policy Group addressing some of these issues.)

These largely private transactions, however, ultimately depend on expectation of public bailouts via central banks should they ever spin out of control, as they did in 1998. I.e. huge private speculative financial gains are ultimately underwritten by public "crisis insurance," as in the U.S. S&L crisis, Mexican bond crisis, Asian financial crisis, Russian default crisis, Argentine crisis, U.S. TMT equity bubble crash, etc., etc. Ask yourself, is that fair and honest? (my blog's motto)

Cramer and his public equity market competitors were blind-sided by just such hidden private transactions in the fall 1998 by the problems at one of the most well-regarded (with two Nobel Prize winners on board), highly leveraged hedge funds, LTCM.

It's not impossible that something similar could happen again before this global credit tightening cycle is over, although the central banks are moving in such well telegraphed, choreographed, tiny baby steps as to try to lessen that possibility (and thus have perversely encouraged even more rampant credit market speculation).

E.g., big speculators are closely keeping a wary eye on the Bank of Japan's expected shift in its unlimited "free money" policy since it has supplied so much excess liquidity to global so-called "carry trades."

I also should briefly mention that Warren Buffett has questioned in his just released annual "Chairman's Letter" (link) the large fees earned by hedge funds. I believe average hedge fund performance was about 7% last year, which is too low to justify very high "performance fees" much longer.

Yet there are a trillion dollars of hedge fund money and more in private equity funds trying to justify such fees by earning very high returns, along with the proprietary trading desks of large banks.

In a low-yield world, the unrelenting, risky, leveraged chase after super-high returns of this largely unregulated massive global pool of free-floating, nationless speculative financial capital, which nevertheless is protected by the now "Bernanke put," is grossly distorting global capital flows, as long-term investments are sacrificed for short-term returns.

In his book, Cramer understandably seems to take pride in consistently being able to anticipate and take advantage of Wall Street's spooked herd mentality. (2) footnote quoting Cramer's book at end of article.

(Many decades ago another famous market speculator, Keynes, made a similar observation on how to beat the market with his analogy of correctly judging the popular judging of beauty queens.)

Perhaps Cramer cares about the economic implications of misallocating massive amounts of capital through such a speculative financial system, but is a realist who feels he just has to accept that's the way human nature is and always has been, and makes the best of it. Perhaps he feels there is no other better alternative. Or perhaps he could care less, as long as he can successfully game the system. I obviously have no way of knowing.

Cramer's aptly titled 2002 first book, "Confessions of a Street Addict," reflects the mind frame of most of Wall Street continually needing more and more and more, no matter how much they already have. (Hopefully, judging by the cover photos on his two books, Cramer now seems happier, less stressed, more at ease, less addicted, so to speak. Maybe he now has enough.)

In his earlier book, Cramer tells how he came back from the depths of financial despair after a very large drawdown in October 1998. I don't have that book in front of me, but if I recall, despite providing his clients with excellent returns for many years, some of them evidently seemed on the verge of abandoning his fund, putting Cramer in an even more difficult position as he tried to navigate a very volatile market.

I don't recall whether Cramer acknowledges that, in addition to his own professionalism and trading savvy, he and a lot of other aggressive hedge fund managers in similar very deep holes during that Russian default-LTCM crisis were strongly helped out by Greenspan's three rapid rate cuts that fall 1998, and by the NY Fed's arrangement of large banks bailing-out the very over-leveraged LTCM.

The stock market was sling-shot by those Fed actions into perhaps its most manic year in its history, 1999, when the NASDAQ went up well over 80% and hundreds of essentially fraudulent, in all but legal status, IPO's were allowed to be brought public.

Thus, it's important to note that Cramer's Wall Street professional career occurred not only during the greatest secular bull market in history. It also roughly coincided with Greenspan's nineteen-year tenure as Fed chairman. During this period, starting with the 1987 stock market crash, aggressive speculators came to expect to be bailed out by Greenspan's Fed.

This implicit protection racket eventually explicitly became known by the late 1990s as the infamous "Greenspan put" (so much for so-called "free markets"), creating immense "moral hazard" leading to massive mis-allocation of capital, including in the 2000s real estate boom/home equity ATM quite deliberately touched off by three years of negative real interest rates.

Imho, Cramer's success, and that of other hedge fund managers and, more generally, very successful people in any field of endeavor, is more due to a usually very early natural "feel" for some area of interest and the sustained passion and intensity with which they use their innate talents to play their preferred game, than to the actual methods used, which as described in Cramer's recent book might appear simplistic, especially to those with an academic and/or quantitative bias.

I.e., as in most businesses, it really comes down to persistently successfully executing a "hedgehog" (to use the term from Jim Collins' popular 2001 "Good to Great") focus on a few basic, key, sound, adaptive approaches. And few enjoy playing the stock market as much as Cramer, a man who has truly found his calling.

That is not to downplay the useful insights of the rules Cramer very helpfully lays out in this latest book (buy the book to get the rules), it's just that for them to work one must diligently do a lot of "homework," as he correctly emphasizes, he recommends an hour per stock per week, which is where many if not most individual investors, with lots of other things in their lives, probably might fall short (similar to most half-hearted dieters who know the abc's of nutrition and exercise).

A potential danger for investors who try to follow Cramer's advice, style or rules is that they simply may not be capable, flexible and opportunistic enough to do so successfully. Cramer clearly has the long-term track record to prove that he is. But imho, very few are, including professional fund managers, otherwise their mediocre results would be better.

Mistakenly believing that one can do something that few professionals can might end up being dangerous to an individual investor's financial health, even given certain advantages he may have over the professional.

In particular, Cramer seems proud of the fact that he can turn on a dime. But many investors, both individual and professional, can't or won't, for various reasons, some of them simply psychological, but still nevertheless real.

The ability to rapidly change one's views can almost appear schizoid or bipolar at times, but in fact, as Cramer correctly notes, it is actually very realistic and necessary for investment survival, especially at critical market junctures, for most investors, with the possible exception of those with a very long-term, very deep, and I do mean deep, value style, which most don't have.

The most well-known example of Cramer switching his views, which being candid he discusses upfront in his book (pg 18), was when he went from being bullish (pounding the table bullish, if I correctly recall his website comments at the time) in December 1999 and January-February 2000, to a "March 15, 2000, piece saying to take things off the table, four days after the exact top in the Nasdaq."

He goes on, "Rather than feeling guilty about some who stayed in too long, I prided myself in recognizing that the market had changed for the worse in the spring of 2000, after the greatest run of all time, and you had to switch direction, no matter what your previous pronouncements and beliefs had been. You had to stay flexible to be conservative, to be prudent, to be commensensical and keep your gains."

There is no doubt all this is true and worked out very well for Cramer. To his credit as a professional money manager, he had a hugely positive year in 2000, during the beginning of one of the two worst bear markets in history.

Sometimes, when Cramer changes his mind on individual stocks, sectors or even the market, it might not be such a big deal. His market call in March 2000, right before NASDAQ fell 78% (if I recall correctly) top to bottom from March 2000 to October 2002, was a very big deal. Those who failed to follow it, again for whatever reason, if even just simply missing reading it, may have paid a heavy price.

To sum up my concern, I would guess that many individual investors, even professional money managers, simply may find it very difficult to consistently keep up with Cramer's changing advice, which as a professional and self-professed "street addict" he is very good at doing.

I want to strongly emphasize that is very definitely NOT Cramer's responsibility or fault, per se. But it is something that investors who choose to follow him should recognize and be very aware of.

And, as a highly influential stock picker and market commentator, having his followers keep up with him is perhaps also a heavy burden for Cramer, who, as I said upfront in this article, I believe is genuinely very well meaning in trying to help his followers beat the market.

I would especially recommend Cramer's latest book to academic financial economist types who still believe in "efficient capital markets" even after the destruction of $8 trillion in market capitalization during the 2000-02 stock market crash, the largest in history. Then again, if they are still true believers after that critical test, maybe nothing will shake their "free market" ideological faith in financial market efficiency.

Most academic types might have difficulty with such a close brush with a real market player such as Cramer (it's much safer to study time series data). I can just imagine their stunned reaction to his manic antics on his current tv show, which in all fairness I've only seen once.

Cramer's term "insane" in his book's sub-title is at certain critical times far more accurate than "efficient" for the financial, not necessarily real, world, though I will let his viewers and readers decide on his claimed "sane" approach, regardless of his financial success.

There is a quote in Emanuel Derman's "My Life as a Quant: Reflections on Physics and Finance," 2004, which I don't have in front of me so I may have it a little wrong, in which he is advised that the equity business is one in which being very smart, he has an Ivy League Ph.D. in physics, is not a competitive advantage.

Cramer is very, very smart--just look at his extraordinary investment track record--but in a different street savvy way than a quant, and just as important, very energetic and very passionate about what he does. Despite his Harvard degrees, Cramer is clearly no fan of the academic approach, from his viewpoint, the ka-ching of the bottom line is all that counts.

Derman, like most quants, was on the fixed income and derivatives sides of Wall Street, a far different world than the one Cramer inhabits, which actually in this post-2000 credit cycle is home to much larger speculative excesses than the stock market, excluding emerging market equities. (Both Derman and Cramer worked at Goldman Sachs in the 1980s.)

For a much different perspective on how to manage one's stock portfolio from another very successful professional money manager, also see Joel Greenblatt's "The Little Book That Beats the Market," 2005, which I will comment on later, along with Barton Biggs' recent "Hedgehogging."

(1) "Real Money," pg 97: "way too many people get confused; they think we are trading the actual companies themselves....Untrue. These [stocks] are, in the end, simply pieces of paper, to be bought, sold, or manipulated up and down by those with more capital than others. All other investment books stress the linkage between the stock and the company. Me? I stress the abject lack of short-term linkage and the opportunities that such an unconnectedness presents....over the short-term, the twelve- to eighteen-month time frame that is most applicable to most owners these days...the fundamentals of the company play only a part in what moves a stock up or down. In fact, I believe the reason that so many professional money managers and amateurs fail to beat the market or make big money is that they are way too hung up on the largely artificial linkage, short-term, between a company's health and the health of the stock. I think that deep down they like the linkage because it makes them feel that they aren't gambling with their money (or their clients' money). They think that if they stay focused on the fundamentals they have turned gambling into investing." pg 98: "I don't care how we catch the moves....I just want us to catch the darned moves. Again, I know this is heresy. No investing text advocates trying to catch these moves. No market professional wants to be affiliated with these moves because they can be short-term in nature and they resemble gambling more than 'investing.' But so what?" pg 100: "when you are trying to find the next Game Breaker move, you are strictly embracing speculation because, by nature, you are on unproven and subjective grounds....the investing that looks the least like gambling produces the most humbling returns, while the investing that seems much more like wagering produces the heftiest returns."

(2) "Real Money," pg 105-106: "what if instead of earnings estimates changing radically, the M [multiple, i.e. p/e ratio] changes? What happens if you can figure out that the multiple is going to get bigger?...At Cramer Berkowitz, where I compounded at 24 percent year after year with no down years, I specialized in trying to determine whether the multiple was going to expand or contract on the same earnings. I spent most of my time trying to develop models and methods that would predict that the M would go up, often in conjunction with work that showed that the E [earnings] was about to increase beyond what people expected. I did this because it was obvious to me that if I could figure out which companies were going to beat expectations, I could get in front of large moves before they happened....the vast majority of people, including professionals, have no idea why a multiple will expand and don't even think it is possible to figure this out. These people are wrong. Given that I have repeatedly managed to predict multiple expansion, I know it is not only possible, but given the directives I am about to describe, it is actually easy."

Frankly, Cramer is being much too modest and/or encouraging. Playing the investment game Cramer's way, not the only viable method, is doable, but not easy. It requires a lot of "homework," and perhaps sometimes a little luck too.