Friday, August 26, 2011

A Volatile August in the US Equity Markets

August has been a notable month in the US equity markets. Since I won't be writing posts next week, I thought I'd express some thoughts about it today.

If the S&P500 Index closes next Wednesday anywhere near it's current (mid-day Friday) level of 1168, it will be the worst monthly decline for the average since February of 2009.

My proprietary volatility measure for options soared from a 'call' allocation to a notional, but not very strong 'put' by the second day of August. Just two days later, the measure was in full put territory. And has more than doubled since then. My volatility measure hasn't been this high since late March of 2009.

The options-related indicator, however, is much more sensitive than my equity signal. More 'real-time,' if you will, because options move so much more quickly.

That said, such high volatility rarely persists for months. It did persist in the fall of 2009 through early 2010, thanks to the compound nature of an economic recession and a financial sector crisis. I doubt anything quite like that is looming just now. So to benefit from the decline either through puts or shorting equities, one may have already missed the fattest part of the phenomenon.

The equity signal has yet to move to either an 'out,' i.e., uninvested or cash, allocation, or 'short' position. But it's easily only a few months from signaling short, depending upon how badly the S&P continues to perform. Suffice to say, even a merely lackluster index performance for the next few months could signal short allocations by year's end.

With this background, it's been entertaining to listen to the many guest pundits and hosts on Bloomberg and CNBC this month argue back and forth that it's either the best of times, or the worst of times.

Really, it all depends upon your asset levels, risk appetite, and time horizon.

While I continue to believe that macro-trends argue for lower global economic growth rates among developed nations for the foreseeable future, as consumers save more, to replace the expected shortfall of non-existent government-promised pension and health care benefits, that doesn't mean I see equities collapsing.

Rather, I believe equity strategies like my own, which has continued to handsomely outperform the S&P this summer, even amidst the continued market decline, will identify and hold shares of companies which generate positive total returns, both absolutely and relative to the index.

If one can maintain a long investment horizon and sustain some near-term softness in returns, I suspect that, mostly long positions will continue to pay off. My own equity strategy may yet signal a period of being in cash or short. However, barring it being of a duration like that of the post-tech-bubble collapse, or 2008, such a period of short positions are unlikely to be significant. It's too early to tell.

What is clear is that August's sudden spike in volatility in US equity markets is a warning to be prepared for an investing inflection point. The speed with which, and the levels to which volatility has risen are rare. If the equity market is provided sufficient fuel to prolong and increase such volatility, look out. Otherwise, chances are good that it will begin to ease, accompanying a long, slow rise in the S&P500.

Regarding Warren Buffett's Investment in BofA Preferred Stock

Yesterday's other major business news story, aside from Steve Jobs' resigning as CEO of Apple, was Warren Buffett's Berkshire Hathaway buying $5B of BofA preferred stock with a 6% dividend, plus warrants- terms set by Buffett.

As with his prior capital infusions to Goldman Sachs ($5B @ 10%, plus warrants) and GE ($3B @ 10%, plus warrants) during the 2008 financial crisis, Buffett capitalized on BofA's weakness in the eyes of investors, but carefully avoided buying common equity.

Despite Moynihan's and Buffett's comments that this represents the latter's vote of confidence in the bank, that's not strictly true. If it were, Buffett would have purchased common equity in the market. It's more a case of Buffett extracting a hefty price- the 6% dividend and warrants- for being an unofficial credit rating agency whose selective investments calm other investors. 

It's crucial to understand that in all three cases- Goldman, GE and, now, BofA, Buffett focuses on preferred stock, which is senior to common equity, and on which he can demand a special premium, plus warrants, just in case the firm pulls out of its problems.

Think of him as a sort of reverse greenmailer. Instead of the greenmailers of old, like Carl Icahn, whom companies paid to go away, these companies pay Buffett to come on in. In short, it's crony capitalism, because you'll never get access to the deals Warren Buffett does. But don't expect the SEC to be investigating him anytime soon for extracting such a high dividend rate on his preferred shares. Or, apparently, the BofA board for being so wasteful with its shareholders' money.

However, as the nearby chart illustrates, and at least one Bloomberg talking head had the guts to say yesterday, Buffett's equity kickers, the warrants, have been busts. Neither his GE nor Goldman warrants are in the money.

I've included in the nearby price chart Wells Fargo, as well, since Buffett is known to maintain a large position in that bank. I don't know when he began building his position, but it, too, has underperformed the S&P500 Index for the past five years.

In searching for articles with information on the date of Buffett's initial Wells Fargo investment, the best I could do was to estimate that he's been invested in the bank since at least 1999. He says he bought equity prior to the 1998 Norwest merger. The second price chart displays WFC's and the S&P500 Index's prices since 1985. If Buffett bought Wells in, say, 1995, then he's done better than the index. But if he bought later than sometime in 1997, he's probably no better off than he would have had he bought the index.

So much for Buffett's fabled equity selection skills, and back to the BofA preferred equity buy.

Late this afternoon, a family office manager and guest on Bloomberg explained that he had done much the same as Buffett only about a week or so ago. Not wanting to risk his capital on BofA equity, he found the preferred to yield an acceptable dividend with much less risk. But his yield is not as great as the one demanded by Buffett.

One of the Bloomberg anchors jokingly asked a pundit if he thought the administration asked Buffett to shore up BofA by investing in it. I don't think that's just a joke.

It also focuses on the lack of risk in Buffett's position, which is different than that of the bank or its common equity holders. First, Buffett has so ingratiated himself with this administration that it's unlikely to take any actions toward BofA which would endanger Buffett's investment.

Second, Buffett knows that BofA is one of the 'too big to fail' institutions, so chances are it will be bailed out by the government before Buffett loses his investment.

Recall, if you will, that freely-operating markets are supposed to result in neither buyer nor seller having sufficient power to dictate price or terms. Buffett's move, the third such example of his dictating investment terms to his targets in three years, demonstrates how our financial markets aren't fair. Buffett can engage in crony capitalism, using his name and resources to extract expensive terms for his borrowers, while other market participants have to resort to the markets to buy their investments.

On that subject, I learned yesterday that Buffett had insisted, as part of the terms of his Goldman Sachs investment, that no Goldman senior executives could sell shares in the firm until he had his money back. In that case, I suspect Buffett realized he was playing with some very sharp operators who wouldn't think twice about leaving him holding an empty bag.

In BofA's case, it was reported that no such terms were required. I suspect that speaks both to Buffett's sense that the firm's management is mediocre, and that the government will unquestionably step in to save his investment before it would vaporize amidst a bankruptcy.

Watching this sort of activity by Buffett, while generating no whiff of impropriety, validates for me how useless the SEC has become.

Thursday, August 25, 2011

Steve Jobs Leaves Apple

After the equity markets closed last night, Apple released the news that Steve Jobs has resigned- permanently, it appears- as Apple's CEO, but will be chairman of the board of directors. Tim Cook will assume Jobs' duties.

The major buzz on business/finance cable news and in the Wall Street Journal is the future of Apple and its equity price.

For example, in a development to which I alluded in today's prior post, Tyler Mathisen grilled a guest technology sector analyst by demanding that he forecast Apple's equity price two years hence. This, of course, is a perennially stupid question because equities always have some component of their price movement linked to equity index levels. To be a veteran financial network executive and/or anchor and not understand the uselessness of that question is, well, to be Tyler Mathisen.

But, back to Apple......

Apple has been in my equity strategy's monthly selections frequently for the past few years. Anyone holding the stock has had to expect that some day, any day, this event could occur, probably triggering a decline in the equity's price.

Between yesterday's close and this morning's open, Apple's share price declined 5%.

But to put that in perspective, here are the respective returns for Apple (post-Jobs departure decline) and the S&P500 in my strategy's portfolios since November:

Month             Apple           S&P500
Nov                 +14%            -4%
Dec                 +13%             -3.8%
Jan                  +7.5%            -7.5%
Feb                      0%             -10.9%
Mar                 +6.3%            -11.8%
May                 +3.5%           -11.8%

So if the 5% decline constitutes most of the damage to the stock, I don't think it's a big deal.

To me, there are three elements to assessing the effect of Jobs' departure as CEO on Apple and its equity price.

The first is actual product development and strategy. I believe those are probably set for the next 18-24 months, so the company's fundamental performance shouldn't suffer. Moreover, I would anticipate that as long as Jobs is alive and able, he will continue to be involved with these areas, with management's blessing.

The second element is investor perception of the impact of Jobs' departure as a full-time operating executive at the firm. In that regard, I believe that one should largely ignore this element, so long as the company's strategy and operations continue to provide strong fundamental performance, i.e., earnings growth.

In this regard, I recall holding Dell in 1998, when nearly every analyst publicly said the company couldn't sustain its torrid profitable growth. My portfolio held two of the S&P500's top ten total return equities for that year- Dell and Schwab. Both were negatively assessed throughout most of the year, only to defy predictions of their demise. In Dell's case, most analysts failed to see how much more capable Dell's management then was, compared to their peers, and how attractive their product/market segment was. The stock doubled that year.

My quantitative strategy's proprietary evaluation criteria determined Dell to be surprisingly within a normal range of performance on an attribute that most analysts viewed differently and, thus, incorrectly.

For Apple, now, I believe that its fundamentals are very similar to Dell's 13 years ago. It won't be for perhaps two more years that Apple's strategy and products suffer from Jobs' absence.

Finally, there will come a time, probably about 18-24 months after Jobs' ceases any active involvement, even if it were reduced to periodic dabbling in development and product strategy, when the company's performance begins to falter. That's when it will be time to be out of Apple.

But I suspect that time is still a few years off. In the meantime, it's very likely that consistently superior returns will be earned by owners of Apple equity. The cost of being a few months late to sell will almost certainly be offset by owning it until then.

Good News, Bad News on CNBC This Morning

The goods news- I awoke to view CNBC's SquawkBox this morning and was delighted to see and hear Rick Santelli co-anchoring in the studio! Evidently he was dragged in during the annual vacation season when all three regular anchors are out.

The bad news- brainless Tyler Mathisen is there, too.

Who said life was fair? But it's not too hard to mute when Mathisen is talking or just ignore him. I can never get enough of Santelli's candid remarks and solid, spontaneous assessments.

Wednesday, August 24, 2011

Mike Holland vs. Tom Brown On BofA Equity

Another week...another disappointing decline in BofA's equity price. This morning's Wall Street Journal carried an article highlighting the record prices of insuring BofA debt, and the implied higher borrowing costs for the financial utility down the road.

Most assuredly, then, bank fund manager Tom Brown was on Bloomberg, all carefully coiffed and attired in conservative blue suit yesterday, naming BofA as first among his three top financial service selections.

Meanwhile, this morning on Bloomberg, veteran fund manager Mike Holland politely said, when asked, that he had zero interest in BofA shares. He quickly lauded the bank's lawyer/CEO Brian Moynihan as being "all over" the various legal issues involving lawsuits from the legacy home lending business his predecessor, Ken Lewis, bought via Countrywide.

But Holland made clear he wouldn't touch the troubled North Carolina-based bank with a ten-foot pole. Except, of course, he said it in a manner calculated not to cause a run on the bank or a bear attack on its equity by short-sellers.

A check of the nearby 5-day chart of equity prices for BofA, Chase, Wells Fargo, Citi and the S&P500 Index reveals that the index beat all four of the banks. Wells and Chase declined by only about 5%- just a bit more than the index.

Citigroup fell by about 10%, and BofA by more than 15%.

I have no direct knowledge of Brown's fund. I don't know its size or its management style, other than it is restricted to financial entities and selections are apparently on Brown's subjective whims.

Thus, I don't have direct knowledge as to whether Brown tries to juice returns with leverage. But can you imagine the panic he would feel if Brown had borrowed to fund the BofA positions which he (see my prior posts under the BankAmerica label for details) late in the spring?

The second chart shows the same entities' price series for the past three months. The rank orders and relative performances look about the same, except, of course, that magnitudes are larger.

The S&P, Chase and Wells Fargo are down twice as much as for the past five days, while Citi and BofA are down about three times as much.

On a raw actual price basis, the third chart shows BofA fell from between $11-$12 after mid-May to $6 and change yesterday. I don't know exactly when Brown bought his BofA positions for his fund, but it must have been prior to his June 3rd Bloomberg appearance.

The worse news for Tom Brown's fund clients is that BofA's equities have declined pretty much monotonically for the past six months. So their loss could be in the 50% range on that position.

No wonder Brown is on Bloomberg as often as possible shilling for the hapless financial leviathan's equity. His fund's holders- and presumably Brown, as well- have lost a bundle on his call this time.

Oh, as an aside, in his Bloomberg appearance yesterday morning, Brown replied "yes" to the anchor's question/assertion that Brown was only a financial sector portfolio manager now, and no longer holds himself out as an (presumably-objective) analyst.

Tuesday, August 23, 2011

The Failure of Keynesian Economics

Stephen Moore wrote an editorial in Friday's Wall Street Journal decrying the current administration's wholesale, unquestioned embrace of Keynesian macroeconomics. He began his piece with these passages,

"Consider what happened last week when Laura Meckler of this newspaper dared to ask White House Press Secretary Jay Carney how increasing unemployment insurance "creates jobs." She received this slap down: "I would expect a reporter from The Wall Street Journal would know this as part of the entrance exam just to get on the paper."

Mr. Carney explained that unemployment insurance "is one of the most direct ways to infuse money into the economy because people who are unemployed and obviously aren't earning a paycheck are going to spend the money that they get . . . and that creates growth and income for businesses that then lead them to making decisions about jobs—more hiring." "

If you stop and think about Carney's response, it's a lot like Keynes' own suggestion that, if necessary, pay men to dig, then fill holes, in order to 'prime the pump.'

If economics were a so-called hard science, like physics or biology, these theories would have been carefully tested to determine their veracity, and, if so, under what conditions or constraints.

But since economics is considered more of a social science in actuality, but taught and beheld by many politicians as a hard science, Keynes' theories gained credibility without real tests.

Over the years that I've written this blog, I've reviewed articles in the Journal by eminent economists and near-economists concerning the lack of evidence that Keynesianism ever worked. For example, recently, I wrote this post discussing Richard Rumelt's recent Journal piece reminding us, via facts, that FDR's domestic spending during the Depression didn't rescue the US economy. Neither did WWII. It was the forced savings during the war, via rationing and bond drives, that led to the subsequent economic growth from all that savings and pent-up demand which was forcibly denied during WWII.

Earlier, in this post, I cited Alan Reynolds' empirical survey of analyses of government spending and recessions. A quote from Reynolds in that post is appropriate here,

"A 1999 study in The Journal of Economic Perspectives by Christina Romer (now head of the Council of Economic Advisers) found that "real macroeconomic indicators have not become dramatically more stable between the pre-World War I and post-World War II eras, and recessions have become only slightly less severe." Ms. Romer also noted that "recessions have not become noticeably shorter" in the era of Big Government. In fact, she found the average length of recessions from 1887 to 1929 was 10.3 months. If the current recession ended in August, then the average postwar recession lasted one month longer—11.3 months. The longest recession from 1887 to 1929 lasted 16 months. But there have been three recessions since 1973 that lasted at least that long.

In the late 19th and early 20th centuries, nobody thought the government could or should do anything except stand aside and let the mistakes of business and banking be fixed by those who made them. There were no Keynesian plans to borrow and spend our way out of recessions. And bankers had no Federal Reserve to bail them out until 1913. Yet recessions after the Fed was created soon turned out to be much deeper than before (1920-21, 1929-33, 1937-38) and often more persistent.

It's clear that U.S. history does not support the theory that Big Government means shorter and milder recessions. In reality, recessions always ended without government prodding, long before anyone heard of Keynes and long before the Fed existed. What's more, recessions ended more quickly before the New Deal's push for Big Government than they have in the past three decades. The economy's natural recuperative powers before the 1930s proved superior to recent tinkering by Big Government economists, politicians and central bankers."

With those examples in mind, here are the later passages from Moore's Friday editorial,

"How did modern economics fly off the rails? The answer is that the "invisible hand" of the free enterprise system, first explained in 1776 by Adam Smith, got tossed aside for the new "macroeconomics," a witchcraft that began to flourish in the 1930s during the rise of Keynes. Macroeconomics simply took basic laws of economics we know to be true for the firm or family—i.e., that demand curves are downward sloping; that when you tax something, you get less of it; that debts have to be repaid—and turned them on their head as national policy.

As Donald Boudreaux, professor of economics at George Mason University and author of the invaluable blog Cafe Hayek, puts it: "Macroeconomics was nothing more than a dismissal of the rules of economics." Over the years, this has led to some horrific blunders, such as the New Deal decision to pay farmers to burn crops and slaughter livestock to keep food prices high: To encourage food production, destroy it.

The grand pursuit of economics is to overcome scarcity and increase the production of goods and services. Keynesians believe that the economic problem is abundance: too much production and goods on the shelf and too few consumers. Consumers lined up for blocks to buy things in empty stores in communist Russia, but that never sparked production. In macroeconomics today, there is a fatal disregard for the heroes of the economy: the entrepreneur, the risk-taker, the one who innovates and creates the things we want to buy. "All economic problems are about removing impediments to supply, not demand," Arthur Laffer reminds us. "

I highlighted Art Laffer's comment because it seems useful to me to focus on the true fundamental nature of man's economic problem: scarcity. Economics has always been, at root, about how to allocate scarce resources for the production of goods and services to satisfy a population's demands, at prices which satisfy both producer and consumer.

I may be one of the very few Americans to have read a slim volume on economics from the 1939 entitled The Theory of Idle Resources by W.H. Hutt. It was a response to Keynes' General Theory of Employment, Interest and Money (1935), which I have also read in full.

Keynes' basic ideas seem sensible, until you read Hutt's rebuttal. Particularly Hutt's scathing rebuke of Keynes' notion of MPP (the marginal physical product of labor). Hutt studied economics at the LSE and taught in Cape Town all of his professional life. The jacket of my copy of the book contains an approving accolade from no less than Von Mises, attesting that Hutt was "not contested by any competent critic."

Prior to Keynes, the classical theory of macroeconomics correctly equated PQ and MV, or the price of goods and services produced, multiplied by quantities, and the money supply multiplied by its velocity. But nobody believed that macroeconomic forces could or perhaps should be forcibly altered by government action. No economic theorists were that vain and egotistical to believe that they could counsel government on how to prevent economic cycles.

I have always found it ironic that neo-Keynesian Paul Samuelson (father-in-law of the current administration's economic maven, now departed, Larry Summers) won his Nobel prize for a theory, the 'accelerator-multiplier,' which actually explained why the classical approach of macroeconomic non-intervention would allow economies to pass through their various cycles without interference.

Of course, Samuelson and his followers instead used his theory to argue for government intervention in order to magically short-circuit recessions. Something that, as Reynolds noted, even citing another current (also now departed) administration economic advisor, Christine Romer, has never actually occurred.

I shudder every time I hear new-Keynesians and their followers decry classical economics as some hoary pre-Enlightenment sort of faith-healing. Though Keynesian proponents can offer not one credible shred of evidence for the actual effectiveness of government debt-financed spending as a tonic for economies in recession, they seem to appeal to human nature's desire to believe that doing something is better than simply allowing the large, complex and difficult- if not impossible- to control entity that is a modern developed nation's economy to experience the natural cycles it must. Patience is hardly a modern virtue, either, so that's another basis on which classical economics seems to be judged guilty by modern Keynesians.

But the reality is that without naturally-occurring cycles in economies which clear out failure, re-allocate resources and allow new growth, you don't get constant economic expansion with low inflation. Instead, you get politically-allocated resources borrowed on behalf of taxpayers, along with the recession that was promised to be ended sooner and more mildly than without the deficit spending.

Monday, August 22, 2011

Michael Lewis' The Big Short- Initial Observations

After writing this post earlier this month about Michael Lewis' 20+ year old book Liar's Poker and exchanging comments with a reader presenting himself as a young prospective investment banker, I went ahead and bought two of his subsequent books, Moneyball and The Big Short. Incidentally, in keeping with the times, I ordered both as nearly-virgin, used copies from Amazon resellers for no more than $10 each, including shipping. The latter arrived looking every bit like a brand new, unopened book.

Despite my intentions to save The Big Short, published last year, to read in a classic summer situation of electronic unconnectedness, I have read roughly one-fifth of it already. Being the second of Lewis' financial books that I've read, and having reread Liar's Poker, his first, in the past few weeks, I have a few observations to offer on The Big Short.

The first is simply how Lewis focuses on people with amazingly good luck. In Liar's Poker, he made the point of how few people were granted the exalted status he enjoyed by being hired by then-dominant Salomon Brothers.

In The Big Short, he initially profiles a one-eyed doctor-turned-equity portfolio manager, Mike Burry. Burry first attracts attention from Joel Greenblatt and his colleagues, New York-based hedge fund managers, rather unbelievably from their following his selections as posted on stock trading message boards of the time, and his own nascent AOL 'blog.' Later, Lewis confirms that Burry was the only person Greenblatt's firm ever subsequently approached with an offer to buy part of his firm. Then Burry, seeking to profit from the troubles of companies involved in sub-prime finance, shifts from equities to debt, buying derivatives on CDOs which he is certain will lose the bulk of their value due to underlying defaults. His investors, learning of this, want to, but can't redeem their funds because of Burry's lock-up rules.

Then Burry manages to coax, badger and persuade several banks to sell him the derivatives he wants on selected mortgage-backed CDOs. Eventually, the banks catch on and begin doing the same, all the while Burry and the traders at these banks lie to each other about exactly what they are doing.

What's ironic is that Lewis paints Burry as the most honest of hedge fund managers, eschewing a fixed management fee. But he doesn't adequately, in my opinion, explain the very serious fraud Burry committed when he informed his investors and backers that he'd completely changed the investments in his portfolio. That Burry survived this is even more immense luck.

It's likely that Burry's being a subjective stock picker had a lot to do with his intellectual property not simply being stolen. I have friends who unwisely approached GE Capital years ago with a financial concept. The management at GE officially rejected the concept, but only months later were seen having appropriated the idea and implemented it at the unit, at scale. Suffice to say, my friends were out millions due to unrealistic expectations of GE Capital's operating procedures.

Similarly, when, a few years ago, an intermediary offered to introduce a then-business partner and me to Goldman Sachs, in order to obtain investment funds, we declined. We realized we weren't going to be, for example, in a private meeting with the firm's CEO or any other single senior officer. Instead, the intermediary was probably going to have us presenting our IP to, and answering the questions of, a dozen or more smart, hungry Goldman junior staffers all eager to climb over each other- and us- to make their fortune.

One of my business partner's colleagues in private equity later confirmed that it was imperative we never let a large investment bank or fund manager, like Goldman, have any whiff of the details of our approach, lest they move heaven and earth to obtain information on our trades and mimic them for free. And that we were correct to avoid providing any details of my equity portfolio management approach to anyone at Goldman.

More often than not, an existing financial firm will take what they can, rather than formally approach someone with a new, profitable concept and offer value for it.

Thus, it's very difficult to adequately explain, or overstate, just how wildly improbably Burry's good fortune was. First, to be a subjective equity analyst-cum-investor who actually beat the S&P500 is pretty rare. To have divulged his selections online and then have a hedge fund find, track and ultimately buy a piece of his operation is even rarer. And to survive essentially completely changing the nature of his fund without giving investors a chance to redeem.

Think rare as in the exceedingly long odds of any one low-income, uneducated minority youth devoting all his time to playing basketball, and eventually making it through a college basketball program to be selected by an NBA team and actually playing for at least a few seasons, thus scoring the sports equivalent of a lottery win.

Lewis writes engaging, interesting and true stories. He has a wry manner of educated the novice in the arcane ways of finance, while exposing fraud, luck, and many other aspects of the human condition.

The way in which Lewis has, so far as I have read at this point, composed The Big Short gives the appearance of a few honest, initially-naive souls at Oppenheimer and elsewhere standing up to widespread housing finance fraud, fighting the good fight and, I'm assuming, ultimately triumphing through immense financial gains.

As I read Chapter Two, In The Land of the Blind, about Burry, I couldn't help but think about the legions of other analysts and investors who could and probably did have other equally-profitable approaches, but, at some stage of their efforts, failed to receive the luck which found Burry.

In short, I think Lewis' tales of finance give the illusion of skill trumping fraud and greed, when, more accurately, it's luck and some skill accidentally getting a lightning strike amidst greed, fraud and herd investing mentality in the fund management, trading and investment banking businesses.