This morning's Wall Street Journal featured a rather surprising article in the Money & Investing section.
It seems that CALPERS and other large, pension-related, asset-rich entities, all members of the Institutional Limited Partners Association (ILPA), have explicitly met to formulate a set of 'principles' which they will demand private equity funds adopt.
In response, several private equity shops are exploring a lawsuit on anti-trust bases.
The Journal piece ends with what is probably the most sensible point, which is a quote from an attorney expressing the view that the federal bench isn't going to go to bat for the likes of Henry Kravis.
While almost certainly true, it is, also, beside the point. Justice is supposed to be blind, and if the private equity groups have a case, well, then, they have a case.
But they really don't.
The ILPA may meet to draft common principles. But who said that's the entire market for private equity funding? In fact, if anything, the ILPA is probably doing themselves a favor by potentially excluding themselves from private equity deals.
After all, look at Cerberus. Great job with GMAC and Chrysler, guys. Isn't that John Snow, former Treasury Secretary, overseeing those embarrassments?
The situation here is really quite simple.
Over the past few decades, private equity groups became overwhelmed with funding. Their activity levels, and the prices of their acquisitions, soared. In time, Blackstone even went partially-public, enriching its partners at previously unheard-of levels.
If that's not a sign of an overheated market, what is? And ILPA members were very likely in the vanguard of the rush to overfund private equity groups.
Now, having become disappointed with results, these institutions are crying foul and developing "principles."
By the way, last time I looked, CALPERS had done a very fine job of screwing up on its own with a reckless land investment scheme that's gone sour at a huge cost to the entity's assets.
Here's what will actually happen in years to come.
First, the ILPA will try to hold private equity groups to the newly-restrictive terms. The vaunted "principles" center around, as you'd expect, pricing. Terms such as fees, disclosure and investor oversight.
Second, a few ailing private equity groups will cave in, to preserve funding. But the better firms won't.
Third, the better-performing private equity groups will be pursued by ILPA members who will toss away their newly-created terms in order to get a piece of the best returns in the sector.
That's how these cycles always work. Hedge funds are the same way. Once burned, institutional investors declare that they won't stand for such restrictive terms. Then, when the hedge funds become the best-performing investment firms, such concerns are easily discarded in the pursuit of returns.
There won't be a lawsuit by private equity groups. The weak ones will want it, but the stronger ones realize it serves no purpose to air this dirty laundry. And they will naturally regain the institutional customers once market conditions turn to their favor once more.
Still, it's an interesting circus to watch. Institutional investors looking to blame the recipients of their investments, rather than admit to their own mistakes, while the weaker private equity groups run for legal cover.
Showing posts with label Markets. Show all posts
Showing posts with label Markets. Show all posts
Tuesday, March 23, 2010
Thursday, April 02, 2009
The Unseen Costs of Government Intervention in Businesses
Yesterday morning, I heard Alabama's Republican Senator and ranking member of the Senate Banking Committee, Richard Shelby, say on CNBC, in reference to the auto maker bailouts, to paraphrase,
'I hope GM succeeds.'
Frankly, I was horrified. It's bad enough that both the Bush and Obama administrations allowed GM and Cerebrus/Chrysler to avoid bankruptcy court via Chapter 11.
But to hear a conservative Republican express a desired outcome for a specific company was very disappointing.
In my opinion, the sentiment which Senator Shelby should have expressed was,
"As a member of Congress, I cannot, of course, express preference for one competitive US company to the detriment of another. To indicate that I, rather than the market, possess a desire for any US company to have a specific outcome is improper.
Rather, I wish that GM receive and experience what our markets, both consumer and financial, judge appropriate for the company.
If that means survival now, on its own resources, and success in the future, so be it. If, instead, it means the firm cannot continue operations, and must file for Chapter 11 bankruptcy, again, so be it."
It is simply wrong for our federal government to engage in such massive intervention as to be lending private-sector companies money, in hopes of avoiding their demise.
How can our government possible know, better than the natural forces of our markets, that the best use of, for example, some building in Flint, Michigan, is as a GM plant, rather than the new home of some entrepreneur's business?
What if the fall in rental price of that former plant is the key to allowing some new business to flourish, employing workers and having better growth prospects than GM?
In the same way as the administration's hamhanded approach to mortgage foreclosure relief is frustrating attempts by new aspirants to homeownership, about which I wrote here recently, the distressing attempts by our government to "pick winners" in the private sector is mistakenly substituting governmental preference for that of our consumer and capital markets.
Isn't this what the Soviet Union tried, and ultimately found to be inefficient, unworkable and a failure for most of the 20th century?
Who among us truly believes that our federal government is more skilled than consumers and investors in the selection of those business which ought to survive and prosper?
By propping up GM and refusing to allow it, if necessary, to enter Chapter 11 proceedings, our government- both Congress and the administration- is merely delaying the inevitable market-clearing dissolution of failing and failed companies, the recycling of their resources a la Schumpeter's observations of eighty years ago, and the freeing up of labor to be employed in new ventures.
Government isn't the right institution to select our economy's winners and losers. For that, we have a process which we have trusted for most of our country's life- our freely-operating, private capital and consumer markets.
'I hope GM succeeds.'
Frankly, I was horrified. It's bad enough that both the Bush and Obama administrations allowed GM and Cerebrus/Chrysler to avoid bankruptcy court via Chapter 11.
But to hear a conservative Republican express a desired outcome for a specific company was very disappointing.
In my opinion, the sentiment which Senator Shelby should have expressed was,
"As a member of Congress, I cannot, of course, express preference for one competitive US company to the detriment of another. To indicate that I, rather than the market, possess a desire for any US company to have a specific outcome is improper.
Rather, I wish that GM receive and experience what our markets, both consumer and financial, judge appropriate for the company.
If that means survival now, on its own resources, and success in the future, so be it. If, instead, it means the firm cannot continue operations, and must file for Chapter 11 bankruptcy, again, so be it."
It is simply wrong for our federal government to engage in such massive intervention as to be lending private-sector companies money, in hopes of avoiding their demise.
How can our government possible know, better than the natural forces of our markets, that the best use of, for example, some building in Flint, Michigan, is as a GM plant, rather than the new home of some entrepreneur's business?
What if the fall in rental price of that former plant is the key to allowing some new business to flourish, employing workers and having better growth prospects than GM?
In the same way as the administration's hamhanded approach to mortgage foreclosure relief is frustrating attempts by new aspirants to homeownership, about which I wrote here recently, the distressing attempts by our government to "pick winners" in the private sector is mistakenly substituting governmental preference for that of our consumer and capital markets.
Isn't this what the Soviet Union tried, and ultimately found to be inefficient, unworkable and a failure for most of the 20th century?
Who among us truly believes that our federal government is more skilled than consumers and investors in the selection of those business which ought to survive and prosper?
By propping up GM and refusing to allow it, if necessary, to enter Chapter 11 proceedings, our government- both Congress and the administration- is merely delaying the inevitable market-clearing dissolution of failing and failed companies, the recycling of their resources a la Schumpeter's observations of eighty years ago, and the freeing up of labor to be employed in new ventures.
Government isn't the right institution to select our economy's winners and losers. For that, we have a process which we have trusted for most of our country's life- our freely-operating, private capital and consumer markets.
Tuesday, July 01, 2008
It's Official.....Time To Go Short!!!!
I am very, very sorry to note that my proprietary equity allocation signal has finally gone to "short" for the first time since 2001.
Believe it or not, even January's rollercoaster ride and March's collapse didn't trigger it. Almost, but the April bounce lifted the S&P just enough to keep us long for a while.
For my partner and I, now, that means calls rather than puts, since we have moved on from straight equities. But the message from the underlying equity markets is still important, and not to be taken lightly.
June's S&P return of at best -9%, on first glance using a simple Yahoo-sourced price difference, is the worst in ages, and sends my proprietary market turbulence/allocation signal firmly into short/put territory.
It will take at least a +3% July S&P return to reverse this, based on my tools.
I don't predict the S&P, and I don't market time. My tools are more like hurricane warnings than daily weather forecasts. And right now, I'd be boarding up the windows and filling the bathtub with water. At least for the next few weeks.
More as conditions develop later this month. But for now, we are almost certainly going to be buying puts next week, when end-of-June Compustat data arrives to drive July selections and weights.
Believe it or not, even January's rollercoaster ride and March's collapse didn't trigger it. Almost, but the April bounce lifted the S&P just enough to keep us long for a while.
For my partner and I, now, that means calls rather than puts, since we have moved on from straight equities. But the message from the underlying equity markets is still important, and not to be taken lightly.
June's S&P return of at best -9%, on first glance using a simple Yahoo-sourced price difference, is the worst in ages, and sends my proprietary market turbulence/allocation signal firmly into short/put territory.
It will take at least a +3% July S&P return to reverse this, based on my tools.
I don't predict the S&P, and I don't market time. My tools are more like hurricane warnings than daily weather forecasts. And right now, I'd be boarding up the windows and filling the bathtub with water. At least for the next few weeks.
More as conditions develop later this month. But for now, we are almost certainly going to be buying puts next week, when end-of-June Compustat data arrives to drive July selections and weights.
Monday, March 31, 2008
Secretary Paulson's New Financial Markets Regulatory Blueprint
Hank Paulson's speech last Wednesday to the US Chamber of Commerce on financial markets regulatory redesign, about which I wrote here, was, in retrospect, a warning about today's release of the Secretary's 'blueprint' for a new scheme.
You can read all about it in today's Wall Street Journal. The details would be many, I am sure. The executive summary was reported to be some 22 pages, the full report running to something in excess of 200.
However, to me, three facets of the recommendations stand out.
The first is one on which I picked up during Paulson's speech on Wednesday- forming exchanges for current OTC instruments such as credit default swaps. When he referred to this on Wednesday, I found it telling.
When Paulson mentioned it twice today- once in his speech, and another in an interview on CNBC- it told me that Paulson correctly understands that these unregulated instruments, whose settlement and clearing has become problematic, are going to be reined in hard.
This is a good thing. Leaving them roaming in OTC land has become a dangerously destabilizing feature of today's financial markets. It may end up as one of Paulson's two best legacy achievements.
The other would be Federalizing the insurance markets. Paulson took the politically difficult, but economically- and regulatorialy-necessary step of calling for Federal supervision of insurance to supersede any existing state-level regulations. Citing national and international scale of providers and a need for competitive developments in the industry, Paulson's recommendation may finally force loose a major stumbling block which has helped delay meaningful progress on affordable healthcare insurance plans in this country. It would be his other monumental legacy to accomplish this particular Federalization.
The third noteworthy aspect of Paulson's recommendations is the near-term formation of a Federal mortgage certification board. The intended consequence of this board would ostensibly create a body of Federally licensed mortgage industry professionals.
Are there no bad practitioners of law or medicine? Plumbing, electrical work or carpentry?
Licensing alone will not prevent the shoddy lending practices or improper mortgage broker activity which played their parts in the home lending debacles now being sorted out.
A recent Wall Street Journal editorial noted that requiring licensing for a profession typically raises prices, but offers no guarantees of better products or services. This will, sadly, be true for the mortgage business, as well.
Rather, as my partner suggested over a month ago, the more obvious and simple solution is to require a 20% cash downpayment for any mortgage made in the US. Period.
No exceptions. A borrower's balance sheet must be frozen and clean, and on that balance sheet must he sufficient cash to constitute 20% of the purchase price of the home.
Most of the problems with subprime mortgages or shady brokers would have been mitigated simply by requiring the borrowers to qualify with 20% of the purchase price in cash.
It is very similar to the original installment credit regulations in place in the US in the 1950s, before the growth of installment lending via bank credit cards.
Other than overloading the Fed with excess supervision duties, as I noted in my earlier, linked post, and this bad idea for mortgage banking licensing, Paulson's recommended blueprint for newly-regulated US financial markets holds great promise, and is long overdue.
You can read all about it in today's Wall Street Journal. The details would be many, I am sure. The executive summary was reported to be some 22 pages, the full report running to something in excess of 200.
However, to me, three facets of the recommendations stand out.
The first is one on which I picked up during Paulson's speech on Wednesday- forming exchanges for current OTC instruments such as credit default swaps. When he referred to this on Wednesday, I found it telling.
When Paulson mentioned it twice today- once in his speech, and another in an interview on CNBC- it told me that Paulson correctly understands that these unregulated instruments, whose settlement and clearing has become problematic, are going to be reined in hard.
This is a good thing. Leaving them roaming in OTC land has become a dangerously destabilizing feature of today's financial markets. It may end up as one of Paulson's two best legacy achievements.
The other would be Federalizing the insurance markets. Paulson took the politically difficult, but economically- and regulatorialy-necessary step of calling for Federal supervision of insurance to supersede any existing state-level regulations. Citing national and international scale of providers and a need for competitive developments in the industry, Paulson's recommendation may finally force loose a major stumbling block which has helped delay meaningful progress on affordable healthcare insurance plans in this country. It would be his other monumental legacy to accomplish this particular Federalization.
The third noteworthy aspect of Paulson's recommendations is the near-term formation of a Federal mortgage certification board. The intended consequence of this board would ostensibly create a body of Federally licensed mortgage industry professionals.
Are there no bad practitioners of law or medicine? Plumbing, electrical work or carpentry?
Licensing alone will not prevent the shoddy lending practices or improper mortgage broker activity which played their parts in the home lending debacles now being sorted out.
A recent Wall Street Journal editorial noted that requiring licensing for a profession typically raises prices, but offers no guarantees of better products or services. This will, sadly, be true for the mortgage business, as well.
Rather, as my partner suggested over a month ago, the more obvious and simple solution is to require a 20% cash downpayment for any mortgage made in the US. Period.
No exceptions. A borrower's balance sheet must be frozen and clean, and on that balance sheet must he sufficient cash to constitute 20% of the purchase price of the home.
Most of the problems with subprime mortgages or shady brokers would have been mitigated simply by requiring the borrowers to qualify with 20% of the purchase price in cash.
It is very similar to the original installment credit regulations in place in the US in the 1950s, before the growth of installment lending via bank credit cards.
Other than overloading the Fed with excess supervision duties, as I noted in my earlier, linked post, and this bad idea for mortgage banking licensing, Paulson's recommended blueprint for newly-regulated US financial markets holds great promise, and is long overdue.
Monday, February 18, 2008
Last Week's S&P500 Performance
We seem to be in a period of weeks of indeterminate financial markets behavior.
For the evolving month of February, the S&P is down, with roughly a -2.2% return. That's including last week's +1.4% return, and the prior week's -4.6% return.
Looking at my newly-devised monthly standard deviation measure of daily S&P500 Index returns, it's hard to get excited about last week's return. That is because it falls within the confidence interval of 68% that such a return could occur, plus or minus, in one day for the S&P.
The daily returns last week were: +0.59%, +0.73%, +1.36%, -1.34%, and +0.08%.
Tuesday's rise was attributed to Warren Buffett's self-serving offer to reinsure municipal instruments. Wednesday's gain was allegedly due to positive corporate earnings reports and some positive sales data. This, by the way, amidst what more pundits, and a few economists, including former Fed chairman Greenspan have decided is, or is about to be a recession.
Thursday's large drop occurred as Treasury Secretary Paulson, Fed Chairman Bernanke and SEC Chairman Cox all testified before Congress. Given the typically-hostile attitude of the Democratic-chaired committee to the Republican administration officials, it's not all that surprising that the subsequent testimony roiled markets.
Some felt that Bernanke left the door open to a further rate cut of 1/4% point at the next Fed meeting.
Finally, on Friday, despite poor manufacturing data and a low Michigan Index of Consumer Confidence, as well as reported investor concerns about inflation, the index managed a small gain.
Confused about investors' reactions to various 'news' items? You're not alone. At least I'm with you.
So, as we head into the last half of this month, the S&P is so volatile that there is a good chance it will either slice most of the negative return, or add another -1.4% to it, on any given day. In any two day period, the index could turn positive, or more than double its negative return for the month.
After reviewing this past week's sample of putative causes and effects on the index's daily performance, it gives one pause to have any sense of which way it will finish this month.
It's so tentative that my partner and I are actually watching daily S&P performances, in order to keep up with the latest moves in this very unstable market. Until one of the major indicators which we monitor either confirms its current position, or moves significantly in another direction, we are unlikely to take any new positions in equities or options.
It's simply too difficult to discern a longer-term market direction for the next few months at this time.
For the evolving month of February, the S&P is down, with roughly a -2.2% return. That's including last week's +1.4% return, and the prior week's -4.6% return.
Looking at my newly-devised monthly standard deviation measure of daily S&P500 Index returns, it's hard to get excited about last week's return. That is because it falls within the confidence interval of 68% that such a return could occur, plus or minus, in one day for the S&P.
The daily returns last week were: +0.59%, +0.73%, +1.36%, -1.34%, and +0.08%.
Tuesday's rise was attributed to Warren Buffett's self-serving offer to reinsure municipal instruments. Wednesday's gain was allegedly due to positive corporate earnings reports and some positive sales data. This, by the way, amidst what more pundits, and a few economists, including former Fed chairman Greenspan have decided is, or is about to be a recession.
Thursday's large drop occurred as Treasury Secretary Paulson, Fed Chairman Bernanke and SEC Chairman Cox all testified before Congress. Given the typically-hostile attitude of the Democratic-chaired committee to the Republican administration officials, it's not all that surprising that the subsequent testimony roiled markets.
Some felt that Bernanke left the door open to a further rate cut of 1/4% point at the next Fed meeting.
Finally, on Friday, despite poor manufacturing data and a low Michigan Index of Consumer Confidence, as well as reported investor concerns about inflation, the index managed a small gain.
Confused about investors' reactions to various 'news' items? You're not alone. At least I'm with you.
So, as we head into the last half of this month, the S&P is so volatile that there is a good chance it will either slice most of the negative return, or add another -1.4% to it, on any given day. In any two day period, the index could turn positive, or more than double its negative return for the month.
After reviewing this past week's sample of putative causes and effects on the index's daily performance, it gives one pause to have any sense of which way it will finish this month.
It's so tentative that my partner and I are actually watching daily S&P performances, in order to keep up with the latest moves in this very unstable market. Until one of the major indicators which we monitor either confirms its current position, or moves significantly in another direction, we are unlikely to take any new positions in equities or options.
It's simply too difficult to discern a longer-term market direction for the next few months at this time.
Wednesday, February 13, 2008
The Dow-Jones Industrials: Out With The Old....
The Wall Street Journal reported this week on the change in complexion of its major market index, the Dow-Jones 30 Industrials.
Out went Honeywell and Altria, in came BofA and Chevron.
I suppose there are various reasons for the changes. One is that Altria is effectively going away shortly, as the company's offshore tobacco businesses are being split from the old Phillip Morris.
As for Honeywell's ouster, apparently the folks at Dow-Jones feel that oil now represents a greater component of US economic activity than the diversified, high-value-added manufacturing and distribution of engineered material and systems produced by Honeywell.
Curiously, BofA was added, again, on the pretext that financial services is now underrepresented in the 30 company group.
Out of curiosity, I produced charts of all four companies on Yahoo, over 2-year and 'maximum' year timeframes.
The nearby two-year chart shows all four companies moving more or less in a band together until early last year. Then things got interesting.Honeywell, one of the exiting companies, spurted ahead of two of the others, with Chevron slightly outperforming it, but with a similar pattern.
Altria, also exiting, also outperformed BofA, the worst of the lot. Of course, as the year wore on, and Ken Lewis had "about as much fun as (he could) take" in investment banking, BofA's performance slid sharply. In fact, so sharply that it nearly ended the two years back where it began.
The DJIA itself actually underperforms all the firms save BofA.
Turning to a much longer-term view of the four companies' stock prices, we see that all of them, except Altria, had remarkably similar paths for the past 38 years. There was a bit of untracking in the late '80s to mid '90s, and, as I noted above, in the last few years. And Honeywell declined noticeably from the path that Chevron and BofA shared for the early years of this decade.Amazingly, the outperformer of the bunch has been the tobacco-and-sometime-packaged-goods giant, Altria, once a/k/a Phillip Morris..
What does all this mean for the Dow? I guess the rough parity of the three non-tobacco firms means you might expect similar Dow-Jones performance going forward. Maybe there's even a sort of central-tendency play going on, wherein the outliers over time, Honeywell and Altria, are dropped, in favor of two more attenuated stocks, BofA and Chevron.
Since the DJIA, over this long timeframe, nests right in among BofA and Chevron, this would seem to be true, even if it's not actually why Dow-Jones made these specific replacements.
Being focused more on the S&P, I really don't pay any serious attention to the Dow. If anything, this sort of shuffling merely points out how sensitive to membership is any market index composed of only 30 companies. Did the staff at Dow-Jones have to work exhaustively to choose a mix of outgoing and incoming companies, such that their effects upon at least the recent past of the Dow's performance would be minimal?
Choosing a bank and an oil company in an era of huge write-offs among commercial banks, including BofA, and dwindling opportunities for oil reserves acquisition by US majors worldwide, poses an intriguing question about the real reasons behind these choices.
As a few pundits opined, you can bet the folks at Dow-Jones want the index to do better, not worse, over time. Thus, they must be placing an implicit "call" on BofA and Chevron and, by extension, financials and oil in the US economy. And an implicit "put" on tobacco and diversified manufacturing onshore.
That's not a view I would have expected them to take, all other things equal. It should be interesting to see what sort of comments are made on these changes in the months and years ahead.
Thursday, November 29, 2007
On Recent Equity Markets 'Volatility' & MFQ
Much is heard recently on the 'volatility' of US equity markets.
What is meant by this? My business partner and I discussed this topic yesterday over lunch.
Technically, volatility usually is inferred to mean something associated with a type of standard deviation measure, or some derivative thereof, such as variance (the square of a standard deviation).
On that basis, a graph of S&P monthly returns from 1990 to the present looks like this (click on the chart to see it in a larger version).Optically, you can see that the S&P monthly returns became more dispersed in the middle of the period covered by the graph, but has calmed down noticeably in the past 3-4 years.
This next graph portrays the standard deviation of the S&P monthly returns over trailing 12, 24, 48 and 96 month period.
As you would expect, the standard deviations of the longer periods move much more gradually.Even so, all four measures have been in notable and significant decline since early 2003. Only this month's current -6.6% S&P monthly return has disturbed this pattern in recent years. Even so, it isn't necessarily a bigger shock than those of mid-2004, which were only a brief exception to the longer-term, continuing decline of the standard deviation of S&P monthly returns.
If the S&P monthly returns, measured over various timeframes, aren't showing increasing 'volatility,' on what measure would the S&P, as the best broad US equity market measure, depict rising 'volatility?'
As my partner argued that my reference to this graph missed the point, we debated what would be relevant? That question led my partner and me to construct the following measure yesterday.
Begin with the daily adjusted closing price series of the S&P500, available, for free, from Yahoo's finance website. Calculate the first differences, i.e., a series of daily raw change in adjusted closing S&P500 price. From this series, identify each raw daily change as either positive, or negative in sign.
Then, construct a series which looks at each day's adjusted closing price difference sign, relative to the preceding day's closing price difference sign. The value for a day in this series will be "1" if the signs changed between daily adjusted close differences, and "0" they were the same.
In effect, each time the S&P close changes direction from the prior day, that day registers a "1." If the market records two consecutive up, or down days, the values for those second days would be "0" in this last series.
We call this last series, and its monthly total, the Market Fluctuation Quotient, or MFQ.The nearby graph displays the S&P500's MFQ, on a monthly basis, from January of 2000 until yesterday.
The highest value we've seen for the MFQ was 17, in August of 2005. The lowest value was a 6, in September of 2001. However, that was affected by the market's close for a period during the week following the WTC attacks. Other than that datapoint, the series hit a low of 8 three times in the 95 months measured.
To more clearly understand the distribution of MFQ values during the 95 months of this decade, here is the same data arrayed in a histogram, by frequency of occurrence.Two of the six MFQ values over 14, since January of 2000, have occurred since July of this year. If either today or tomorrow sees a closing S&P value lower than the preceding day, then November, 2007, will be the third over-14 MFQ value out of seven since the beginning of the measured period.
Since July of this year, no MFQ value has been below 11. The last similar period of elevated MFQs was from February to June of 2005, just prior to that year's hurricane season-affected equity markets.
If you are a frequent trader, than the MFQ is relevant. It clearly captures the recent, heightened day-to-day volatility, when that term means changes in closing market value direction.
We, however, are longer-term investors. Even in our equity options portfolios. As such, the MFQ doesn't really affect our investment decisions very much.
Still, it's interesting to note how divergent the two different perspectives on market 'volatility' can be- a series of standard deviations of month-to-month S&P returns, and a series measuring S&P daily close sign changes.
Clearly, volatility is in the eye of the beholder, and his/her frame of reference.
Tuesday, November 06, 2007
Why Wall Street Repeats Risk-Related Mistakes
Dennis Berman penned an article in today's Wall Street Journal's Money & Investing section, entitled, "Why Street Bankers Get Away With Repeating Old Mistakes."
Mr. Berman's pieces are typically interesting and well-reasoned. Today's is no exception. He asks the question, in reference to subprime mortgages and CDOs,
"What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?"
He quotes a money manager as saying,
"That's the thing about Wall Street that amazes me. They keep making the same mistakes."
Toward the end of his thought-provoking piece, Mr. Berman writes,
"Consider another sector of this upside-down world. Over the last few years, standard bank deposits became less desirable. It was too costly building branches and bidding for deposits, especially when more flexible wholesale funding could be created at a moment's notice via fresh short-term paper. That was the reasoning of Countrywide Financial, and a slew of other players such New Century Financial and Northern Rock PLC of the United Kingdom.
It was great, as long as the paper could be repeatedly rolled over. When it couldn't, the companies would be well out of business. But how could that possibly happen?
As a hedge-fund manager himself, Mr. Bookstaber acknowledges that in the real world of "normal accidents and primal risks, limitless trading possibilities might cause more harm than good."
Financial cycles are natural, we're told. Of course they are. But they also make a wonderful excuse for lots of bad, or downright dumb, behavior. Does it really have to be?"
I actually sent an email to him at the address provided at the article's end, saying, "yes," it does really have to be.
Let me explain. A few weeks ago, while talking with my brother, a creative SVP at a major ad agency, he asked me,
'What happens to traders and investment bankers when they get older? Do they retire?'
And I realized, as I began to explain the industry's career paths, that few people actually understand this key driver of the behavior Mr. Berman has observed.
Most people have little idea of the compensation structures and career paths of Wall Street traders and investment bankers. Or even, for that matter, lower-paid people in other highly-paid service sectors, such as consulting.
For instance, a little less than fifteen years ago, an acquaintance of mine who was a retired Fortune 50 CEO was shocked to learn the pay structure of Andersen Consulting's partners. I worked there at the time, for a very skilled managing partner who wore many hats. Between running a large regional industry practice, the local city office of the same industry, representing the Americas for that industry segment, and selling some engagements, he was earning something north of $400K. This would have been in 1993.
Further, there were easily at least 50 other managing partners at Andersen making as much or more as my direct manager at the time.
My acquaintance was stunned, remarking that in his very large commodity-producing giant, perhaps only three executives were making that much money.
Well, compensation is even more disparate on Wall Street.
For example, most really good traders are off the floor by age 35. They either burn out or move up the ranks to manage larger 'desks,' and collections of trading units. In the process, it's nothing for a good trader to make a few million dollars per year. The same is true for investment bankers involved in mergers and acquisitions, or active underwriting areas. As business volumes ebb and flow, these amounts will, of course, change.
But in general, a young investment bank employee who rises through the trading or M&A ranks can amass compensation worth tens of millions of dollars by his or her mid-thirties. And, as I mentioned in this video post, more young investment bankers are being counseled to remain with their firm, and eschew going to business school for a graduate degree, because it no longer makes economic sense.
So, we have the situation of many mid-thirties bankers in a position to 'retire' anytime they wish, and likely own more assets than most Americans will earn in a lifetime of work.
If a senior executive at, say, to use Mr. Berman's example, Boeing or J&J, do really well, they might retire with a few million dollars. They make planes, or drugs, or medicines, but are paid in dollars.
Traders and investment bankers use, work in, money, and get paid in it, too. And because of the incredible volumes of money that flow through their hands, paying the better players millions per year makes economic sense.
Thus, to get back to the answer to my brother's question, old traders and bankers don't really 'retire.'
First, on the way up, they realize that risk taking pays. As I wrote in this recent post, which I sent to Mr. Berman, by way of answer to his question,
"At diversified financial service firms, managers compete for promotions, compensation and control. In order to win these, they must out-grow their peers.
So they take excessive risks in the mid-cycle of a business, riding high growth and turning it into more explosive, riskier growth.Sometimes, this approach works and the executives involved rise to lead the firm. If not, they still get compensated well, and the firm takes the hit to its balance sheet when the risk catches up with the earnings.
When I was at Chase Manhattan Bank in the early 1990s, the Real Estate division pushed for high, risky growth via construction lending in Manhattan. Eventually, that bubble burst, leaving the bank to take several hundred million dollars in writedowns in 1990. Meanwhile, the executives who made the loans, often found, upon later auditing, to be improperly documented, if documented at all, received large bonuses for making loan origination quotas.
In a large, diversified financial services firm, this drama plays continuously. That is why some element of a diversified financial conglomerate like BofA, Citi, Chase, Merrill, et.al., seems to explode in fantastic losses every few years.
In short, it's risk management that brings down large, diversified financial service firms every time. More than anemic growth, excessive growth in one or two businesses inevitably leads to excessive risks, which are typically hidden from the credit and audit functions, as well as senior management. After all, the executives are playing with the firm's money, so it's a win/win or lose/win proposition for them. Either way, their firm takes any losses.
The days of smallish Wall Street partnerships in which risks were well-understood, acknowledged, and managed, because the partners owned the risk, are long gone now. Instead, diversified financial mega-firms such as Merrill and BofA own many business units, in which managers play a risky game to advance their careers.
Thus, the entire complexion of financial service businesses, markets, and the risks inherent in them, have changed irrevocably, as a function of the sector's current organization. That's why you can expect something like the current Merrill writedowns and firings every few years at one or more diversified financial giants."
Remaining direct descendants of the original private partnerships among investment banks- Goldman and Morgan Stanley- still appear to have superior risk management cultures. Newer entrants into the field- Lehman, Merrill, and the large commercial banks- seem to have problems like I described.
So you have a lot of 30- and 40-something multi-millionaires who can easily leave one large, public financial services firm, and either: start their own fund, or; join a hedge fund, or; join a private equity shop.
Many well-paid, even moderately successful traders and bankers can start their second career in their 40s and make even more money. Or move to a smaller shop and enjoy a somewhat more relaxed schedule, compared to a bigger job, with more pressure, at a large publicly-held investment or commercial bank.
Because the rewards for failure are not that bad, and the rewards up until a possible failure are great, virtually nobody in the publicly-held firms has an incentive not to push the boundaries concerning risk to their firm's capital.
And that, Mr. Berman, I contend, is the answer to your question. The behavior you are observing is neither bad, nor downright dumb, for the people at these firms. Only for the firms and, temporarily, the financial system in which they exist.
Even traders and front-line investment bankers can make enough money over a good five-year run to 'retire' financially secure and ready for their second career, even if they blew their firms up in the process through excessively risky behavior.
Are not traders from Amaranth, the commodities firm the blew up last year due to bad bets on natural gas, are already back in circulation?
The key to all of this is to realize that in the financial services sector, it's fairly typical for ten-year veterans of the money-making functions- trading, underwriting and M&A- to amass sufficient capital to make them indifferent to being fired, resigning to join a smaller firm, or simply to (more prudently) risk their own capital in a similar endeavor. To these people, mistakes that get them fired simply end a lucrative merry-go-round ride a little early. But not usually too early to walk away in shape for their next act.
Mr. Berman's pieces are typically interesting and well-reasoned. Today's is no exception. He asks the question, in reference to subprime mortgages and CDOs,
"What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?"
He quotes a money manager as saying,
"That's the thing about Wall Street that amazes me. They keep making the same mistakes."
Toward the end of his thought-provoking piece, Mr. Berman writes,
"Consider another sector of this upside-down world. Over the last few years, standard bank deposits became less desirable. It was too costly building branches and bidding for deposits, especially when more flexible wholesale funding could be created at a moment's notice via fresh short-term paper. That was the reasoning of Countrywide Financial, and a slew of other players such New Century Financial and Northern Rock PLC of the United Kingdom.
It was great, as long as the paper could be repeatedly rolled over. When it couldn't, the companies would be well out of business. But how could that possibly happen?
As a hedge-fund manager himself, Mr. Bookstaber acknowledges that in the real world of "normal accidents and primal risks, limitless trading possibilities might cause more harm than good."
Financial cycles are natural, we're told. Of course they are. But they also make a wonderful excuse for lots of bad, or downright dumb, behavior. Does it really have to be?"
I actually sent an email to him at the address provided at the article's end, saying, "yes," it does really have to be.
Let me explain. A few weeks ago, while talking with my brother, a creative SVP at a major ad agency, he asked me,
'What happens to traders and investment bankers when they get older? Do they retire?'
And I realized, as I began to explain the industry's career paths, that few people actually understand this key driver of the behavior Mr. Berman has observed.
Most people have little idea of the compensation structures and career paths of Wall Street traders and investment bankers. Or even, for that matter, lower-paid people in other highly-paid service sectors, such as consulting.
For instance, a little less than fifteen years ago, an acquaintance of mine who was a retired Fortune 50 CEO was shocked to learn the pay structure of Andersen Consulting's partners. I worked there at the time, for a very skilled managing partner who wore many hats. Between running a large regional industry practice, the local city office of the same industry, representing the Americas for that industry segment, and selling some engagements, he was earning something north of $400K. This would have been in 1993.
Further, there were easily at least 50 other managing partners at Andersen making as much or more as my direct manager at the time.
My acquaintance was stunned, remarking that in his very large commodity-producing giant, perhaps only three executives were making that much money.
Well, compensation is even more disparate on Wall Street.
For example, most really good traders are off the floor by age 35. They either burn out or move up the ranks to manage larger 'desks,' and collections of trading units. In the process, it's nothing for a good trader to make a few million dollars per year. The same is true for investment bankers involved in mergers and acquisitions, or active underwriting areas. As business volumes ebb and flow, these amounts will, of course, change.
But in general, a young investment bank employee who rises through the trading or M&A ranks can amass compensation worth tens of millions of dollars by his or her mid-thirties. And, as I mentioned in this video post, more young investment bankers are being counseled to remain with their firm, and eschew going to business school for a graduate degree, because it no longer makes economic sense.
So, we have the situation of many mid-thirties bankers in a position to 'retire' anytime they wish, and likely own more assets than most Americans will earn in a lifetime of work.
If a senior executive at, say, to use Mr. Berman's example, Boeing or J&J, do really well, they might retire with a few million dollars. They make planes, or drugs, or medicines, but are paid in dollars.
Traders and investment bankers use, work in, money, and get paid in it, too. And because of the incredible volumes of money that flow through their hands, paying the better players millions per year makes economic sense.
Thus, to get back to the answer to my brother's question, old traders and bankers don't really 'retire.'
First, on the way up, they realize that risk taking pays. As I wrote in this recent post, which I sent to Mr. Berman, by way of answer to his question,
"At diversified financial service firms, managers compete for promotions, compensation and control. In order to win these, they must out-grow their peers.
So they take excessive risks in the mid-cycle of a business, riding high growth and turning it into more explosive, riskier growth.Sometimes, this approach works and the executives involved rise to lead the firm. If not, they still get compensated well, and the firm takes the hit to its balance sheet when the risk catches up with the earnings.
When I was at Chase Manhattan Bank in the early 1990s, the Real Estate division pushed for high, risky growth via construction lending in Manhattan. Eventually, that bubble burst, leaving the bank to take several hundred million dollars in writedowns in 1990. Meanwhile, the executives who made the loans, often found, upon later auditing, to be improperly documented, if documented at all, received large bonuses for making loan origination quotas.
In a large, diversified financial services firm, this drama plays continuously. That is why some element of a diversified financial conglomerate like BofA, Citi, Chase, Merrill, et.al., seems to explode in fantastic losses every few years.
In short, it's risk management that brings down large, diversified financial service firms every time. More than anemic growth, excessive growth in one or two businesses inevitably leads to excessive risks, which are typically hidden from the credit and audit functions, as well as senior management. After all, the executives are playing with the firm's money, so it's a win/win or lose/win proposition for them. Either way, their firm takes any losses.
The days of smallish Wall Street partnerships in which risks were well-understood, acknowledged, and managed, because the partners owned the risk, are long gone now. Instead, diversified financial mega-firms such as Merrill and BofA own many business units, in which managers play a risky game to advance their careers.
Thus, the entire complexion of financial service businesses, markets, and the risks inherent in them, have changed irrevocably, as a function of the sector's current organization. That's why you can expect something like the current Merrill writedowns and firings every few years at one or more diversified financial giants."
Remaining direct descendants of the original private partnerships among investment banks- Goldman and Morgan Stanley- still appear to have superior risk management cultures. Newer entrants into the field- Lehman, Merrill, and the large commercial banks- seem to have problems like I described.
So you have a lot of 30- and 40-something multi-millionaires who can easily leave one large, public financial services firm, and either: start their own fund, or; join a hedge fund, or; join a private equity shop.
Many well-paid, even moderately successful traders and bankers can start their second career in their 40s and make even more money. Or move to a smaller shop and enjoy a somewhat more relaxed schedule, compared to a bigger job, with more pressure, at a large publicly-held investment or commercial bank.
Because the rewards for failure are not that bad, and the rewards up until a possible failure are great, virtually nobody in the publicly-held firms has an incentive not to push the boundaries concerning risk to their firm's capital.
And that, Mr. Berman, I contend, is the answer to your question. The behavior you are observing is neither bad, nor downright dumb, for the people at these firms. Only for the firms and, temporarily, the financial system in which they exist.
Even traders and front-line investment bankers can make enough money over a good five-year run to 'retire' financially secure and ready for their second career, even if they blew their firms up in the process through excessively risky behavior.
Are not traders from Amaranth, the commodities firm the blew up last year due to bad bets on natural gas, are already back in circulation?
The key to all of this is to realize that in the financial services sector, it's fairly typical for ten-year veterans of the money-making functions- trading, underwriting and M&A- to amass sufficient capital to make them indifferent to being fired, resigning to join a smaller firm, or simply to (more prudently) risk their own capital in a similar endeavor. To these people, mistakes that get them fired simply end a lucrative merry-go-round ride a little early. But not usually too early to walk away in shape for their next act.
Wednesday, September 12, 2007
Equivocation from the Pages of The Wall Street Journal
Last week, the Wall Street Journal published a rather equivocating piece by one of it's columnists, Justin Lahart. I found the piece to be, at best, a waste of time and, at worst, supporting and advocating specious analysis regarding Fed rate cuts and subsequent investment performance.
Consider these quotes from the Lahart's piece,
"Perhaps some of the rules are changing. Investors tend to believe that interest-rate cuts are good for stocks. Research seems to bear that out....
But interest rate cycles don't always appear to be a great guide to stock performance. In the 1960's, for example, stocks did well even as interest rates were rising. It would be unwise to ignore the past 33 years of history, but it might also be unwise to put too much weight on them."
Gee, thanks Justin. Glad you could add value on this issue.
Does Lahart fill us in on inflation rates during the periods involved? That might help us understand the effect of Fed rate cuts, in that the overall market and economic contexts clearly matter. How about GNP growth during the periods, too?
Oh, and what about the market impact of technology in at least three ways: the advent of derivatives trading; computerized trading technology, and; availability of information via computerized technology, to more rapidly and thoroughly react to fundamental and technical information?
Does anyone really believe that you can just compare one activity or measure, such as Fed rate cuts, over time, and assume it will soak up/account for total variance of something like overall stock prices?
Not only is Lahart's piece of no actionable use, it questions credulity as to its reasonability.
I wonder if this thesis would even rate a grade of "D" in any graduate economics course. I expect better from the Money Section of the Wall Street Journal.
Don't you?
Consider these quotes from the Lahart's piece,
"Perhaps some of the rules are changing. Investors tend to believe that interest-rate cuts are good for stocks. Research seems to bear that out....
But interest rate cycles don't always appear to be a great guide to stock performance. In the 1960's, for example, stocks did well even as interest rates were rising. It would be unwise to ignore the past 33 years of history, but it might also be unwise to put too much weight on them."
Gee, thanks Justin. Glad you could add value on this issue.
Does Lahart fill us in on inflation rates during the periods involved? That might help us understand the effect of Fed rate cuts, in that the overall market and economic contexts clearly matter. How about GNP growth during the periods, too?
Oh, and what about the market impact of technology in at least three ways: the advent of derivatives trading; computerized trading technology, and; availability of information via computerized technology, to more rapidly and thoroughly react to fundamental and technical information?
Does anyone really believe that you can just compare one activity or measure, such as Fed rate cuts, over time, and assume it will soak up/account for total variance of something like overall stock prices?
Not only is Lahart's piece of no actionable use, it questions credulity as to its reasonability.
I wonder if this thesis would even rate a grade of "D" in any graduate economics course. I expect better from the Money Section of the Wall Street Journal.
Don't you?
Wednesday, September 05, 2007
The Union Picket Line: How To Explain This Anachronism?
It's funny how some things grow to be anachronisms, yet we don't stop to notice until someone else points it out.
For reference, Merriam-Webster's Online Dictionary defines anachronism as:
2 : a person or a thing that is chronologically out of place; especially : one from a former age that is incongruous in the present
The anachronism du jour is the union picket line. Let me explain.
Recently, the school which one of my daughters attends began construction on a new building. As a letter from the school's head noted, the construction contractor was selected on the basis of price and quality. Evidently, the lucky winner does not employ unionized operating engineers. We know this, because members of said union now constitute a small pair of picket lines across entrances to the school property which are used for construction materials, workers, and other school visitors.
Thus, throughout the long, hot summer, we have been treated to the sight of unkempt, largely overweight males standing, sitting, or sprawling on the nearby sidewalk, sometimes sporting signs which I have no doubt purport to explain their presence. On occasion, one of them dons a cloth suit made to represent a rat. On other occasions, a large, presumably inflatable rat is located at the other entrance.
I frankly didn't give all of this hoopla much thought, until my daughters each asked, independently, what this odd-looking display was on the sidewalk outside the nearby school, and why these men were engaged in this activity.
Thus it occurred to me that there no longer is a plausible explanation for these sorts of picket lines. Eighty years ago, they made sense. Not in my town today.
In order to explain what strikes and picket lines were supposed to do, I asked my daughters to think about what would have to happen for these anachronisms to have a function. Together, we discussed how local customers of the picketed business or institution would have to behave in such a manner as to support the striking union members, refuse to give their custom to the struck entity, thereby causing it to succumb to the union's demands.
Further, we discussed how this might work if: the community was experiencing significant unemployment; the union members were visible, known community members, too; the organization being struck was viewed as unfair or with some suspicion; the replacement workers were viewed as accepting, or known to have accepted unfairly low compensation, and; the unemployment of said union members had a significant effect upon the community at large.
None of these conditions obtains in the present situation involving the striking union members. They are, for the most part, from other towns or states. Nobody local to the school or neighborhood knows them.
It turns out that schools undergoing building projects are a favorite target of the operating engineers union. My business partner noted that they recently struck a public school in his nearby town when it, too, was doing new construction. Public and private schools are hardly the sort of organization you consider to be borderline criminal or shady when doing something like constructing new buildings. Further, the taxpaying residents and/or parents paying tuition to the relevant schools know they will be paying for the construction, one way or another. Thus, seeing union members striking might actually give them a feeling of comfort, that the price of the construction is not artificially inflated by absurdly high union wages and benefits.
Construction in this area continues to be very active, so it's likely that any competent laborer who wants to work at this trade is employed. At competitive wages. The striking, non-working union members, if anything, look foolish and incompetent. They refuse to take available jobs at good pay, choosing instead to spend their day sitting in the hot sun wearing silly-looking signs and/or animal suits.
Finally, since they don't live in the area, their unemployment has virtually no effect upon the local economy.
To sum up, there is zero support from the local populace for this strike. The picket line fits the definition of an anachronism. It's a tool from a bygone era.
Perhaps in the deepest Bronx or Queens, such a picket line might have an impact. Or in some smaller, poorer, more blue-collar rural town in a predominantly "blue" state.
But not in this upscale, economically well-off, predominantly white-collar town in which many residents commute into New York City to work in the financial services sector.
Thus, the image of scabs being physically assaulted as they cross the picket line at the school across the street from my home, resulting in news coverage of the conflict, is fantasy. The strike, and its picket line, is an exercise in futility.
What does this tell us about the mental capacity, sensibility, and awareness of modern times of the leaders of the local operating engineers union in my area?
For reference, Merriam-Webster's Online Dictionary defines anachronism as:
2 : a person or a thing that is chronologically out of place; especially : one from a former age that is incongruous in the present
The anachronism du jour is the union picket line. Let me explain.
Recently, the school which one of my daughters attends began construction on a new building. As a letter from the school's head noted, the construction contractor was selected on the basis of price and quality. Evidently, the lucky winner does not employ unionized operating engineers. We know this, because members of said union now constitute a small pair of picket lines across entrances to the school property which are used for construction materials, workers, and other school visitors.
Thus, throughout the long, hot summer, we have been treated to the sight of unkempt, largely overweight males standing, sitting, or sprawling on the nearby sidewalk, sometimes sporting signs which I have no doubt purport to explain their presence. On occasion, one of them dons a cloth suit made to represent a rat. On other occasions, a large, presumably inflatable rat is located at the other entrance.
I frankly didn't give all of this hoopla much thought, until my daughters each asked, independently, what this odd-looking display was on the sidewalk outside the nearby school, and why these men were engaged in this activity.
Thus it occurred to me that there no longer is a plausible explanation for these sorts of picket lines. Eighty years ago, they made sense. Not in my town today.
In order to explain what strikes and picket lines were supposed to do, I asked my daughters to think about what would have to happen for these anachronisms to have a function. Together, we discussed how local customers of the picketed business or institution would have to behave in such a manner as to support the striking union members, refuse to give their custom to the struck entity, thereby causing it to succumb to the union's demands.
Further, we discussed how this might work if: the community was experiencing significant unemployment; the union members were visible, known community members, too; the organization being struck was viewed as unfair or with some suspicion; the replacement workers were viewed as accepting, or known to have accepted unfairly low compensation, and; the unemployment of said union members had a significant effect upon the community at large.
None of these conditions obtains in the present situation involving the striking union members. They are, for the most part, from other towns or states. Nobody local to the school or neighborhood knows them.
It turns out that schools undergoing building projects are a favorite target of the operating engineers union. My business partner noted that they recently struck a public school in his nearby town when it, too, was doing new construction. Public and private schools are hardly the sort of organization you consider to be borderline criminal or shady when doing something like constructing new buildings. Further, the taxpaying residents and/or parents paying tuition to the relevant schools know they will be paying for the construction, one way or another. Thus, seeing union members striking might actually give them a feeling of comfort, that the price of the construction is not artificially inflated by absurdly high union wages and benefits.
Construction in this area continues to be very active, so it's likely that any competent laborer who wants to work at this trade is employed. At competitive wages. The striking, non-working union members, if anything, look foolish and incompetent. They refuse to take available jobs at good pay, choosing instead to spend their day sitting in the hot sun wearing silly-looking signs and/or animal suits.
Finally, since they don't live in the area, their unemployment has virtually no effect upon the local economy.
To sum up, there is zero support from the local populace for this strike. The picket line fits the definition of an anachronism. It's a tool from a bygone era.
Perhaps in the deepest Bronx or Queens, such a picket line might have an impact. Or in some smaller, poorer, more blue-collar rural town in a predominantly "blue" state.
But not in this upscale, economically well-off, predominantly white-collar town in which many residents commute into New York City to work in the financial services sector.
Thus, the image of scabs being physically assaulted as they cross the picket line at the school across the street from my home, resulting in news coverage of the conflict, is fantasy. The strike, and its picket line, is an exercise in futility.
What does this tell us about the mental capacity, sensibility, and awareness of modern times of the leaders of the local operating engineers union in my area?
Tuesday, September 04, 2007
An Apocryphal Tale: The Ten Best/Worst Days In Ten Years
There's an old aphorism with which I am acquainted that goes something like this:
"In any ten year period, if you miss the ten best days of the S&P, you'll lose half (or some similar value) of the return during the period."
To some extent, while the concept seems reasonable, I have treated it somewhat apocryphally.
Until now.
Last week, in the midst of the recent market turmoils, with various pundits calling for, demanding, expecting, etc., a Fed rate cut later this month, I thought it propitious to revisit this old tale.
Here's what I did. Using a daily adjusted S&P500 price series from Yahoo, I created a ten year series, from which I calculated daily total returns.
I then sorted the total return series by returns, in descending order.
For the ten years beginning August 29, 1997, the S&P500 statistics are:
6.5% average annual return
.03% average daily return
.05% median daily return
1.14% standard deviation of daily returns
+5.73% best daily return
-6.87% worst daily return
So far, so good. We see that the past ten years have, largely due to 2001-02, provided an average annual S&P500 return which is slightly more than half of the long term annual average return of 11%. The median daily return is above the mean daily return, informing us that the distribution of daily S&P returns is skewed positively. This is despite the worst daily return being lower, in absolute value terms, than the best daily return. The standard deviation of the daily returns, at 1.14%, is far greater than the mean or median daily return, indicating a very volatile daily value.
But, what about the aphorism that led to this ad hoc research? What are the returns of the ten best (and worst) days of the S&P over this ten year period?
+48.4% summed return of the ten best days of the S&P during the period
-48.% summed return of the ten worst days of the S&P during the period
This gives us:
65.2% summed actual daily returns for the S&P over the ten year period
16.8% summed daily returns for the S&P over the ten year period, without the ten best days
113.2% summed daily returns for the S&P over the ten year period, without the ten worst days
Each group of 10 days, best and worst, comprise approximately 74% of the ten years' summed total returns of the S&P. If we compare these two 'ten day' returns to the long run average annual S&P return of 11%, they comprise only +/- 44% of the total return of an average ten year period.
So, if we took a number of samples of ten year periods of the S&P, we might very well find that the aphorism is true. Something approaching half of the value of the S&P returns over a ten year period may be accounted for by just the ten best, or worst, days of the S&P over the period.
So what?
Well, it demonstrates how good your 'market timing' had better be, if you are a market timer. Miss a few days, either way, and you have an entirely different return than the market, even if you are only invested in the S&P500.
Frankly, it is simply stunning. At least to me. I can think of no other word.
To learn that missing only 10 out of some 2,500 days of S&P daily returns can remove between 50% and 75% of the total return of the ten year period confirms my belief that market timing is folly. Or making daily market calls, like Jim Cramer did this morning, on CNBC.
My own equity investment strategy approach distinguishes between markets in which we should be long, and those in which we should be short. Long term. Period. No attempts to predict daily, weekly, or monthly market moves.
Our equity strategy typically mirrors large daily moves in the S&P, but with larger magnitudes.
Now that our major focus is applying the equity strategy via long-dated, out of the money call options, this is doubly true. Although, relative to comparable S&P500 calls, it's not yet clear if this behavior extends to options.
Nonetheless, the validating of this little apocryphal tale heavily reinforces my belief in remaining invested, long or short, continuously, and abstaining from going to cash, unless very briefly, amidst noisy long term market signals.
"In any ten year period, if you miss the ten best days of the S&P, you'll lose half (or some similar value) of the return during the period."
To some extent, while the concept seems reasonable, I have treated it somewhat apocryphally.
Until now.
Last week, in the midst of the recent market turmoils, with various pundits calling for, demanding, expecting, etc., a Fed rate cut later this month, I thought it propitious to revisit this old tale.
Here's what I did. Using a daily adjusted S&P500 price series from Yahoo, I created a ten year series, from which I calculated daily total returns.
I then sorted the total return series by returns, in descending order.
For the ten years beginning August 29, 1997, the S&P500 statistics are:
6.5% average annual return
.03% average daily return
.05% median daily return
1.14% standard deviation of daily returns
+5.73% best daily return
-6.87% worst daily return
So far, so good. We see that the past ten years have, largely due to 2001-02, provided an average annual S&P500 return which is slightly more than half of the long term annual average return of 11%. The median daily return is above the mean daily return, informing us that the distribution of daily S&P returns is skewed positively. This is despite the worst daily return being lower, in absolute value terms, than the best daily return. The standard deviation of the daily returns, at 1.14%, is far greater than the mean or median daily return, indicating a very volatile daily value.
But, what about the aphorism that led to this ad hoc research? What are the returns of the ten best (and worst) days of the S&P over this ten year period?
+48.4% summed return of the ten best days of the S&P during the period
-48.% summed return of the ten worst days of the S&P during the period
This gives us:
65.2% summed actual daily returns for the S&P over the ten year period
16.8% summed daily returns for the S&P over the ten year period, without the ten best days
113.2% summed daily returns for the S&P over the ten year period, without the ten worst days
Each group of 10 days, best and worst, comprise approximately 74% of the ten years' summed total returns of the S&P. If we compare these two 'ten day' returns to the long run average annual S&P return of 11%, they comprise only +/- 44% of the total return of an average ten year period.
So, if we took a number of samples of ten year periods of the S&P, we might very well find that the aphorism is true. Something approaching half of the value of the S&P returns over a ten year period may be accounted for by just the ten best, or worst, days of the S&P over the period.
So what?
Well, it demonstrates how good your 'market timing' had better be, if you are a market timer. Miss a few days, either way, and you have an entirely different return than the market, even if you are only invested in the S&P500.
Frankly, it is simply stunning. At least to me. I can think of no other word.
To learn that missing only 10 out of some 2,500 days of S&P daily returns can remove between 50% and 75% of the total return of the ten year period confirms my belief that market timing is folly. Or making daily market calls, like Jim Cramer did this morning, on CNBC.
My own equity investment strategy approach distinguishes between markets in which we should be long, and those in which we should be short. Long term. Period. No attempts to predict daily, weekly, or monthly market moves.
Our equity strategy typically mirrors large daily moves in the S&P, but with larger magnitudes.
Now that our major focus is applying the equity strategy via long-dated, out of the money call options, this is doubly true. Although, relative to comparable S&P500 calls, it's not yet clear if this behavior extends to options.
Nonetheless, the validating of this little apocryphal tale heavily reinforces my belief in remaining invested, long or short, continuously, and abstaining from going to cash, unless very briefly, amidst noisy long term market signals.
Wednesday, August 29, 2007
Second-Rate Economists & CNBC
They're at it again!
Yesterday, CNBC featured two little-known 'economists,' one from UBS, another from PNC, who agreed that the US economy is now in danger of a recession. Both solemnly lectured that Fed Chairman Ben Bernanke had better cut the Fed funds rate next month by a quarter-point, or he wouldn't be managing the economy effectively.
Honestly, this kind of thing just turns my stomach. Who do these guys think they are? They are so far from being credible it isn't even funny.
This morning, on CNBC, for the eighteen-thousandth time since the end of July, the anchors are holding a 'debate' among various guests and pundits, as to whether the Fed should cut rates next month. You're not going to hear much else for the next few weeks, until that magical afternoon when the Fed announces its rate action, or inaction.
It seems to always be this way now. If there's anything but blue sky and sunshine in the financial markets or on their horizons, then CNBC spends most of its air time on "Fedwatch," conducting unending discussions, day after day, week after week, as to what the Fed will and should do at its next meeting, and why. Nevermind that there's insufficient data released daily, let alone weekly, to justify this. It's merely 'entertainment.'
However, as Brian Wesbury, a better-known and credible economist, wrote of the business media's tendency to hold pro vs. con on camera "debates," these mistakenly give people the impression that, say, economists are evenly divided on the subject of the likelihood of a recession, when, in reality, they are not at all 'evenly divided.'
In his August 9th editorial in the Wall Street Journal, Wesbury wrote,
"Any reasonable sample of economists these days would include at least 80% optimists. So why all the bad news?"
And, again, this very morning, while listening to/watching CNBC in background, I heard Erin Burnett report that in phone calls she had (Yes! She actually talked to real people- not just regurgitated her own journalistic opinions.) with banking executives around the country, most of them saw no reason for a Fed rate cut.
For what it's worth, Wesbury believes that,
"...people gather knowledge about the rest of the economy, the part they cannot see, from watching news. As a result, it could be that the format behind most business journalism skews perceptions and creates pessimism.....But what seems clear is that in the name of producing an entertaining product, and in an attempt to provide contrasting views, the true consensus of experts is rarely reported."
As I discussed this with my partner the other day, we returned to a topic we've touched on before. That is, when Harry Markowitz developed efficient market theory and the concept of portfolios, he probably never imagined a world in which the white noise would crowd out true information.
Recall, if you will, the world of the late 1950s, in which Markowitz formed his theories. Markets were telephone order-driven, brokerage rates were astronomical, there was no cable television, nor on-going business news throughout the day. With trading so expensive at retail, investment was the order of the day. Computers were non-existent, so forget program trading, too. Most business "news" was just that, and the amount of commentary on it was a lot less than today. Magazines like Fortune, Forbes and Businessweek (if it existed then) held much more sway than they do today.
It's hard to set a hard and fast rule among today's surfeit of business 'information,' but, surely, the babbling of some third-rate economist at a third-tier financial institution hardly qualifies as similar in quality, or, probably, 'information,' next to, say, a Fed president's remarks, or those of a Nobel Laureate in economics. Or the CEO of a well-performing, large hedge fund or private equity group. Not all the utterances we hear on CNBC, booked to fill up air time, are deserving of the description 'information.'
Most of it is, in reality, just noise. Recycled worries and warnings, and hand-wringing by people who, otherwise, would never be exposed to the wide world of business media viewers. Nobody said these guests and commentators are actually credible, or competent.
Yesterday, I actually heard one of the less intelligent CNBC morning anchors say something like,
'well, if bank CEOs aren't believable, don't you have to listen to large company CEOs, who have their ears to the ground?'
My laughter was immediate. CEOs with ears to the ground? You've got to be kidding!
When you hear drivel like that from a CNBC on-air anchor, you know you should heavily discount most of what you hear on the network that is not breaking news, and carefully choose which of their guest pundits to believe.
Yesterday, CNBC featured two little-known 'economists,' one from UBS, another from PNC, who agreed that the US economy is now in danger of a recession. Both solemnly lectured that Fed Chairman Ben Bernanke had better cut the Fed funds rate next month by a quarter-point, or he wouldn't be managing the economy effectively.
Honestly, this kind of thing just turns my stomach. Who do these guys think they are? They are so far from being credible it isn't even funny.
This morning, on CNBC, for the eighteen-thousandth time since the end of July, the anchors are holding a 'debate' among various guests and pundits, as to whether the Fed should cut rates next month. You're not going to hear much else for the next few weeks, until that magical afternoon when the Fed announces its rate action, or inaction.
It seems to always be this way now. If there's anything but blue sky and sunshine in the financial markets or on their horizons, then CNBC spends most of its air time on "Fedwatch," conducting unending discussions, day after day, week after week, as to what the Fed will and should do at its next meeting, and why. Nevermind that there's insufficient data released daily, let alone weekly, to justify this. It's merely 'entertainment.'
However, as Brian Wesbury, a better-known and credible economist, wrote of the business media's tendency to hold pro vs. con on camera "debates," these mistakenly give people the impression that, say, economists are evenly divided on the subject of the likelihood of a recession, when, in reality, they are not at all 'evenly divided.'
In his August 9th editorial in the Wall Street Journal, Wesbury wrote,
"Any reasonable sample of economists these days would include at least 80% optimists. So why all the bad news?"
And, again, this very morning, while listening to/watching CNBC in background, I heard Erin Burnett report that in phone calls she had (Yes! She actually talked to real people- not just regurgitated her own journalistic opinions.) with banking executives around the country, most of them saw no reason for a Fed rate cut.
For what it's worth, Wesbury believes that,
"...people gather knowledge about the rest of the economy, the part they cannot see, from watching news. As a result, it could be that the format behind most business journalism skews perceptions and creates pessimism.....But what seems clear is that in the name of producing an entertaining product, and in an attempt to provide contrasting views, the true consensus of experts is rarely reported."
As I discussed this with my partner the other day, we returned to a topic we've touched on before. That is, when Harry Markowitz developed efficient market theory and the concept of portfolios, he probably never imagined a world in which the white noise would crowd out true information.
Recall, if you will, the world of the late 1950s, in which Markowitz formed his theories. Markets were telephone order-driven, brokerage rates were astronomical, there was no cable television, nor on-going business news throughout the day. With trading so expensive at retail, investment was the order of the day. Computers were non-existent, so forget program trading, too. Most business "news" was just that, and the amount of commentary on it was a lot less than today. Magazines like Fortune, Forbes and Businessweek (if it existed then) held much more sway than they do today.
It's hard to set a hard and fast rule among today's surfeit of business 'information,' but, surely, the babbling of some third-rate economist at a third-tier financial institution hardly qualifies as similar in quality, or, probably, 'information,' next to, say, a Fed president's remarks, or those of a Nobel Laureate in economics. Or the CEO of a well-performing, large hedge fund or private equity group. Not all the utterances we hear on CNBC, booked to fill up air time, are deserving of the description 'information.'
Most of it is, in reality, just noise. Recycled worries and warnings, and hand-wringing by people who, otherwise, would never be exposed to the wide world of business media viewers. Nobody said these guests and commentators are actually credible, or competent.
Yesterday, I actually heard one of the less intelligent CNBC morning anchors say something like,
'well, if bank CEOs aren't believable, don't you have to listen to large company CEOs, who have their ears to the ground?'
My laughter was immediate. CEOs with ears to the ground? You've got to be kidding!
When you hear drivel like that from a CNBC on-air anchor, you know you should heavily discount most of what you hear on the network that is not breaking news, and carefully choose which of their guest pundits to believe.
Thursday, August 23, 2007
David Malpas On The Current Financial & Economic Outlook
A little over two weeks ago, which now seems like a year ago in these markets, David Malpass, chief economist of Bear Stearns, wrote a wonderful editorial in the Wall Street Journal concerning the distinction between credit markets and the 'real' economy.
Now, many economists and other pundits are declaring that we are on the edge of a recession, and that recent credit market problems have crippled, or are crippling, the 'real' economy.
To the contrary, Malpass wrote,
"Equity markets have recently lost over $2 trillion in the U.S. and even more globally -- many times the likely amount of mortgage and corporate debt losses in the foreseeable future. This is in part a correction from the sharp global equity run-up through mid-July. Current prices still signal growth ahead.
Another aspect of the market disruption is a dramatic stand-off between bond buyers and sellers: Buyers in both housing and debt markets are using the market discontinuity to claw prices and terms back to Earth. The slowdown talk weighing on equities also reflects the Wall Street view that debt, mortgage and takeover businesses have replaced General Motors as the economy's bellwether. According to the bears: As goes the credit market, so goes the economy.
Fortunately, Main Street is not that fickle. Housing and debt markets are not that big a part of the U.S. economy, or of job creation. It's more likely the economy is sturdy and will grow solidly in coming months, and perhaps years.
U.S. growth has endured other waves of equally loud pessimism -- over high gasoline prices, low (pre-revision) estimates of job growth, a supposedly negative personal savings rate (revised to positive on July 27 by the Commerce Department) and even the 2003 tax cut on labor and capital. Remember the argument that tax cuts would put the economy on a path toward fiscal collapse and recession? Now, the U.S. deficit is set to fall below $150 billion by Washington's September fiscal year-end, thanks to strong tax receipts."
Thus, Malpass calls our attention to some pretty badly mistaken prior economic calls by some of these so-called 'experts.' On the subject of using housing as a piggy-bank, Malpass wrote,
"The bearish view is that Americans live, breathe and spend their houses and mortgages. Yet the July 31 consumer confidence survey by the Conference Board jumped to 112, the highest in the six-year expansion. Data and theory show clearly that houses are not the be-all and end-all of the economy. Jobs matter more. For many, the value of future employment is much greater than their home equity. The low jobless claims and unemployment rate -- clear signs of a strong labor environment -- raise confidence and likely future wages. This outweighs changes in wealth, whether from declines in house prices or the stock market, especially for lower-income workers.
Neither the economy nor job growth has been dependent on housing. Residential construction declined to 4% of GDP in the second quarter -- right on the 1990s average -- having boomed excessively in 2004 and 2005 and subtracted heavily from GDP in 2006. But strength in commercial construction more than offset the weakness in residential construction, allowing overall construction to add to GDP for the first time in a year.
Concerns about high inventories of unsold homes are exaggerated. At 537,000 per the Commerce Department, the June inventory equals 7.4 months of 2007's average sales. This is only a bit above the 6.7 months average inventory from 1980-1995. The leaner inventories in the 1996-2005 "sellers' market" resulted in part from the super-low interest and mortgage rates earlier this decade, and the 1997 cut in the capital-gains tax on houses.
Those overstating housing's impact on jobs often use dates spanning the 2001 recession, as in the widely quoted calculation that 37% of the net new jobs were in housing. That was true only between March 2001 and September 2005, because housing jobs grew in the recession while other jobs shrank. A fairer picture of the role of housing in the expansion is to start counting from any month after the recession. From the end of 2003 through present, jobs from residential construction plus real estate and mortgage brokers created only 3.6% of the net new jobs, 5.3% if all credit intermediation jobs are also included.
Nor has consumer spending been dependent on "cashing in" on the housing boom. The increase in mortgage equity withdrawals in 2004 and 2005 funded big net additions to household financial assets, while consumption growth remained steady. Mortgage equity withdrawals slumped throughout 2006, yet consumption growth was particularly fast in the fourth quarter of 2006 and the first quarter of 2007."
Thus, Malpass dispels the common notion among many in the business media that all Americans have done for the past decade is borrow against their rising home values to spend, spend, spend! Rather, Malpass notes they have invested, invested, invested! A housing value decline might cause some loss of demand for financial assets and, thus, some price declines, but not wholesale loss of consumer spending as a driver of the overall US economy.
On that theme, what about the egregious rises in sub-prime mortgage payments coming soon? Won't those rises in monthly mortgage payments be the final death blow to the US economy? Not so, wrote Malpass,
"In the long list of worries about consumption, the threat of mortgage-rate resets is providing the latest fixation. It shouldn't. Payments on some $500 billion of adjustable rate mortgages are scheduled to go up in 2007. If the mortgage rate is adjusted upward by an average two percentage points, that's $10 billion in added payments. To put this in perspective, wages for nonsupervisory workers increased by $296 billion over the last 12 months. The July 27 revision alone added $130 billion to the last year's total U.S. personal income, raising it to $11.5 trillion, reflecting the hard-to-track dynamism of the U.S. economy.
The constant warnings of a housing-related collapse in domestic consumption overstates the importance of housing in the economy, while understating the importance of jobs and economic growth, both of which have been solid. Of course, sellers of both houses and bonds would like more froth in their markets. But buyers, and likely the economy as a whole, will probably benefit over time from the wrenching return to more normal market conditions."
It is truly a pleasure to read a balanced, reasoned, informed opinion in a major news medium which contradicts the current hand-wringing that, thanks to a few sub-prime mortgages that were made, securitized, and sold as investments, our entire economy is about to be brought to its knees.
It's not. The sliver of the housing market that is sub-prime is but a piece of an otherwise dynamic and resilient US economy, still the envy of the world's other economies.
Now, many economists and other pundits are declaring that we are on the edge of a recession, and that recent credit market problems have crippled, or are crippling, the 'real' economy.
To the contrary, Malpass wrote,
"Equity markets have recently lost over $2 trillion in the U.S. and even more globally -- many times the likely amount of mortgage and corporate debt losses in the foreseeable future. This is in part a correction from the sharp global equity run-up through mid-July. Current prices still signal growth ahead.
Another aspect of the market disruption is a dramatic stand-off between bond buyers and sellers: Buyers in both housing and debt markets are using the market discontinuity to claw prices and terms back to Earth. The slowdown talk weighing on equities also reflects the Wall Street view that debt, mortgage and takeover businesses have replaced General Motors as the economy's bellwether. According to the bears: As goes the credit market, so goes the economy.
Fortunately, Main Street is not that fickle. Housing and debt markets are not that big a part of the U.S. economy, or of job creation. It's more likely the economy is sturdy and will grow solidly in coming months, and perhaps years.
U.S. growth has endured other waves of equally loud pessimism -- over high gasoline prices, low (pre-revision) estimates of job growth, a supposedly negative personal savings rate (revised to positive on July 27 by the Commerce Department) and even the 2003 tax cut on labor and capital. Remember the argument that tax cuts would put the economy on a path toward fiscal collapse and recession? Now, the U.S. deficit is set to fall below $150 billion by Washington's September fiscal year-end, thanks to strong tax receipts."
Thus, Malpass calls our attention to some pretty badly mistaken prior economic calls by some of these so-called 'experts.' On the subject of using housing as a piggy-bank, Malpass wrote,
"The bearish view is that Americans live, breathe and spend their houses and mortgages. Yet the July 31 consumer confidence survey by the Conference Board jumped to 112, the highest in the six-year expansion. Data and theory show clearly that houses are not the be-all and end-all of the economy. Jobs matter more. For many, the value of future employment is much greater than their home equity. The low jobless claims and unemployment rate -- clear signs of a strong labor environment -- raise confidence and likely future wages. This outweighs changes in wealth, whether from declines in house prices or the stock market, especially for lower-income workers.
Neither the economy nor job growth has been dependent on housing. Residential construction declined to 4% of GDP in the second quarter -- right on the 1990s average -- having boomed excessively in 2004 and 2005 and subtracted heavily from GDP in 2006. But strength in commercial construction more than offset the weakness in residential construction, allowing overall construction to add to GDP for the first time in a year.
Concerns about high inventories of unsold homes are exaggerated. At 537,000 per the Commerce Department, the June inventory equals 7.4 months of 2007's average sales. This is only a bit above the 6.7 months average inventory from 1980-1995. The leaner inventories in the 1996-2005 "sellers' market" resulted in part from the super-low interest and mortgage rates earlier this decade, and the 1997 cut in the capital-gains tax on houses.
Those overstating housing's impact on jobs often use dates spanning the 2001 recession, as in the widely quoted calculation that 37% of the net new jobs were in housing. That was true only between March 2001 and September 2005, because housing jobs grew in the recession while other jobs shrank. A fairer picture of the role of housing in the expansion is to start counting from any month after the recession. From the end of 2003 through present, jobs from residential construction plus real estate and mortgage brokers created only 3.6% of the net new jobs, 5.3% if all credit intermediation jobs are also included.
Nor has consumer spending been dependent on "cashing in" on the housing boom. The increase in mortgage equity withdrawals in 2004 and 2005 funded big net additions to household financial assets, while consumption growth remained steady. Mortgage equity withdrawals slumped throughout 2006, yet consumption growth was particularly fast in the fourth quarter of 2006 and the first quarter of 2007."
Thus, Malpass dispels the common notion among many in the business media that all Americans have done for the past decade is borrow against their rising home values to spend, spend, spend! Rather, Malpass notes they have invested, invested, invested! A housing value decline might cause some loss of demand for financial assets and, thus, some price declines, but not wholesale loss of consumer spending as a driver of the overall US economy.
On that theme, what about the egregious rises in sub-prime mortgage payments coming soon? Won't those rises in monthly mortgage payments be the final death blow to the US economy? Not so, wrote Malpass,
"In the long list of worries about consumption, the threat of mortgage-rate resets is providing the latest fixation. It shouldn't. Payments on some $500 billion of adjustable rate mortgages are scheduled to go up in 2007. If the mortgage rate is adjusted upward by an average two percentage points, that's $10 billion in added payments. To put this in perspective, wages for nonsupervisory workers increased by $296 billion over the last 12 months. The July 27 revision alone added $130 billion to the last year's total U.S. personal income, raising it to $11.5 trillion, reflecting the hard-to-track dynamism of the U.S. economy.
The constant warnings of a housing-related collapse in domestic consumption overstates the importance of housing in the economy, while understating the importance of jobs and economic growth, both of which have been solid. Of course, sellers of both houses and bonds would like more froth in their markets. But buyers, and likely the economy as a whole, will probably benefit over time from the wrenching return to more normal market conditions."
It is truly a pleasure to read a balanced, reasoned, informed opinion in a major news medium which contradicts the current hand-wringing that, thanks to a few sub-prime mortgages that were made, securitized, and sold as investments, our entire economy is about to be brought to its knees.
It's not. The sliver of the housing market that is sub-prime is but a piece of an otherwise dynamic and resilient US economy, still the envy of the world's other economies.
Wednesday, August 22, 2007
Brian Wesbury's Excellent Analysis of The Current Credit Market Situation in the WSJ
We're very fortunate to have a lucid, informed and competent economist of the stature of Brian Wesbury writing frequently in the Wall Street Journal.
On Monday, Mr. Wesbury wrote an inspired piece entitled "The Fed's Job."
In brief, he makes the point that, throughout our country's history, people have wrongly diagnosed economic problems as 'a lack of liquidity.' Now, Wesbury explains, the problem is leverage and uncertainty- but not liquidity.
This is at variance with such biased commentators as financial entertainer Jim Cramer, self-interested Senator Chris Dodd (Democratic Presidential candidate and Senator from the home state of many hedge funds, Connecticut), and CNBC economist wannabe, Steve Liesman. All three of these observers have been shouting loudly for various 'liquidity' bromides, ranging from the Fed cutting the interest rate by one-quarter to one-half of a point, to allowing Fannie Mae and Freddie Mac to 'invest' in jumbo mortgages.
Thankfully, Wesbury explains why all of this is unnecessary, but, never the less, in the long tradition of populist blowhards crying for easy credit.
To wit, Wesbury wrote,
"Blaming monetary policy for economic and financial market turmoil is a time honored tradition. Maybe the most famous bashing was in 1896 when William Jennings Bryan, an original populist, ranted against hard money and for inflation: ". . . we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold."
Monetary policy makes an easy scapegoat because printing money (like drinking a cup of coffee) is an easy way to give an economy a temporary boost. But if what ails the economy or markets was not caused by tight money in the first place, a temporary boost will not help. It may cover up the symptoms temporarily, but in the end it does not solve the underlying issue (a lack of sleep).
In fact, easy money always leads to greater problems down the road -- either rising inflation, or a reduced sensitivity to risk, as markets come to expect rate cuts to bail them out.
Lately, modern-day William Jennings Bryans have been loudly calling on the Fed to cut interest rates and inject cash into the banking system. They believe more money would stop financial markets from seizing up any further.
This would make sense if money was already tight -- or to put it another way, if a lack of liquidity was the real issue. But trades are clearing, banks are well capitalized, commercial and industrial loans are growing, credit-worthy borrowers are getting mortgages, and the economy is still expanding.
...the current turmoil in the financial markets has nothing to do with a lack of liquidity. More importantly, there is little hope that any liquidity the Fed would inject into the banking system would actually get to the sectors of the market where only sporadic, fire-sale pricing of securities is taking place.
Some are arguing that a sharp decline in the three-month Treasury bill yield, to 3.85% from roughly 5% during the past few days, shows the need for a huge infusion of cash that would force the federal funds rate down. But the drop in T-bill yields is a reflection of three issues: a flight to quality, a guess that the Fed will lower rates at its next meeting and a very liquid market."
Well, if liquidity, per se, is not needed, then what precisely is going on currently in financial markets? Wesbury continues his article with this explanation,
"The real problem with the financial markets is that extreme leverage and extreme uncertainty have met in the subprime loan market. No one knows how many loans will go bad, who owns these mortgages and what leverage they have applied. We do know that subprime lending is just 9% of the $10.4 trillion dollar mortgage market, and delinquencies are running at about 18%. The Alt-A market is about 8% of all mortgages and about 5% of this debt is delinquent.
As an example, let's take a very low probability event and assume that losses triple from here. Let's assume that 54% of all subprime loans and 15% of all Alt-A loans actually move to foreclosure. Then, assume that lenders are able to recover 50% of the value of their loans. In this scenario, total losses in the subprime market would be 27%, while total losses in Alt-A would be 7.5%.
From this we can estimate a price for the securitized pools of these assets. Without doing any actual adjustment for yields, or for different tranches of this debt, the raw value of the underlying assets would be 73 cents on the dollar for subprime pools and 92.5 cents for the Alt-A pools. Getting a bid on this stuff should be easy, right? After all, the market prices risky assets every day.
But this is the rub. A hedge fund, or financial institution, that uses leverage of 4:1 or more, would be wiped out if it sold subprime bonds at those levels. A 27% loss on Main Street turns into a 100% loss on Wall Street very easily. But because hedge funds can slow down redemptions, at least for awhile, and because they are trying desperately not to implode, they hold back from the market. At the same time, those with cash smell blood in the water, patiently wait, and put low-ball bids on risky bonds. The result: No market clearing price in the leveraged, asset-backed marketplace."
Thus, Mr. Wesbury comes to the logical and sensible conclusion that what we are witnessing is not a shortage of liquidity, but the realization on the part of a lot of supposedly-smart hedge fund managers and other institutional investors, that they weren't so smart in their headlong use of sub-prime mortgage-based instruments without understanding the underlying risks to those mortgages. It's no different than any other case of sophisticated and/or institutional investors making poor investment choices- they lose money. In the cases of many of the hedge funds, some of whom call Senator Dodd's state home, they have used leveraged money, and are, quite likely, now insolvent.
So we have populists crying for the relief of wealthy hedge fund investors and managers, at the same time that they also cry for relief for the sub-prime mortgage borrowers! At least it's equal-opportunity financial forgiveness. However, it's unnecessary.
In his conclusion, Mr. Wesbury goes on to state,
"There is a lesson here. Populism is in the air these days, and the threat from tax hikes, trade protectionism and more government involvement in the economy, is rising. This reduces the desire to take risk. Congress is working on a legislative response to current mortgage market woes as well. And as with the savings and loan industry (forcing S&Ls to sell junk bonds at fire-sale prices), and Sarbanes-Oxley, the legislative response almost always compounds the problems.
The interaction of an uncertain regulatory and tax environment with a highly leveraged, illiquid market for risky mortgage debt creates conditions that look just like an economy-wide liquidity crisis. But it's not. A few rate cuts will not help.
What William Jennings Bryan was really complaining about in 1896 was falling commodity prices, especially falling farm prices. What he and the other populists ignored was that these prices were falling because of productivity, not tight money. His "Cross of Gold" speech was a clear stepping stone to the creation of the Fed in 1913. Since then, inflation has been much higher than it would have been under the gold standard. But all that inflation never did save the family farm.
Similarly, even very easy money today can't put off the day of reckoning for subprime mortgage holders who bought homes with no money down and thought interest rates would stay low forever. It can't help overly leveraged investors who thought they were getting risk-free 20% annual returns. Providing enough liquidity to allow markets to function, while keeping consumer prices as stable as possible, is the best the Fed can do. It should be all we really ask."
Amen, Mr. Wesbury. Ben Bernanke is wisely providing 'liquidity' to banks, in order that they may accept and offer, for repos, paper of dubious quality, in order to assure that credit markets continue to function, and do not impeded the normal course of our non-financial economic sectors. Truly, that's all for which we should ask from the Fed. Beyond that, borrowers and investors must accept the consequences of their own financial decisions.
On Monday, Mr. Wesbury wrote an inspired piece entitled "The Fed's Job."
In brief, he makes the point that, throughout our country's history, people have wrongly diagnosed economic problems as 'a lack of liquidity.' Now, Wesbury explains, the problem is leverage and uncertainty- but not liquidity.
This is at variance with such biased commentators as financial entertainer Jim Cramer, self-interested Senator Chris Dodd (Democratic Presidential candidate and Senator from the home state of many hedge funds, Connecticut), and CNBC economist wannabe, Steve Liesman. All three of these observers have been shouting loudly for various 'liquidity' bromides, ranging from the Fed cutting the interest rate by one-quarter to one-half of a point, to allowing Fannie Mae and Freddie Mac to 'invest' in jumbo mortgages.
Thankfully, Wesbury explains why all of this is unnecessary, but, never the less, in the long tradition of populist blowhards crying for easy credit.
To wit, Wesbury wrote,
"Blaming monetary policy for economic and financial market turmoil is a time honored tradition. Maybe the most famous bashing was in 1896 when William Jennings Bryan, an original populist, ranted against hard money and for inflation: ". . . we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold."
Monetary policy makes an easy scapegoat because printing money (like drinking a cup of coffee) is an easy way to give an economy a temporary boost. But if what ails the economy or markets was not caused by tight money in the first place, a temporary boost will not help. It may cover up the symptoms temporarily, but in the end it does not solve the underlying issue (a lack of sleep).
In fact, easy money always leads to greater problems down the road -- either rising inflation, or a reduced sensitivity to risk, as markets come to expect rate cuts to bail them out.
Lately, modern-day William Jennings Bryans have been loudly calling on the Fed to cut interest rates and inject cash into the banking system. They believe more money would stop financial markets from seizing up any further.
This would make sense if money was already tight -- or to put it another way, if a lack of liquidity was the real issue. But trades are clearing, banks are well capitalized, commercial and industrial loans are growing, credit-worthy borrowers are getting mortgages, and the economy is still expanding.
...the current turmoil in the financial markets has nothing to do with a lack of liquidity. More importantly, there is little hope that any liquidity the Fed would inject into the banking system would actually get to the sectors of the market where only sporadic, fire-sale pricing of securities is taking place.
Some are arguing that a sharp decline in the three-month Treasury bill yield, to 3.85% from roughly 5% during the past few days, shows the need for a huge infusion of cash that would force the federal funds rate down. But the drop in T-bill yields is a reflection of three issues: a flight to quality, a guess that the Fed will lower rates at its next meeting and a very liquid market."
Well, if liquidity, per se, is not needed, then what precisely is going on currently in financial markets? Wesbury continues his article with this explanation,
"The real problem with the financial markets is that extreme leverage and extreme uncertainty have met in the subprime loan market. No one knows how many loans will go bad, who owns these mortgages and what leverage they have applied. We do know that subprime lending is just 9% of the $10.4 trillion dollar mortgage market, and delinquencies are running at about 18%. The Alt-A market is about 8% of all mortgages and about 5% of this debt is delinquent.
As an example, let's take a very low probability event and assume that losses triple from here. Let's assume that 54% of all subprime loans and 15% of all Alt-A loans actually move to foreclosure. Then, assume that lenders are able to recover 50% of the value of their loans. In this scenario, total losses in the subprime market would be 27%, while total losses in Alt-A would be 7.5%.
From this we can estimate a price for the securitized pools of these assets. Without doing any actual adjustment for yields, or for different tranches of this debt, the raw value of the underlying assets would be 73 cents on the dollar for subprime pools and 92.5 cents for the Alt-A pools. Getting a bid on this stuff should be easy, right? After all, the market prices risky assets every day.
But this is the rub. A hedge fund, or financial institution, that uses leverage of 4:1 or more, would be wiped out if it sold subprime bonds at those levels. A 27% loss on Main Street turns into a 100% loss on Wall Street very easily. But because hedge funds can slow down redemptions, at least for awhile, and because they are trying desperately not to implode, they hold back from the market. At the same time, those with cash smell blood in the water, patiently wait, and put low-ball bids on risky bonds. The result: No market clearing price in the leveraged, asset-backed marketplace."
Thus, Mr. Wesbury comes to the logical and sensible conclusion that what we are witnessing is not a shortage of liquidity, but the realization on the part of a lot of supposedly-smart hedge fund managers and other institutional investors, that they weren't so smart in their headlong use of sub-prime mortgage-based instruments without understanding the underlying risks to those mortgages. It's no different than any other case of sophisticated and/or institutional investors making poor investment choices- they lose money. In the cases of many of the hedge funds, some of whom call Senator Dodd's state home, they have used leveraged money, and are, quite likely, now insolvent.
So we have populists crying for the relief of wealthy hedge fund investors and managers, at the same time that they also cry for relief for the sub-prime mortgage borrowers! At least it's equal-opportunity financial forgiveness. However, it's unnecessary.
In his conclusion, Mr. Wesbury goes on to state,
"There is a lesson here. Populism is in the air these days, and the threat from tax hikes, trade protectionism and more government involvement in the economy, is rising. This reduces the desire to take risk. Congress is working on a legislative response to current mortgage market woes as well. And as with the savings and loan industry (forcing S&Ls to sell junk bonds at fire-sale prices), and Sarbanes-Oxley, the legislative response almost always compounds the problems.
The interaction of an uncertain regulatory and tax environment with a highly leveraged, illiquid market for risky mortgage debt creates conditions that look just like an economy-wide liquidity crisis. But it's not. A few rate cuts will not help.
What William Jennings Bryan was really complaining about in 1896 was falling commodity prices, especially falling farm prices. What he and the other populists ignored was that these prices were falling because of productivity, not tight money. His "Cross of Gold" speech was a clear stepping stone to the creation of the Fed in 1913. Since then, inflation has been much higher than it would have been under the gold standard. But all that inflation never did save the family farm.
Similarly, even very easy money today can't put off the day of reckoning for subprime mortgage holders who bought homes with no money down and thought interest rates would stay low forever. It can't help overly leveraged investors who thought they were getting risk-free 20% annual returns. Providing enough liquidity to allow markets to function, while keeping consumer prices as stable as possible, is the best the Fed can do. It should be all we really ask."
Amen, Mr. Wesbury. Ben Bernanke is wisely providing 'liquidity' to banks, in order that they may accept and offer, for repos, paper of dubious quality, in order to assure that credit markets continue to function, and do not impeded the normal course of our non-financial economic sectors. Truly, that's all for which we should ask from the Fed. Beyond that, borrowers and investors must accept the consequences of their own financial decisions.
Friday, August 10, 2007
Risk Week: All Risks Are Not Alike- Lessons From Hershey Park
As this week has worn on, and I have written about risk each day, the US equity markets have exhibited incredible volatility, while probably ending today up as much as 1%. Our equity portfolio has demonstrated similar performance.
We're not down in the double digits of percentage return this week, or this month. We hold large-cap, S&P500 equities, and call options thereon.
We don't sell calls. We don't sell puts. We don't buy or sell on margin. We don't try to hedge different instruments, in hopes of taking advantage of relationships which are, in general, predictable, but perhaps not so during times of financial uncertainty. We buy no bundles of mixed securities, such as mortgage CDOs, or other CDOs, nor do we buy or sell them in pairs, to hedge their returns.
A few weeks ago, as I spent several days with my daughters at a well-known amusement park in the next state, I mused about how my behavior at that park was rather like the investment behaviors my partner and I evince in the equity markets.
Since we only deal in listed US equities, or call options for them, that means we eschew some very unpredictable instruments which lend themselves to pricing and demand irregularities with frightening frequency.
Similarly, I don't take my children to just any amusement park. Some are rather lax in their admissions security checks and general behavior requirements. Others are less well-known, and subject to my concerns about the safety of some of their rides.
For instance, my daughters and I love to ride roller coasters. We are addicted. Thus, we've spent at least a few days during each of the last few summers at Hershey Park. As I am being rocketed around one of the older, more exciting wooden coasters, I regularly consider how little would be left of all of us if the cars left the track. You basically have no chance of survival whatsoever. None.
Thus, while I engage in the, to some, risky behavior of riding roller coasters, I only do it at a park where I trust the management to operate totally safe roller coaster rides. I never worry about boarding any ride at Hershey. Between the park's long reputation for cleanliness and safety, and the related food operations of the parent, I am confident the company's management of the park brooks absolutely no lapses which could lead to any fatalities or serious injuries on the rides.
Each year, there's a story about someone dying while riding and, falling out of or from, some ride at some amusement park somewhere in the US. But never Hershey.
The lesson I draw from my amusement park behavior, and apply to my investment behavior, is that it is important to set hierarchical, conditional criteria for risk.
We don't invest in instruments other than large-cap, US equities, and the purchase of options thereon (calls in markets expected to remain strong, puts in markets expected to remain weak).
Having set that initial criterion, we remain invested through market turmoil such as these past few weeks. My partner and I monitor the conditions that affect the companies whose equities we may purchase, but we don't worry unnecessarily about the trouble other investors create for themselves through injudicious trading and investing in various esoteric instruments.
That is very germane to this week's market activity. Although some extremists, such as Jim Cramer or Gary Shilling, believe there is a global liquidity and capital contraction which is of systemic proportions, I do not share that view.
Global economic growth and corporate activity remain healthy and robust. Profits are up. Most financial instruments- equities, corporate debt, Treasuries- are in good shape.
The genesis of the current financial volatility and perceived liquidity problems lie primarily with those parties who have chosen to buy, hold, and/or depend upon other parties with positions in relatively high risk instruments involving sub-prime residential US mortgages.
Just a week ago, James Cayne, Chairman of Bear Stearns, got the denial ball rolling by alleging that this is the 'worst debt market in twenty years.'
Only if you happen to dabble significantly in the riskiest, least creditworthy, shallow and illiquid parts of it. Which Bear did.
By Tuesday of this week, other scorched trading and portfolio players, also guilty of expecting constant profit from sub-prime debt, echoed Cayne's claim that the market was unraveling, and, therefore, they had not done anything extreme, greedy or unwise. They were merely victims of a bad market.
Someone would have to fix that bad market. Oh, yes, and, in the process, bail out those who chose to play with that brand of fire labelled 'sub-prime.'
As the French swung into action yesterday, with Paribas' idiotic suspension of redemptions in several of its sub-prime-related funds, and the EuroBank loudly announced its provision of liquidity to their markets, the panic began. Cayne, Cramer & Co. had accomplished their objectives, by causing sufficient uncertainty that counterparties to known holders of sub-prime-related issues stampeded out of positions.
As my partner has pointed out, the actual expected loss on sub-prime mortgages, were they simply to be written off, is far, far less than the total amount of market value destruction seen over the past week in the global financial markets.
Over very, very short periods of time, like the past few weeks, the mass of mediocre, poorly-informed and -reasoning investors, analysts, money managers and pundits can cause temporary market behaviors to depart radically from what more reasoned, informed market participants believe is warranted.
As such, as we have seen recently, volatility can soar, and assets can appear to lose even their intrinsic values. But this is a purely short term effect when there is no serious, structural economic problem underpinning the behavior.
Right now, being in US large-cap equities and options has insulated our portfolio from egregiously magnified losses of those experienced in the S&P500. We still have risk exposure, but we feel it is far, far less than that of investors who have engaged in complex, hedged positions which rely on modeled behavior of prices for esoteric, thinly-traded debt instruments.
We're not down in the double digits of percentage return this week, or this month. We hold large-cap, S&P500 equities, and call options thereon.
We don't sell calls. We don't sell puts. We don't buy or sell on margin. We don't try to hedge different instruments, in hopes of taking advantage of relationships which are, in general, predictable, but perhaps not so during times of financial uncertainty. We buy no bundles of mixed securities, such as mortgage CDOs, or other CDOs, nor do we buy or sell them in pairs, to hedge their returns.
A few weeks ago, as I spent several days with my daughters at a well-known amusement park in the next state, I mused about how my behavior at that park was rather like the investment behaviors my partner and I evince in the equity markets.
Since we only deal in listed US equities, or call options for them, that means we eschew some very unpredictable instruments which lend themselves to pricing and demand irregularities with frightening frequency.
Similarly, I don't take my children to just any amusement park. Some are rather lax in their admissions security checks and general behavior requirements. Others are less well-known, and subject to my concerns about the safety of some of their rides.
For instance, my daughters and I love to ride roller coasters. We are addicted. Thus, we've spent at least a few days during each of the last few summers at Hershey Park. As I am being rocketed around one of the older, more exciting wooden coasters, I regularly consider how little would be left of all of us if the cars left the track. You basically have no chance of survival whatsoever. None.
Thus, while I engage in the, to some, risky behavior of riding roller coasters, I only do it at a park where I trust the management to operate totally safe roller coaster rides. I never worry about boarding any ride at Hershey. Between the park's long reputation for cleanliness and safety, and the related food operations of the parent, I am confident the company's management of the park brooks absolutely no lapses which could lead to any fatalities or serious injuries on the rides.
Each year, there's a story about someone dying while riding and, falling out of or from, some ride at some amusement park somewhere in the US. But never Hershey.
The lesson I draw from my amusement park behavior, and apply to my investment behavior, is that it is important to set hierarchical, conditional criteria for risk.
We don't invest in instruments other than large-cap, US equities, and the purchase of options thereon (calls in markets expected to remain strong, puts in markets expected to remain weak).
Having set that initial criterion, we remain invested through market turmoil such as these past few weeks. My partner and I monitor the conditions that affect the companies whose equities we may purchase, but we don't worry unnecessarily about the trouble other investors create for themselves through injudicious trading and investing in various esoteric instruments.
That is very germane to this week's market activity. Although some extremists, such as Jim Cramer or Gary Shilling, believe there is a global liquidity and capital contraction which is of systemic proportions, I do not share that view.
Global economic growth and corporate activity remain healthy and robust. Profits are up. Most financial instruments- equities, corporate debt, Treasuries- are in good shape.
The genesis of the current financial volatility and perceived liquidity problems lie primarily with those parties who have chosen to buy, hold, and/or depend upon other parties with positions in relatively high risk instruments involving sub-prime residential US mortgages.
Just a week ago, James Cayne, Chairman of Bear Stearns, got the denial ball rolling by alleging that this is the 'worst debt market in twenty years.'
Only if you happen to dabble significantly in the riskiest, least creditworthy, shallow and illiquid parts of it. Which Bear did.
By Tuesday of this week, other scorched trading and portfolio players, also guilty of expecting constant profit from sub-prime debt, echoed Cayne's claim that the market was unraveling, and, therefore, they had not done anything extreme, greedy or unwise. They were merely victims of a bad market.
Someone would have to fix that bad market. Oh, yes, and, in the process, bail out those who chose to play with that brand of fire labelled 'sub-prime.'
As the French swung into action yesterday, with Paribas' idiotic suspension of redemptions in several of its sub-prime-related funds, and the EuroBank loudly announced its provision of liquidity to their markets, the panic began. Cayne, Cramer & Co. had accomplished their objectives, by causing sufficient uncertainty that counterparties to known holders of sub-prime-related issues stampeded out of positions.
As my partner has pointed out, the actual expected loss on sub-prime mortgages, were they simply to be written off, is far, far less than the total amount of market value destruction seen over the past week in the global financial markets.
Over very, very short periods of time, like the past few weeks, the mass of mediocre, poorly-informed and -reasoning investors, analysts, money managers and pundits can cause temporary market behaviors to depart radically from what more reasoned, informed market participants believe is warranted.
As such, as we have seen recently, volatility can soar, and assets can appear to lose even their intrinsic values. But this is a purely short term effect when there is no serious, structural economic problem underpinning the behavior.
Right now, being in US large-cap equities and options has insulated our portfolio from egregiously magnified losses of those experienced in the S&P500. We still have risk exposure, but we feel it is far, far less than that of investors who have engaged in complex, hedged positions which rely on modeled behavior of prices for esoteric, thinly-traded debt instruments.
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