Quote of the Day

“The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.” - J.K. Galbraith, "A Short History of Financial Euphoria"

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The K-T Boundary - The Epicurean Dealmaker

Summary:
Epicurean Dealmaker elaborates on John Gapper's FT comment about how the investment banking industry got to this stage. The problematic component of i-banking is the capital markets business. Maintaining a credible and effective capital markets operation has always been an expensive proposition, compared to the advisory side of the business. When fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially. Started using a much larger amount of money trading for their own account, on a proprietary basis. As a result of US's ballooning trade deficit, and low interest rates under Greenspan, capital markets operations became the dominant business line of all major investment banks over the past couple of decades. Compensation systems at investment banks could not deal with this development. Imbalances built up, risk and return became misaligned. But capital markets business has always been an integral part of an investment bank's advisory business. No better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client. Pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it. Catch-22. capital markets capabilities cannot pay for themselves without proprietary trading operations. (Published: 16/09/08)

Notes:

• how did the investment banking industry get itself into this pickle, and where does it go from here?
• John Gapper, "May Day": the elimination of fixed commissions for stock trades in 1975
• launched the industry onto the path of relentless growth in capital, people and profits
• capital markets business
• securities sales and trading activities
• has always been a key component of the investment banking model
• but: maintaining a credible and effective capital markets operation has always been an expensive proposition
• requires a lot of people, information technology, dedicated real estate, and other doodads that cost a lot of money to install and a lot of money to maintain
• unlike the advisory side of the business
• your typical M&A banker requires very little in the way of infrastructure
• May Day: when fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially
• banks needed to find another use for all that investment in infrastructure
• Salomon Brothers:
  
• first to make the transition from using relatively small amounts of in-house capital to support underwriting and market-making activities to using a much larger amount of money trading for their own account, on a proprietary basis
• because they were "in the flow" and saw the securities markets from the privileged position of market makers, "prop desks" at investment banks started making money hand over fist
• i.e. they started acting like hedge funds
• ballooning federal deficits of the Reagan years
  
• resulted in huge trading volumes in fixed income securities and related derivatives
• led to an explosion in equity trading
• accompanied the internet boom
• Alan Greenspan
  
• plying the financial markets with liquidity "like a whorehouse madam plies shore-leave sailors with booze"
• result: capital markets operations became the dominant business line of all major investment banks over the past couple of decades
• trouble in paradise
• problems caused by trying to incorporate a volatile principal-oriented business like proprietary trading into an organization that was otherwise focused on agency business like M&A advisory, capital raising, and underwriting
• when the prop traders made a bundle betting for the firm, they brought home annual bonuses that struck even the highly overcompensated bankers in M&A and corporate finance as nothing short of obscene
  
• when their trades blew up in their faces everybody else at the firm suffered big cuts in compensation regardless of how good their individual years had been
• compensation systems at investment banks could not deal with this development
• proprietary traders, CDO structurers, and derivatives specialists began taking and holding positions with longer and longer risk tails
• but still got measured and paid based on systems designed to measure the annual production of a banker conducting traditional agency business, like M&A or equity underwriting
• imbalances built up, risk and return became misaligned, "and various pieces of shit began hitting various fans"
• paying traders, corporate financiers, and M&A advisors with long-vesting restricted stock did create some sort of alignment with the firm's and shareholders' interests
• but: it was too blunt an instrument to contain and control the stresses building up in the new hybrid hedge fund-investment banking model
• why didn't the investment banks abandon the securities sales and trading business when it became unprofitable after May 1975? Three reasons:
1. commissions did not vanish in one fell swoop after May 1, 1975
• competition was introduced, and commissions shrank gradually over a number of years
• investment banks did not necessarily see the writing on the wall for quite some time
• by the time they realized that pure agency capital markets was now and forever a loss leader business, it was in many respects too late to change
2. capital markets businesses were always large
• controlling roughly half the resources of a typical investment bank and sometimes more
• very difficult to kill a business line with so much human, psychological, and political capital committed to it
• plus sharp-elbowed leaders who are committed to fight for it
3. most importantly: the capital markets business has always been an integral part of an investment bank's advisory business
• obvious for corporate finance activities like selling bonds to raise capital for a railroad or underwriting an initial public stock offering for a technology company
• raising capital for corporate clients has always been an extremely important business line for investment banks
• was really the only business investment banks conducted for many years after their separation from commercial banks in the 1930s after Glass-Steagall
• until the emergence of a new business in the late 1970s which came to be known as mergers and acquisitions advisory
• "client bankers" to Ford Motor Company, CSX Corporation, and Netscape did and do rely heavily on their buddies on the capital markets desk to gauge investor demand, structure attractive security offerings, and help sell their clients' securities to new investors
• M&A bankers rely heavily and often on their capital markets colleagues, too
• in the case of corporate clients, there is all sorts of useful intelligence an M&A banker can glean from his capital markets partners
• bears directly on the approach, feasibility, and potential price of doing a deal
• publicly traded corporations want to know how the markets will react to the announcement of a transaction
• CEOs want to know who are the top 20 critical investors they should talk to to explain the rationale for selling a division or buying their biggest competitor
• there is no better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client
• pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it
• capital markets operations of any consequence are too expensive to support solely with the revenues a successful M&A practice brings in
• Catch-22:
• advisory practices cannot compete with fully integrated investment banks in all situations without capital markets capabilities
• but: capital markets capabilities cannot pay for themselves without proprietary trading operations
  
• we seem to be stuck with the integrated i-bank model, whether we like it or not

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After 73 years: the last gasp of the broker-dealer - FT.com

Summary:
According to John Gapper, recent events mark the end of 73 years of full-service investment banking, i.e. buying and selling shares and bonds for customers as well as advising companies and trading with its own capital. In order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them. Two milestones in the history of IBs: 1933 Glass-Steagall Act (enforced the separation of banks and investment banks) and May 1 1975 (fixed commissions for trading securities were abolished) Despite the latter setting off a squeeze on broking revenues, IBs prospered for the next 30 years, mainly through gambling with their own (and later others') capital. But the gambles were potentially life-threatening: IBs did not have sufficient capital to cope with a severe setback in the housing market or markets generally. According to Gapper, there are two options for Goldman and Morgan Stanley: sell out to a large commercial bank with a big capital and deposit base, or scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds. (Published: 15/09/08)

Notes:

• Goldman Sachs and Morgan Stanley last hold-outs among Wall Street's independent investment banks
• future also in doubt
• full-service investment bank is doomed
• i.e. buying and selling shares and bonds for customers as well as advising companies and trading with its own capital
• in order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them.
  
• investment banks in future will be smaller, specialist institutions
• like the merchants of old
• history
  
• 1933 Glass-Steagall Act
• enforced the separation of banks and investment banks
• e.g. Morgan Stanley founded in 1935
  
• May 1 1975
• fixed commissions for trading securities were abolished
• set off a squeeze on broking revenues
• abolition of the system that has enriched them in good times and pulled many of them through during long periods of market slack,
• investment banks had relied on these commissions during the financial doldrums following the 1973 oil crisis.
• following 1975, investment banks went on to enjoy 30 years of prosperity
• grew rapidly, taking on thousands of employees and expanding around the world
• but: under the surface they were ratcheting up their risk-taking
• was increasingly hard to sustain themselves by selling securities
• the traditional core of their business -
  
• because commissions had shrunk to fractions of a percentage point per trade
• so they were forced to look elsewhere for their profits
• started to gamble more with their own (and later others') capital
• Salomon Brothers pioneered the idea of having a proprietary trading desk that bet its own money on movements in markets
  
• at the same time as the bank bought and sold securities on behalf of its customers
• banks insisted that their safeguards to stop inside information from their customers leaking to their proprietary traders were strong
• but there was no doubt that being "in the flow" gave investment banks' trading desks an edge
• also expanded into the underwriting and selling of complex financial securities
  
• e.g collateralised debt obligations
• were aided by the Federal Reserve's decision to cut US interest rates sharply after September 11 2001
• set off a boom in housing and in mortgage-related securities
• catch: investment banks were taking what turned out to be life-threatening gambles
• did not have sufficient capital to cope with a severe setback in the housing market or markets generally
• when it occurred, three (so far) of the five biggest banks ended up short of capital and confidence
• a bank can be highly skilled in risk management and trading, as Goldman has proved
• but: a single big mistake may spark a fatal spiral
• two options for Goldman and Morgan Stanley
• sell out to a large commercial bank with a big capital and deposit base
• e.g. Merril
• could provide them with sufficient backing for their capital markets divisions, which can be revenue and profit powerhouses in good times.
• scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds
• would involve a switch from sell side to buy side, where most money is now made
• in exchange for becoming much smaller, they might retain their high margins

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Is the Market Still a Future Indicator? - The Big Picture

Summary:
Barry Ritholz with some thoughts on the Efficient Market Hypothesis, or the idea of markets efficiently reflecting future corporate earnings. Clearly not the case. Some examples: credit crunch; dotcom crash. Note in later case, markets were initially pricing stocks as if earnings didn't matter, whereas three years later some profitable, debt-free tech firms were trading below cash on hand. Stockmarkets now more likely to move in tandem, even lag the trajectory of profits. Blamed on the proliferation of hedge funds. Is making markets increasingly focused on breaking news and short-term swings, rather than longer-term fundamentals. Yet, to an EMH proponent, hedge funds should make markets more, not less efficient. Robert Schiller: The huge mistake EMH proponents have made: just because markets are unpredictable doesn't mean they are efficient. That false leap of logic was one of the most remarkable errors in the history of economic thought. (Published: 11/08/08)

Notes:

• Efficient Market Hypothesis:
• the markets constitute a future discounting mechanism
• i.e. efficiently reflects future corporate earnings
• makes sense, as one ostensibly buys stocks in companies to claim bucketfuls of their future profits
• i.e. behaves like a crystal ball
• should have died a quite death
• but on Wall Street, myths, bad theories, and old information linger far longer than one would expect
• WSJ: "For decades, turns in the stock market typically led earnings by roughly six months. But during the past decade or so, stocks have moved roughly in tandem with, and occasionally lagged, the trajectory of profits, notes Tobias Levkovich, Citigroup's chief U.S. strategist."
• plenty of examples of where markets simply get it wrong
• exhibit A: credit crunch
• began in August 2007 (though some had been warning about it long before that)
• despite all of the obvious problems that were forthcoming, after a minor wobble, stock markets raced ahead
• by October 2007, both the Dow Industrials and the S&P500 had set all time highs
• so much for that discounting mechanism!
• dotcom crash
• March 2000: the market was essentially pricing stocks as if earnings didn't matter
• growth could continue far above historical levels indefinitely
• value was irrelevant
• How'd that work out?
• 3 years later:
• some of the most profitable, debt free tech and telecom names were trading below their book value
• some were even trading below cash on hand.
• the market had "efficiently" priced a dollar at seventy-five cents
• most fascinating aspect of this is the opportunity for anyone in t he market to identify inefficiencies
• discover where the market has a non random error -- we've called it Variant Perception over the years -- and you have a potentially enormous money making opportunity
• is the reason why everyone doesn't simply dollar cost average into index funds
• its the lure of the big score
• proliferation of hedge funds
  
• is making markets increasingly focused on breaking news and short-term swings, rather than longer-term fundamentals.
• contribute to this phenomenon are the narrow niche focuses used to differentiate amongst funds and raise capital
• but: to an EMH proponent, hedge funds should make markets more, not less efficient
• their long lock period (when investors cannot take out cash) means they should have a longer time horizon for investment themes to play out.
• Robert Schiller
• "The huge mistake EMH proponents have made: just because markets are unpredictable doesn't mean they are efficient. That false leap of logic was one of the most remarkable errors in the history of economic thought."
  

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Word of the Day: Haircut

The percentage by which an asset's market value is reduced for the purpose of calculating capital requirement, margin, and collateral levels, or the difference between the actual market value of a security and the value assessed by the lending side of a transaction.

Notes:

• The term haircut comes from the fact that market makers can trade at such a thin spread.
• When they are used as collateral, securities will generally be devalued since a cushion is required by the lending parties in case the market value falls.
  

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Credit Crisis 'Only Now Beginning' - Bloomberg

Summary:
David Goldman, a portfolio strategist at Asteri Capital, talks about the outlook for the U.S. financial-services industry, the impact of the hedge-fund model on market volatility and his investment advice. This is not a mere recession, it's a change in the lives of Americans. We're still in the credit bubble, because of contractual obligations the banks have. The credit crunch hasn't started yet, merely a mild indisposition so far. The credit crunch is what comes next, and it will be brutal. The hedge fund business is very vulnerable. All in the same trade all the time and every turn is like a stampede out of a crowded theater. Only the big funds that have a lock on capital may do well. If you marked everyone to market now, the banks would be in very bad shape, many insolvent. Isn't going to happen and banks will try to generate enough earnings in order to bring in the capital back while they pretend that they're still solvent. But losses from consumer lending may pile up faster. We may have a deflationary outcome, destroying huge amounts of wealth in the form of homes and equities and companies is in principle inflationary. (Published: 14/08/08)

Notes:

• not a recession, not a blip: it's a change in the lives of Americans who've spent the last 10 years in the delusion that they'd fund their retirement by selling homes back and forth to eachother at higher prices
• the financial industry enabled them by sustaining this delusion
• delusion is now coming unravelled
• no one is going to retire, entire neighborhoods will turn into slums and financials will trade at 50% of book
  

• a year from now we're still going to have a very weak economy;
  
• that may be long enough to find the bottom;
• but it's going to take a rebuilding of household balance sheets, ie a lot of saving
• what we have now is a lot of dis-saving
• Mr Market is going to have to kick their teeth down their throats to change their behaviour

• hedge fund business now (compared to 1998) is much bigger and much more vulnerable
• with everyone forced to take the same trade, volatility intra-month so great that those investors who are committed to a month by month sharp ratio low volatility strategy will be forced to redeem and you get wild swings and illiquidity and inability to liquidate positions
• we're going to have a serial catastrophe of hedge funds
• particularly the type of fund that thought it was a great idea to buy loans at 90 cents to the dollar and won't be able to sell them at 80 later this year
  

• private equity can make money in this kind of market, if you're right and you willing to take massive volatility intra-month, and hang on for a year or two; you can do extremely well
  
• but if you have to grind out returns month by month, which is the conventional hedge fund model, you end up creating volatility because you're all in the same trade all the time and every turn is like a stampede out of a crowded theatre
  

• hedge funds are one of the major sources of volatility, and have become one of the major sources of risk
  

• the most important thing to keep in mind is: we have not had a credit crunch yet; we've had a 20% annual rate of increase of bank lending to corporations, and an even faster rate of securities purchases; we've had a credit bubble continuing
• this is because banks are contractually locked into make loans, largely revolving credits, which they can't get out of
• so the credit crunch is only begining to start
• we're now seeing banks cut off home equity lines to consumers, we're seeing the beginning of cut off credit card lines;
  
• but we had a spike in credit card usage because since the home equity lines were cut off, consumers used their credit cards
• the credit crunch is only now beginning because bank capital is so restricted by losses to date that they will have to begin shutting of credit to households and corporations
• and that's when we're going to get the defaults
• what we have had in aggregate is a credit bubble till today; a credit crunch is technically the wrong expression;
  
• the credit crunch is what comes next, and will be brutal compared to the mild indisposition we've had for the past 12 months
  

• financial institutions would be well-advised to try and clear their books as quickly as possible
• take the pain now because it will be more painful later
  

• SIVs are essentially a corpse waiting to be buried;
• you now have a highly ambiguous situations regarding all of the off-balance sheet assets of banks;
  
• the Federal Accounting Standards Board (FASB) was supposed to have ruled in a way that would force banks to take several billion dollars of asset-backed securities and take them out of off-balance sheet structures and consolidate them back on their books, which would increase the capital demands on the banks
• that was one of the reasons that financial stocks were in such hot water during May and June;
  
• the FASB turned around and postponed that ruling;
  
• obviously they looked at the distressed state of the banks and decided that it was a bad time to stress their capital base again;
  
• so a great deal of this remains under negotiation or in complete unclarity because the regulators, the FASB and the SEC, have not decided what to do about it
  

• if you marked everyone to market now, the banks would be in very bad shape;
  
• they certainly would have inadequate tier one capital, many of them would be insolvent
• wouldn't be the first time, the banking system might have been insolvent in 1990, also might have been in 1981
• so no one is going to mark the stuff to market;
  
• the question is can they generate enough earnings in order to bring in the capital back while they pretend that they're still solvent;
  
• but the problem is, as the rot gets into the consumer sector and the losses pile up from consumer loans and high yield loans, my view is their capital is going to be decreasing; instead of earning their way out of it, they're going to be piling up fresh losses
  

• the only hedge fund model that will work now is to be huge and have a lock on money for a long period of time;
  
• if you can take the courage of your convictions and ignore 10 or 20 or 30% down months in order to get 50% up years, then this is a good thing to do;
  
• and if you want to invest in hedge funds, find managers whose convictions you believe in, who are willing to swing for the fences, and will insist on taking your money for a period of time and have the courage to do it
• or keep it in treasury bills

• I believe that we're going to have an enormous taxpayer bailout for the GSEs and for a number of banks; i think it will look like the 80s, when we had a $700b bill for the S&Ls, but it will be larger

• in an economy where there aren't enough hedges, the price of hedges can be arbitrarily high
• what's the price of a last ticket on the Paris-Marseille express on the night of that the Germans march into Paris? The answer is how much do you have in your pocket;
  
• we may have a deflationary outcome, destroying huge amounts of wealth in the form of homes and equities and companies is in principle inflationary;
  
• the hedge against this in the form of commodity investing has turned out not to work that well in the last several weeks,
  
• and the signals that we're getting from the TIPS market - the break-even inflation rate between TIPS and coupons - has actually come in to the lowest in years;
  
• so we may have an inflationary environment

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Back to bust? High technology on course for harder times - FT.com

Summary:
The IT industry may be about to face its toughest period since the dotcom bust due to the slowdown in the economy. Corporate demand, the IT industry's main source of prosperity, will fall significantly. Instability in the financial markets, declining new hires and weakening corporate profits will result in a lowering of capital expenditure and a premium being placed on operational efficiency. This is likely to play out over the next 9 months, with tech stock, already down 19% over the last 12 months, to fall further. Other recent trends that will compound the impact of the economic slowdown are the increase in choice leading to price deflation; the rise of software as a service and virtualisation. Consumer spending and spending on advertising, an important source of revenues for many Web 2.0 startups are also in decline. The downturn, however, may be less painful than the dotcom crash. There is less overcapacity in the industry, and increasing demand from the emerging world for IT services is compensating for the slowdown in the US and UK. (Published: 14/08/08)

Notes:

• information technology industry may be about to face its toughest period since the dotcom bust
• forgotten side of the technology world: industry's main source of prosperity is the corporate customer
  
• the engine that powers Silicon Valley and the rest of the technology industry
• "flashy gadgets such as Apple's iPhone and online consumer services such as Facebook may have captured the popular imagination and created new technology fortunes, but they are not the industry's main source of prosperity"
• companies account for 60-65 per cent of the end-market for technology
• consumer technology represents only about 20-25 per cent
• governments make up the rest
• with a pronounced economic slowdown in the US and the UK, this engine has started to sputter:
1. weakening corporate profits
2. decline in new hires
   
3. instability in the financial markets
   
• these have historically all been warning signs of lower capital spending ahead
• based on the usual lag, the turmoil in credit markets of the past year virtually guarantees that corporate spending on technology will fall over the next nine months or so
• technology demand, which has been growing recently at an annualised rate of 5-6 per cent, could decline by 10 per cent
• tech stock investors
  
• investors in tech stocks are invariably drawn by the promise of superior growth
• made the sector a stock market stand-out for much of last year, as a slowing US economy made growth stocks rarer
• industry's seemingly endless hype cycle feeds this optimism
• there's always a new computing architecture about to go mainstream, a new must-have gadget, and a Next Big Thing
• optimism is often justified given the big markets that new technologies can create
  
• but: investors frequently pay dearly for that potential
• "If it doesn't work, you get your neck broke"
  
• tech stocks have fallen 19 per cent over the 12 months to the end of July
• nearly double the rate of the overall market
• operational execution at a premium
  
• "I expect the slowdown to profoundly impact Silicon Valley internet, networking and technology companies over the next 12 to 18 months"
• "Technology start-ups should already be tightening their cost controls and turning their attention to the nuts and bolts of operational efficiency."
  
• "There are still numerous long-term growth opportunities across Silicon Valley, but operational execution is at a premium and much more of a differentiator than it has been in many years."
  
• Jim Breyer, partner in VC firm Accel Partners
• recent trends in the technology industry compounding the impact of the worsening economic environment
• availability of choice -> price deflation
  
• thanks to the rise of the internet and other standards-based technologies
• made it easier for buyers to shop around
  
• many corporate buyers have come to count on these to help them continually reduce the overall size of their tech budgets
• When the 1990s tech boom reached its peak, corporate buyers were often tied to proprietary systems from single suppliers
• that is no longer the case
• result: a severe price deflation has taken hold in some corners of corporate technology
• rise of "software as a service" and virtualisation
• two of the most powerful recent technology trends that exemplify this change
  
• software as a service (SAS)
• involves shifting corporate computing tasks to online services
• e.g. using a company such as Google to provide an e-mail service
• "I don't have to buy servers, I don't have to buy storage, I don't have to do back-ups"
• many of these service companies have priced their services at rock-bottom rates
• relying on attracting large volumes of customers to spread their large fixed costs
• "We're talking about products that are one tenth the cost of things that were hawked in the last recession"
• virtualisation
• makes it possible to run several computing workloads on a single server,
• greatly reducing the number of machines that companies need to buy and maintain
• trends like these have created new markets and supported the rise of new companies
• but 1: they have also exposed those whose technologies or business models are not suited to the changing times
• e.g. Sun Microsystems
• soared in the dotcom boom as its proprietary servers became the mainstay of Web 1.0
• but has struggled to adapt to the latest generation of low-cost, standards-based machines and open-source software
• but 2: even tech companies that have been better positioned to ride this wave are starting to feel the pinch.
• due to weaker corporate demand
• companies taking a more "pragmatic" approach to their tech budget
• putting off buying new services
• not just weaker corporate demand
• consumer spending on tech, though far less significant overall and traditionally less prone to big dips, could also be hit in a wider downturn
• another big source of growth, the rapid rise in online advertising, has slowed notably this year in the face of a wider softening in consumer advertising
• after growing nearly 26 per cent in 2007, online advertising in the US, is predicted to grow by only 17.5 per cent this year and 14.5 per cent in 2009, before growth eventually pushes back above 20 per cent in 2011
• search still dominates
• people are cutting back on typical display ads
  
• this slowdown in advertising could not have come at a worse time
• many of the consumer web companies created since the dotcom crash have been avidly building an audience in the expectation that they will cash in through advertising

• downturn will not be anywhere near as painful as the one that hit the industry at the start of this decade
• late-1990s tech binge was more than a bubble in stock market valuations:
  
• it also reflected a massive bubble in tech spending
• internet euphoria
• fear that many older IT systems would not be able to handle the date shift at the turn of the millennium
  
• combined to produce a boom in corporate spending
• we don't have the overcapacity in IT systems we had going into the last downturn
• capital spending in the US has been low by historical standards for the past four years
• will cushion the blow from any fall now
• demand from emerging world growing
  
• after many years of investment, these markets are finally on the brink of becoming significant money-earners for some of the industry's biggest players.
• at its current growth rates, these "growth markets" may account for nearly 30 per cent of its revenues in five years' time
• Silicon Valley is once again turning into a place of "haves" and "have-nots"
• those start-ups that raised a comfortable cushion of cash from investors to see them through this more uncertain period and those that risk being left high and dry if business turns down
  

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Bob Farrell's 10 Rules for Investing - Market Watch

Summary:
10 Rules for investors by Bob Farrell (chief stockmarket analyst, Merril Lynch). Markets tend to return to the mean over time; Excesses in one direction will lead to an opposite excess in the other direction; There are no new eras -- excesses are never permanent; Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways; The public buys the most at the top and the least at the bottom; Fear and greed are stronger than long-term resolve; Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names; Bear markets have three stages -- sharp down, reflexive rebound and a drawn-out fundamental downtrend; When all the experts and forecasts agree -- something else is going to happen; Bull markets are more fun than bear markets. (Published: 11/06/08)

Notes:

• investment rules
• tailor-made for tough times, allowing you to stick to a plan just when you need it most
• a rulebook is important in any market climate
• but: it tends to get tossed when stocks are soaring
• sage investors warn people not to confuse a bull market with brains
• Bob Farrell
• pioneered technical analysis in the late 1950s
• rates a stock not only on a company's financial strength or business line but also on the strong patterns and line charts reflected in the shares' trading history
• also broke new ground using investor sentiment figures to better understand how markets and individual stocks might move
• 10 rules
1. Markets tend to return to the mean over time
• when stocks go too far in one direction, they come back
• both euphoric and pessimistic markets can cloud people's heads
• "It's so easy to get caught up in the heat of the moment and not have perspective. Those that have a plan and stick to it tend to be more successful."
2. Excess in one direction will lead to an opposite excess in the other direction
3. There are no new areas - excesses are never permanent
• many investors try to find the latest hot sector
• soon a fever builds that "this time it's different."
  
• never really is
• when that sector cools, individual shareholders are usually among the last to know and are forced to sell at lower price
• it's very hard to switch and time the changes from one sector to another
• find a strategy that you believe in and stay put
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
• a popular sector can stay hot for a long while, but will fall hard when a correction comes
5. The public buys the most at the top and the least at the bottom
• many market technicians use sentiment indicators to gauge investor pessimism or optimism, then recommend that investors head in the opposite direction
6. Fear and greed are stronger than long-term resolve
• investors can be their own worst enemy, particularly when emotions take hold
• it's critical for investors to understand how they're cu
• if you can't handle a 15% or 20% downturn, you need to rethink how you invest
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
• markets and individual sectors can move in powerful waves that take all boats up or down in their wake
• there's strength in numbers, and such broad momentum is hard to stop
• in these conditions you either lead, follow or get out of the way
• when momentum channels into a small number of stocks, it means that many worthy companies are being overlooked and investors essentially are crowding one side of the boat
8. Bear markets have three stages -- sharp down, reflexive rebound and a drawn-out fundamental downtrend
9. When all the experts and forecasts agree -- something else is going to happen
• "If everybody's optimistic, who is left to buy? If everybody's pessimistic, who's left to sell?"
10. Bull markets are more fun than bear markets

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The four horsemen of the market - MarketWatch

Summary:
Views of Jeremy Grantham, Bob Rodriguez, John Hussman and Steve Leuthold. Grantham believes the market fundamentals are very bad, in for two years of disappointment. No time to take risks. Reason is global economic growth is slowing under the weight of increasingly illiquid credit markets and inflationary pressures. Slashes corporate earnings, resulting in poor to middling for equities worldwide. Stocks in both developed and emerging markets are "substantially overpriced." Also concerned about sputtering growth of China. Rodriguez is on "buyer's strike" regarding high-quality bonds with maturities greater than two years. Believes that longer-term Treasury yields aren't substantial enough to compensate investors for inflation's eroding impact on purchasing power. Continues to focus on "caution and capital preservation." Hussman said he's looking for another shoe to drop once investors recognize that the U.S. has not avoided recession. U.S. is mired in recession, and once investors realize that earnings expectations are overblown, stocks will take another major hit. Leuthold is pretty positive. Believes bottom has been made. Economy is going to start showing some positive signs sometime in the first half of 2009. Iis getting in early: loading up on shares of biotechnology and alternative-energy companies in particular. (Published: 29/08/08)

Notes:

• Jeremy Grantham
• chief investment strategist at GMO
• highly regarded Boston-based manager of institutional and high-net-worth accounts
• makes buy and sell decisions with a combination of computerized technical analysis and old-fashioned spadework
• but: nowadays, digging for attractively valued stocks is mostly hitting rocks
• "The fundamentals have turned out to be worse than I had thought. My advice would be, don't take any risk."
• i.e. in this market, don't be a hero; live to fight another day
• reason:
• global economic growth is slowing under the weight of increasingly illiquid credit markets and inflationary pressures
• weaker growth slashes corporate earnings
• since stock prices are tied to earnings, the outlook for equities worldwide is poor to middling
• "Stocks in both developed and emerging markets are "substantially overpriced," with the possible exception of high-quality blue-chip companies that have strong, defensible global franchise."
• "I underestimated in almost every way how badly economic and financial fundamentals would turn out. Events must now be disturbing to everyone, and I for one am officially scared!"
• biggest fears: that "the whole global economy will be weaker than the market expects for quite a considerable time."
  
• How long? "I would guess at least two years of sustained disappointment."
• particularly uneasy about China
• leading engine of world growth seems to be sputtering
• "I worry on behalf of the global economy at the consequences of China stumbling, the whole level of global imports and exports would start to drop."

• Bob Rodriguez
• manager of FPA Capital Fund and bond-focused sibling FPA New Income Fund
• "He's not naturally the most optimistic person you'll ever chat with. Even in the best times he's looking for the gray lining in a silver cloud. That's one of the reasons you invest with him."
• on a self-proclaimed "buyer's strike" regarding high-quality bonds with maturities greater than two years.
• believes that longer-term Treasury yields aren't substantial enough to compensate investors for inflation's eroding impact on purchasing power
• wants to get 5% on 10-year Treasurys before venturing back
• recently yielded 3.8%
• "We will not provide long-term capital to borrowers with unsound and unwise business management practices at unattractive real yields. We require a higher level of compensation -- i.e. more yield, for these potential risks."
• continues to focus on "caution and capital preservation"

• John Hussman
• runs two portfolios: stock-focused Hussman Strategic Growth Fund and bond-centric Hussman Strategic Total Return Fund
• both are run with a careful eye to valuations and broad economic conditions that dictate the degree of market risk that Hussman is willing to accept
• for Hussman nowadays, risk-taking doesn't offer much reward
• "We're fully hedged"
• meaning that a portfolio won't be affected, positively or negatively, by market gyrations
• reason: Hussman said he's looking for another shoe to drop once investors recognize that the U.S. has not avoided recession
• "The stock, bond and foreign-exchange markets continue to trade essentially on the theme that the global economy is weakening, but that the U.S. has dodged a recession."
• Investors' consensus is mistaken, Hussman contends
• "U.S. is mired in recession, and once investors realize that earnings expectations are overblown, stocks will take another major hit."
• "The potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact"

• Steve Leuthold
• flagship funds include Leuthold Core Investment Fund and sibling Asset Allocation Fund
• has offered targeted portfolios with catchy names like the bear-market Grizzly Short Fund (GRZZX) and the bottom-fishing Undervalued and Unloved Fund (UGLYX)
  
• convinced that the U.S. economy is in recession
• but: points out that the stock market typically bottoms around the midpoint of the downturn
• reckons the economy entered recession toward the end of 2007
• the extensive valuation criteria he uses tell him there's now light at the end of the tunnel
• "The bottom has been made. The economy is going to start showing some positive signs sometime in the first half of 2009."
• is getting in early
• loading up on shares of biotechnology and alternative-energy companies in particular
• keeping a modest amount in oil drillers and natural gas producers

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Too much risk? - Interfluidity

Summary:
Steve Waldman argues against the conventional wisdom that the financial system took on "too much risk" in recent years. Hundreds of billions of dollars were poured into new suburbs, while very little capital was devoted e.g. to the alternative energy sector. Capital was withdrawn from a variety of industries deemed "uncompetitive", because to gamble on recovery is far too great a risk. Big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Huge institutions are treating the financial system like a bank: depositing trillions in generic "safe" instruments and expecting wealth to somehow appear. A generation of professionals were trained to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. Investors' childlike demand for safety has made the financial world terribly risky. We must not pretend that risk can be regulated or innovated away. (Published: 07/08/08)

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Word of the Day: (Statistical) Arbitrage

Summary:
Arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically.


Statistical arbitrage (as opposed to deterministic arbitrage) refers to highly technical short-term mean-reversion strategies involving large numbers of securities (hundreds to thousands, depending on the amount of risk capital), very short holding periods (measured in days to seconds), and substantial computational, trading, and IT infrastructure. It involves data mining and statistical methods, as well as automated trading systems. StatArb has become a major force at both hedge funds and investment banks.

Notes:

• arbitrage on Wikipedia
  
• statistical arbitrage on Wikipedia
  

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Buffett on the Stock Market (1999) - Fortune Magazine

Summary:
Buffet looking back in 1999 at the preceding 34 years and looking at the prospects for the stockmarket over the next 17 years. Preceding 34 years consisted of two contrasting 17 year periods. In first period, DJIA hardly moved; in second period, up nearly 10x. Main difference: interest rates and corporate profits. Interest rates down significantly in after 1982, and healthy corporate profits for period. Superimposed was market psychology. Many investors think next 17y will be more of the same. Buffett says this is unlikely: would require lowering of interest rates, and corporate profits after tax as a percentage of GDP to remain in excess of 6%. Profits cannot grow faster than GDP. Returns over next 17y more likely to be around 6%/year (4% reall return). Buffett on the chances of succesfully riding a wave of innovation: just look what happened to the automobile and aviation industries. Much easier to pick losers than to pick winners. However, key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. (Published: 22/11/1999)

Notes:

• explanation of why investors in 1999 are expecting too much
• investing = laying out money now to get more money back in the future in real terms, i.e. after taking inflation into account
• 1965 - 1999: 34 years, 2 periods of 17 years very different
• 1965 - 1981
• DJIA: hardly changed
  
• 31/12/1964: 874.12
• 31/12/1981: 875.00
• GDP: up 370% (almost 5x)
  
• Fortune 500 sales: up >6x
• rates on long-term bonds: tremendous increase
  
• 1964: 4%
• 1981: 15%
• corporate profits after tax as percentage of GDP
• mostly between 4 - 6.5% (normalcy range)
  
• down to 3.5% by 1981
  
• 1982 - 1999
• DJIA:
• 1981: 875.00
• 1999: 9,818.00
  
• GDP: up <3x
• rates on long-term bonds: going down
• 5% in 1998
  
• corporate profits after tax as percentage of GDP
• close to 6% by late 1998
  
• reasons for difference
• INTEREST RATE
  
• act on financial valuations the way gravy acts on matter
• the higher the rate, the greater the downward pull
• if government rate rises, prices of all other investments must adjust downward, to a level that brings their expected rates of return into line
• conversely, if government interest rates fall, the move pushes the prices of all other investments upwards
• basic proposition: what an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free rate
• every time the risk-free rate moves by one basis point - by 0.01% - the value of every investment in the country changes
• easy to see this in case of bonds
• value of which is normally affect exclusively by interest rates
• in case of equities, real estate, farms, etc. other variables also at work
• usually obscuring effect of interest rate changes
• yet effect always there, like the invisible pull of gravity
• huge increase in long-term government bond rates between 65 and 81
• gravitational pull of interest rate more than tripled
  
• huge depressing effect on the value of all investments, including equities
• major explanation of why tremendous growth in economy was accompanied by stock market going nowhere
• 1981-1983: interest rate situation reversed itself (Paul Volcker)
• effect on bonds
• e.g. put $1m into 14% 30-year US bond issued Nov 16 1981
• reinvest coupons, buying more of same bond
  
• end of 1998:
  
• bond selling at 5%
• made ~$8m, annual return >13%
• better than stocks in most 17 year periods
• effect on equities
  
• also pushed up by falling interest rate (in addition to other factors)
  
• e.g. put $1m in the Dow on Nov 16 1981
• reinvest all dividends
• end of 1998:
• made ~$20m, annual return of ~19%
  
• beats anything you can find in history
• AFTER-TAX CORPORATE PROFITS
• as percentage of GDP: portion of GDP that ended up with the shareholders of American business
• from 1951 to ~1980: within 4-6.5% range
• 1981 - 1982: down to 3.5%
• i.e. profits were sub-par and interest rates sky-high
• 1998: up to ~6%
• i.e. profits in upper part of normalcy range and interest rates low
• PSYCHOLOGY
• "Once a bull market gets underway, and once you reach the point where everybody has made money no matter what system he/she followed, a crowd is attracted into the game that is responding not to interest rates and profits by simply to the fact that it seems a mistake to be out of stocks. In effect, these people superimpose an I-can't-miss-the-party factor on top of the fundamental factors that drive the market. Like Pavlov's dog, these investors learn that when the bell rings - in this case the one that opens the New York Stock Exchange at 9:30am - they get fed. Through this daily reinforcement, they become convinced that there is a God and that He wants them to get rich."
• prospect for the next 17 years
• investors today have rosy expectations
• staring fixedly back at the road they just traveled
• expect 12 - 20% returns on 5 - 20 year investments
• Buffett: won't come close even to 12%
  
• 3 things need to happen for next 17 years to be as good as 17 years just passed
  
1. INTEREST RATES MUST FALL FURTHER
   
• if interest rates fell from 6% (now) to 3%, would come close to doubling the value of common stocks
  
• if you think interest rates are going to fall to e.g. 1%, you should buy bond options
  
2. CORPORATE PROFITABILITY IN RELATION TO GDP MUST RISE
   
• growth of a component factor cannot forever outpace that of the aggregate
• wildly optimistic to believe that corporate profits as a % of GDP can, for any sustained period, hold much above 6%
• e.g. competition will keep the percentage down
• also public policy element: if corporate investors, in aggregate, are going to eat an ever-growing portion of the economic pie, some other group will have to settle for a smaller portion
  
• would raise political problems
• reasonable assumption for GDP growth: 5% per year
• 3% real growth ("pretty darn good"), 2% inflation
• unless serious help from interest rates, aggregate value of equities can't grow much more than that
• GDP growth is limiting factor in returns you're going to get
• cannot expect to forever realize a 12% annual increase in valuation of American business if its profitability is growing only at 5%
• inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do
• note: future returns are always affected by current valuations
• and: investors as a whole cannot get anything out of their business except what the businesses earn
• minus "frictional costs", i.e. transaction, advice, fees
  
• e.g. Fortune 500
• 1998 profits: $334b
• 1999 market value: ~$10tr
• i.e. investors were saying in 1999 that they would pay $10tr for $334b in profits
• frictional costs ~$100b/year
  
• i.e. less than $250b return on $10tr
• is "slim pickings"
• Buffett's most probable return over next 17y?
• assuming constant interest rates, 2% inflation and frictional costs: 6%
• minus inflation: 4%
• could just as easily be less than that as more
  
3. SUCCESSFULLY RIDING THE WAVE OF INNOVATION
   
• e.g. IT revolution
• Buffett cautions by using automobile and aviation industries as example
• both transformed the country much earlier in the century
• automobile
• early days of cars: at one time at least 2,000 car makes
• industry was having incredible impact on people's lives
• in hindsight, revolutionized society
• with such knowledge investor would have said: "Here is the road to riches."
• 1990s: only 3 US car companies left, in dire shape
• aviation
• industry with plainly brilliant future, would have caused investors to salivate
• 1919-1939: 300 aircraft manufacturers
  
• today: only handful
• 129 airlines filed for bankruptcy in last 20y
• 1992: since dawn of aviation, money made by all of country's airline companies: zero
• note: much easier in such transforming events to figure out the losers and short them
  
• e.g. possible to grasp importance of car when it came along but how to pick winners?
• better to turn things upside down: short losers, e.g. horses

• "key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage"
• "products and services that have wide, sustainable moats around them are the ones that deliver rewards to investors"
  

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Quote of the Day

"Is there something obviously distortionary or market-abusive about me entering into a contract today to deliver a stock at a known price one week from now without me owning the stock today or borrowing it today and holding the stock for another week?" - Willem Buiter

Notes:

Umair Haque: I think there just might be: it distorts the relationship between shareholders and management. Any incentive shareholders might have had for value creation in the long-run vaporizes (with predictably perverse results). If shareholders aren't in it for the long-run, what's the point of equity? There isn't one: the edifice begins to crack.

If we're really going to argue that short selling is healthy because it aids price discovery, we must also ask: where was this so-called price discovery for the last decade? Why does short selling as price discovery only work when crises accelerate? Conversely, if yesterday's price discovery is meaningless tomorrow, perhaps the real problem is that the institutions we've built aren't adequate for a hyperconnected world.

"A stockmarket is a mechanism of price discovery and should be regulated only with regard to the accuracy of numbers and facts."

Really? Maybe in a textbook - in the real world, today's so-called stock markets are more like mechanisms of information manipulation with almost zero accuracy in terms of "numbers and facts". So perhaps if we focused a bit less on the numbers, and a bit more on the logic, we'd have morepower to understand what's really going on.

What's really going on? In a world of marginal resource scarcity, the value of efficient resource allocation is going to explode.

But can we really trust markets as we know them to allocate resources efficiently anymore? Especially when the only jobs that pay are those that have mostly to do with, well, making markets fail?

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Quote of the Day

"Stock markets work in a fractal way, not in a Gaussian way. Ignore the fat tails at your peril." - anon.

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Government Bailout of Mortgage Firms Sets Risks - PBS Newshour

Summary:
Short PBS documentary about moral hazard, the banking system and the housing crisis. Mother of all moral hazards. Hazard : encouraging too much risk taking because the risk takers think they're protected. Moral: because of the hazard of inducing bad behavior even with the best of intentions. Moral hazard is a common economic problem: e.g. present in safety innovations, personal insurance, deposit insurance, rating agencies and bond insurance. Moral hazard induced bankers to take the risks that led to the crisis bankers to the housing crisis. Job of the Fed is to insure the system, to make sure that no one has to worry about the collapse of the system, which was at risk. Fed's solution to the moral hazard problem is to put government supervision in return for government largesse. (Published: 18/07/08)

Notes:

• government bailing out bad loans and lenders
• rewarding risky behaviour?
• will it create another crisis?
• creates an environment of moral hazard
• "mother of all moral hazards"
• "hazard": encouraging too much risk taking because the risk takers think they're protected
• "moral": because of the hazard of inducing bad behavior even with the best of intentions
• bailing out lavish lenders to save the system may create more lavish lending next time around
• moral hazard: common economic problem
• safety innovations and personal insurance
• e.g. seat belts, airbags, car insurance, flood insurance
• can encourage opposite behaviour
• can even provide incentives to do the bad thing you're protected against
• e.g. fire insurance and arson
• bank insurance, insured deposits
• without deposit insurance, risk of bank runs
• but: if deposits never taken out (insured), banks have more incentive to lend to riskier borrowers than they otherwise would
• more risk in the loans than their otherwise would be
• securitization of loans
• packaging loans up into securities and selling them into the capital markets
• lender made the loan but has none of the risk
• risk passed on to someone else
• rating agencies and bond insurance
• you don't have to figure out how risky a bond is because you've got rating agencies and you've got actual insurance
• investor is covered twice
• will take more risk than he would otherwise
• housing crisis
• moral hazard induced bankers to take the risks that led to the crisis
• no innocence because everybody was getting away with something, on the assumption that they were protected
• home buyers (zero deposits)
• loan originators
• packagers
• rating agencies
• role of the Fed
• job of the Fed is to insure the system, to make sure that no one has to worry about the collapse of the system
• was at risk
• from point of view of Fed, Bear Stearns wasn't bailed out
• stock was trading at >10x buyout price
• many employees have lost their life savings
• many managers have lost their jobs
• Fed's solution to the moral hazard problem
• government supervision in return for government largesse
• so far not very specific
  

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Short-selling reveals corporate realities - FT.com

Summary:
John Gapper argues that, although there is a case for restricting short-selling and resulting bear raids on vulnerable financial institutions just at the moment, markets gain in the long term from this activity. Short-sellers make profits by holding a mirror to the unpleasant reality concealed in some company accounts. It is nonsense to say that Wall Street banks would be all right if it were not for irresponsible hedge funds. If the now obvious flaws in their business had been exposed earlier, there would be less turmoil now. When not enough people are asking tough questions, asset bubbles result. Leads to the misallocation of capital because companies are allowed to obtain it too cheaply and to waste it, and investors get hurt when the bubble collapses. Beauty of short-selling is that it gives people with financial expertise a motive to root around in company accounts and look for problems. (Published: 18/07/08)

Notes:

• During financial crises, short-sellers usually get the blame
• selling company shares they do not own
• investment banks blaming hedge funds
• believe they are ganging up to spread rumours that a healthy financial institution is in trouble and profiting by short-selling
• “This is even worse than insider trading. This is deliberate and malicious destruction of value and people’s lives,” (Jamie Dimon, the chief executive of JPMorgan Chase,)
• UK Financial Services Authority
  
• last month instituted new rules to make short-sellers in companies that are holding rights issues disclose their stakes
• But: even financial regulators admit that most short-selling is a legitimate and beneficial activity
• “naked shorting”: occurs when an investor agrees to sell shares without having borrowed them first.
  
• SEC believes that this creates volatility because it encourages lots of hedge funds to sell shares and then rush to buy them again.
• SEC especially worried about naked shorting of financial institutions
• they are vulnerable to sudden collapse in a way that other companies are not: banks rely on depositors believing in their soundness
  
• Northern Rock’s funding crisis showed what happens when they get doubts.
• Bear Stearns had to be rescued by JPMorgan because it relied on short-term funding and, as soon as investors and institutions that dealt with it lost faith, it could not continue.
  
• Bear Stearns executives say it was a victim of rumours that it was insolvent which became self-fulfilling.
• Traders do spread rumours to make short-term profits in markets – both to ramp shares and to make them fall.
  
• Nonsense to say that Wall Street banks would be all right if it were not for irresponsible hedge funds. In fact, they are having to raise billions to rebuild their capital.
• If the now obvious flaws in their business had been exposed earlier, there would be less turmoil now.
  
• Lots of people have an incentive to get investors to buy shares – from executives to financial analysts whose banks want business.
  
• Not many want to ask tough questions.
• leads to asset bubbles
• investors pile into shares and end up making losses when underlying problems emerge
• not only hurts investors but it also leads to the misallocation of capital because companies are allowed to obtain it too cheaply and to waste it
• beauty of short-selling is that it gives people with financial expertise a motive to root around in company accounts and look for problems
• although bankers complain about false rumour-mongering, professional short-sellers often do diligent and detailed research.
• there is a case for throwing some sand in the wheels of bear raids on vulnerable financial institutions just at the moment
• but markets gain in the long term from having people who make profits by holding a mirror to the unpleasant reality concealed in some company accounts

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Word of the Day: Naked Shorting

Summary:
Ocurs when an investor agrees to sell shares without having borrowed them first. Believed (e.g. by the SEC) to be creating volatility because it encourages lots of hedge funds to sell shares and then rush to buy them again.

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Quote of the Day

"When you have to fit a sixth-order polynomial to capture price history because exponential growth is too conservative, you're probably close to a peak" - John P. Hussman

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A gap in the hedge - The Economist

Summary:
Economist article explaining why owning shares is no shield against the scourge of inflation. The conventional wisdom is that in times of inflation bond markets suffer and equity markets prosper (inflation in prices means profits up for companies). There are limits to the levels of inflations under which this rule holds: the sweet spot for stockmarkets is when inflation is between 2% and 4%. When inflation falls out of the bottom end of that range, the economy is normally flirting with recession and deflation, and stockmarket valuations start to deteriorate sharply. In 1970s, employers were unable to keep lid on wage costs, which meant their margins took a double hit from rising raw materials and labour costs. This time round, workers in the developed world have less bargaining power. However, if workers see their real wages fall at the same time as the credit crunch is construing their ability to borrow, consumer demand will suffer. Whichever way the inflation scare plays out, profits are sure to take a hit and stockmarkets will be retreating accordingly. (Published: 03/07/0)
Notes:

• in times of inflation
• normally: bad for bond markets, good for equity markets
• bonds:
  
• bad because value of most bonds fixed in nominal terms
• bonds are a nominal asset
  
• shares:
• good because inflation is a rice in the price of goods and services
• businesses make those goods and services
• revenues should keep pace in real terms with prices
• shares a hedge against inflationary pressure
  
• equities are a real asset
• current inflation: bonds do well, shares deteriorating
  
• bonds:
  
• bond market has held up well because investors have perceived them as being low-risk
• instead, investors have taken out their feats on the stockmarket
• most recent period of high inflation: 1966-81
• real returns for US shares fell 0.1%/year
• fell 1.3%/year between 1973-81
• gold: earning an annual 10.9% in real terms between 1966 and 1981
• much better inflation hedge
• why have shares been such a flimsy hedge?
• profits did manage to keep pace with prices
• business profits rose (marginally) in real terms during 1970s in both US and Britain
• but: simply keeping up with cantering inflation was not really good enough
• as a share of GDP, US business profits fell from 12.2% in 1965 to 6.4% in 1982
• never touched that low again
• rose steadily to reach temporary peak of 10.5% of GDP in 1997
• then dropped sharply during the dotcom bust to 7.6% in 2001
• rose again to 11.8% in 2006
• investors reacted to this long profits cycle by adjusting the stockmarket rating
• in 1970s, shares were savagely downgraded
• p/e ratios fell to single-digit levels
• explains stockmarket's dismal performance
• 1982-2000 long bull market
• investors enjoyed the twin pleasures of soaring profits and expanding p/e multiples
• culminated in the dotcom buble
• 2003-2007 stockmarket rally
• because of profits growth, not 1990s style surge in multiples
• shares now look a lot more attractively valued than they did in 1000
• based on trailing p/e ratios
• better to look at trailing, rather than prospective, earnings, because profit forecasts are still ludicrously high: investors are expecting a 20% rise in US earnings next year
• problem is not the ratios, but the earnings
• if profits fall as a share of GDP all the way back to their 1982 low (or even to their 2001 nadir), share prices will suffer
• valuation measures that adjust for this, by using a ten-year average for profits, make shares look a lot less appealing
• main questions: why did profits do so badly in 1970s? and are those conditions like to repeat themselves?
• high inflation wrought enormous economic damage
• GDP growth, interest rates and company profits made more volatile
• contrast: 1982-2000 bull-market coincided with the "great moderation" in economics
• sweet spot for stockmarket is when inflation is between 2% and 4%
• when inflation falls out of the bottom end of that range, the economy is normally flirting with recession and deflation
• when inflation rises above 4%, and particularly when it reaches 6%, stockmarket valuations start to deteriorate sharply
• in 1970s, employers were unable to keep lid on wage costs
• meant their margins took a double hit from rising raw materials and labour costs
• this time: workers in the developed world seem to have less bargaining power
• risks of a 1970s-style inflation (and according slump in profits) are thus much lower
• but: if workers see their real wages fall at the same time as the credit crunch is construing their ability to borrow, consumer demand will suffer
• whichever way the inflation scare plays out, profits are sure to take a hit
• stockmarkets retreating accordingly
  

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Bearish battalions - The Economist

Summary:
Economists warns that a lengthy period of gloom in store for the stockmarkets: almost everything that could go wrong is going wrong for world stock markets: falling profits, slowing economic growth, rising inflation and interest rates. All made worse by the credit crunch. Problem for financial markets is that the virtuous circle which pushed asset prices higher (lending on housing collateral) in the middle of this decade is turning vicious. Investors might have coped with the credit crunch if it were not for the high commodity prices, and vice versa, and do not know whether to fear inflation or recession more, but they know that both at once are unpleasant. Best investors can do is hope that something will turn up (e.g. collapse in oil prices). (Published: 03/07/08)

Notes:

• June 2008: US stockmarket had its worst month since 2002
• down >20% from peak
• definition of bear market
• global stockmarkets fell by $3tr
• 10% decline in emerging markets
• Four forces impel stockmarkets
1. economic growth: slowing
   
2. profits growth: slowing
   
3. interest rates: rising
   
4. inflation: rising
• soaring oil and food prices
• high commodity prices
• have acted as a terms-of-trade shock for consuming countries
• the things they buy from abroad cost more compared with the the things they export
• has made them poorer
• questions
• will workers suffer by seeing their wages rise more slowly than inflation?
• will companies have to compensate their workers by raising wages, sacrificing their profit margings?
• will central banks treat high commodity prices as a blip, and leave interest rates low, penalising savers?
• will they raise interest rates and riks pushing the economy into recession?
• all made worse by the credit crunch
• effects can be seen in
• sharp falls in mortgage approvals in both US and Britain
• data produced by the Fed which show that loans made by banks have fallen over the past three months
• thightening in credit has taken long time to show up in the numbers because of the way that banks were operating before the summer of 2007
• had pushed much of their lending business off-balance-sheet
• loans were bought by specialist entities like structured-investment vehicles (SIVs) and conduits
• when the market for subprime loans collapsed, lot of these loans came back on to the banks' balance -sheets
• banks had made back-up commitments to businesses to lend money if needed
• with the collapse in other debt markets (e.g. asset-backed commercial paper), corporate borrowers cashed in those chips
• as a result banks found their loan books expanding
• now banks more careful
• chastened by the huge amounts of capital they have had to raise to strengthen their balance-sheets
• problem for financial markets is that the virtuous circle which pushed asset prices higher in the middle of this decade may be turning vicious
• banks lend money against the collateral of assets
• most notably in the form of housing
• as house prices increase, collateral raises in value and banks are willing to lend more
• enables buyers to bid up prices even further
• when banks stop lending, buyers unable to purchase assets
• some investors forced to sell to pay of loans
• value of collateral fals
• making banks even more reluctant to lend
• markets freeze up, as neither buyers nor sellers have the confidence to do business
• cfr. Finland, Sweden in early 1990s
• house prices fell
• personal-savings rates jumped by 12-14%
• similar move in US or Britain would have a devastating effect on consumer demand, and thus GDP growth over the next couple of years
• as yet, has been more of an effect on consumer sentiment than actual retail sales
• although individual retailers (e.g. M&S) are suffering
• companies: with consumers depressed and banks unwilling to lend, why should they invest?
• market's sorrows have come in batallions, not single spies
• investors might have coped with the credit crunch if it were not for the high commodity prices, and vice versa
• do not know whether to fear inflation or recession more, but they know that both at once are unpleasant
• lengthy period of gloom in store for the stockmarkets
• best investors can do is hope that something will turn up
• e.g. a collapse in oil prices
  

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Summary only...