Tuesday, December 28, 2010
Stranded in Airport Hotel
More flights got canceled tonight, I am getting sick of the crowd. This is too much!
Saturday, December 18, 2010
Thursday, December 16, 2010
Madoff's son found hanged
NEW YORK - Disgraced financier Bernard L. Madoff's eldest son hanged himself in his apartment Saturday, exactly two years after his father's arrest in a multibillion-dollar Ponzi scheme that swindled thousands of investors of their life savings.
Mark Madoff, 46, was found hanging from a ceiling pipe in the living room of his SoHo loft apartment as his 2-year-old son slept in a nearby bedroom, according to law enforcement officials.
Madoff, who reported his father to authorities, has never been criminally charged in the biggest investment fraud in U.S. history and has said he and his brother Andrew never knew of their father's crimes.
Although Mark Madoff was not known to be facing arrest, he and other relatives have remained under investigation and been named in investor lawsuits accusing them of profiting from the scheme.
"This is a terrible and unnecessary tragedy," Madoff's lawyer, Martin Flumenbaum, said in a written statement. "Mark was an innocent victim of his father's monstrous crime who succumbed to two years of unrelenting pressure from false accusations and innuendo."
A lawyer for Mark's mother, Ruth Madoff, said, "She's heartbroken."
Mark Madoff's body was discovered - hanging from a black dog leash - after he sent an e-mail early Saturday morning to his wife, Stephanie, saying that someone should check on their 2-year-old son, law enforcement officials said, speaking on the condition of anonymity because they weren't authorized to speak publicly about the death.
Madoff's wife, who was visiting Disney World in Florida with her 4-year-old daughter, sent her stepfather to the home. The toddler was found unharmed.
Bernard Madoff, 72, swindled a long list of investors out of billions of dollars. He admitted to running his scheme for at least two decades, cheating thousands of individuals, charities, celebrities and institutional investors. Losses are estimated at about $20 billion, making it the biggest investment fraud in U.S. history. He was arrested on Dec. 11, 2008, after confessing his crimes to his sons.
Just days ago, a court-appointed trustee filed a lawsuit seeking to recover any money from the fraud scheme that had been paid to members of the Madoff family, including Mark Madoff's two young children.
Calls to the FBI and U.S. Attorney's office were not immediately returned. Previously, spokesmen for the brothers had repeatedly denied that they had any knowledge of their father's crimes.
Bernard Madoff is serving a 150-year prison sentence in North Carolina. Bureau of Prisons spokeswoman Traci Billingsley said Saturday she didn't have specific information on whether he had been informed of his son's death or would be allowed to attend a service.
Mark Madoff, 46, was found hanging from a ceiling pipe in the living room of his SoHo loft apartment as his 2-year-old son slept in a nearby bedroom, according to law enforcement officials.
Madoff, who reported his father to authorities, has never been criminally charged in the biggest investment fraud in U.S. history and has said he and his brother Andrew never knew of their father's crimes.
Although Mark Madoff was not known to be facing arrest, he and other relatives have remained under investigation and been named in investor lawsuits accusing them of profiting from the scheme.
"This is a terrible and unnecessary tragedy," Madoff's lawyer, Martin Flumenbaum, said in a written statement. "Mark was an innocent victim of his father's monstrous crime who succumbed to two years of unrelenting pressure from false accusations and innuendo."
A lawyer for Mark's mother, Ruth Madoff, said, "She's heartbroken."
Mark Madoff's body was discovered - hanging from a black dog leash - after he sent an e-mail early Saturday morning to his wife, Stephanie, saying that someone should check on their 2-year-old son, law enforcement officials said, speaking on the condition of anonymity because they weren't authorized to speak publicly about the death.
Madoff's wife, who was visiting Disney World in Florida with her 4-year-old daughter, sent her stepfather to the home. The toddler was found unharmed.
Bernard Madoff, 72, swindled a long list of investors out of billions of dollars. He admitted to running his scheme for at least two decades, cheating thousands of individuals, charities, celebrities and institutional investors. Losses are estimated at about $20 billion, making it the biggest investment fraud in U.S. history. He was arrested on Dec. 11, 2008, after confessing his crimes to his sons.
Just days ago, a court-appointed trustee filed a lawsuit seeking to recover any money from the fraud scheme that had been paid to members of the Madoff family, including Mark Madoff's two young children.
Calls to the FBI and U.S. Attorney's office were not immediately returned. Previously, spokesmen for the brothers had repeatedly denied that they had any knowledge of their father's crimes.
Bernard Madoff is serving a 150-year prison sentence in North Carolina. Bureau of Prisons spokeswoman Traci Billingsley said Saturday she didn't have specific information on whether he had been informed of his son's death or would be allowed to attend a service.
Wednesday, December 15, 2010
Correlated or diversified?
Correlation? Markets moving together? Correlation is a misleading metric of little help in measuring or achieving diversification. Highly correlated assets CAN diversify portfolios but some "uncorrelated" managers are too dependent on the market. Below is a hypothetical hedge fund with +1.00 correlation to the S&P 500. Absolute returns in all years and CAGR +17.65% but PERFECTLY correlated to a risky index fund which lost money. It diversified despite that pesky correlation.
The diversification "free lunch" has been arbitraged away, at least in mainstream risky asset classes. The best way to diversify a long is with a short NOT another long. Diversify the right way not diworsify the old way but correlation is STILL used as a critical input for portfolio construction and risk management. Why? During meltdowns correlations rise but now it occurs in "normal" market conditions as well, adding to risk rather than reducing it. Securities may move together more due to herding, ETFs and algorithmic trading. The passive mania forces benchmark components up or down regardless of value whether stocks, bonds or commodities. Hasn't everyone learnt the danger of "cheap" index tracking and its expensive cost?
Beta is often cited as a measure of volatility. But it's really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta security that is high risk and a high beta fund LESS risky than the market. Idiosyncratic risk isn't a risk; it's the idiosyncratic alpha you want. Alpha and absolute returns aren't the same. The textbook calculations of beta and alpha are based on correlation which, as the example above shows, isn't useful. The identification of true beta - dependence on underlying risk factors - and true alpha - value added through skill rather than luck - is much more complicated.
The omnipotent correlation matrix drives much portfolio "optimization". A bunch of inputs from data dredging history whose forward-looking output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On "up days" most stocks go up but they don't all rise by the same percentage. Relative value strategies take advantage of varying price moves even if in the same direction. I don't mind if an investment has correlation of +1.00, 0.00, -1.00 or anything in between. It's irrelevant. I do care it has minimal sensitivity to anything else in the portfolio. Sadly for investors MVO and CAPM have been shown to be simple, elegant and completely useless. MPT is pronounced EMPTY and is better called Medieval Portfolio Theory.
"Modern" portfolio theory requires lots of wild guesses known as capital market assumptions, including expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this weird way and the poor "results" speak for themselves. Those variables aren't robust, stable or likely to be accurate in constructing a long term portfolio. I've kept track of such facile forecasts and the tea leaf reading so-called "experts" who made them. Pretty bad outcomes but those fortune teller predictions keep being used. We are ALL affected by assets being (mis) allocated in this failed framework. Unlike the crystal ball gazers, I find mispriced securities and safer strategies whose returns outweigh the risks. Is that so radical? At least it works.
Severe drawdowns are unacceptable. It is not surprising conventional wisdom has performed so badly with fake "Nobel" prizes awarded for such "efficient", mean variance "optimized" nonsense. Past asset class returns are no indication of the future over any time horizon including centuries, standard deviation does not measure risk and correlation gives no insight on risk factor dependence. So why is this stuff still used? Everybody knows everything so the markets are random, right? CMA causes almost as many problems as absurd actuarial assumptions. If you keep doing what you always do, you receive what you always get: growing liabilities AND declining assets. Safer to go with skill-based strategies that offer absolute alpha not repackaged beta.
Dispersion? Every month reports emerge on how AVERAGE "hedge funds" performed. Those numbers are meaningless with such disparity of skills and zero-sum nature of alpha. Many public domain strategies are too well-known now so it is not surprising AGGREGATE alpha tends to zero. Skill is rare. The average hides a range of numbers from managers performing very well to many that did not. 2008 saw huge dispersion. The typical hedge fund lost -20% but 3,000 MADE money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The basic arithmetic of R-squareds, covariances and variances just don't make the grade.
The best sources of low dependence are time and space diversification. High frequency trading continues to perform well. Amazing how the majority of portfolios still don't allocate to this reliable source of alpha. Last decade was great and returns have also been good this so-called "challenging" year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Despite many years of superior returns most investors avoid high frequency strategies! Perhaps "buy and hold for milliseconds" is the natural evolution from the archaic "buy and hold for years". Everything operates on short time horizons nowadays which is a mismatch with so-called "long term" investing. Instead I favor long term performance.
Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term "emerging markets" is often semantic arbitrage for countries that are actually developed. The big BRIC has lost badly to my BRIC but the SLIME has been the star this year. Sri Lanka, Iran, Mongolia and Estonia were missed by almost all international strategists. Could the geographic diversification strategy nowadays be to invest in places that don't offer ETFs? Don't asset allocate X% to emerging market beta. Invest 100% in alpha WHEREVER it can be found.
Unlike that unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistical parameters, I know that a properly diversified portfolio of the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver over time in all possible scenarios. Changing markets and crowded trades are no excuse for not being able to deliver absolute returns. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important.
Two funds might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on underlying markets and focus on skill-based strategies. I prefer calculating co-relation and association metrics not coRRelations. High correlations show the markets are even more inefficient. But REAL strategy diversification is what investors actually need.
The diversification "free lunch" has been arbitraged away, at least in mainstream risky asset classes. The best way to diversify a long is with a short NOT another long. Diversify the right way not diworsify the old way but correlation is STILL used as a critical input for portfolio construction and risk management. Why? During meltdowns correlations rise but now it occurs in "normal" market conditions as well, adding to risk rather than reducing it. Securities may move together more due to herding, ETFs and algorithmic trading. The passive mania forces benchmark components up or down regardless of value whether stocks, bonds or commodities. Hasn't everyone learnt the danger of "cheap" index tracking and its expensive cost?
Beta is often cited as a measure of volatility. But it's really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta security that is high risk and a high beta fund LESS risky than the market. Idiosyncratic risk isn't a risk; it's the idiosyncratic alpha you want. Alpha and absolute returns aren't the same. The textbook calculations of beta and alpha are based on correlation which, as the example above shows, isn't useful. The identification of true beta - dependence on underlying risk factors - and true alpha - value added through skill rather than luck - is much more complicated.
The omnipotent correlation matrix drives much portfolio "optimization". A bunch of inputs from data dredging history whose forward-looking output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On "up days" most stocks go up but they don't all rise by the same percentage. Relative value strategies take advantage of varying price moves even if in the same direction. I don't mind if an investment has correlation of +1.00, 0.00, -1.00 or anything in between. It's irrelevant. I do care it has minimal sensitivity to anything else in the portfolio. Sadly for investors MVO and CAPM have been shown to be simple, elegant and completely useless. MPT is pronounced EMPTY and is better called Medieval Portfolio Theory.
"Modern" portfolio theory requires lots of wild guesses known as capital market assumptions, including expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this weird way and the poor "results" speak for themselves. Those variables aren't robust, stable or likely to be accurate in constructing a long term portfolio. I've kept track of such facile forecasts and the tea leaf reading so-called "experts" who made them. Pretty bad outcomes but those fortune teller predictions keep being used. We are ALL affected by assets being (mis) allocated in this failed framework. Unlike the crystal ball gazers, I find mispriced securities and safer strategies whose returns outweigh the risks. Is that so radical? At least it works.
Severe drawdowns are unacceptable. It is not surprising conventional wisdom has performed so badly with fake "Nobel" prizes awarded for such "efficient", mean variance "optimized" nonsense. Past asset class returns are no indication of the future over any time horizon including centuries, standard deviation does not measure risk and correlation gives no insight on risk factor dependence. So why is this stuff still used? Everybody knows everything so the markets are random, right? CMA causes almost as many problems as absurd actuarial assumptions. If you keep doing what you always do, you receive what you always get: growing liabilities AND declining assets. Safer to go with skill-based strategies that offer absolute alpha not repackaged beta.
Dispersion? Every month reports emerge on how AVERAGE "hedge funds" performed. Those numbers are meaningless with such disparity of skills and zero-sum nature of alpha. Many public domain strategies are too well-known now so it is not surprising AGGREGATE alpha tends to zero. Skill is rare. The average hides a range of numbers from managers performing very well to many that did not. 2008 saw huge dispersion. The typical hedge fund lost -20% but 3,000 MADE money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The basic arithmetic of R-squareds, covariances and variances just don't make the grade.
The best sources of low dependence are time and space diversification. High frequency trading continues to perform well. Amazing how the majority of portfolios still don't allocate to this reliable source of alpha. Last decade was great and returns have also been good this so-called "challenging" year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Despite many years of superior returns most investors avoid high frequency strategies! Perhaps "buy and hold for milliseconds" is the natural evolution from the archaic "buy and hold for years". Everything operates on short time horizons nowadays which is a mismatch with so-called "long term" investing. Instead I favor long term performance.
Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term "emerging markets" is often semantic arbitrage for countries that are actually developed. The big BRIC has lost badly to my BRIC but the SLIME has been the star this year. Sri Lanka, Iran, Mongolia and Estonia were missed by almost all international strategists. Could the geographic diversification strategy nowadays be to invest in places that don't offer ETFs? Don't asset allocate X% to emerging market beta. Invest 100% in alpha WHEREVER it can be found.
Unlike that unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistical parameters, I know that a properly diversified portfolio of the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver over time in all possible scenarios. Changing markets and crowded trades are no excuse for not being able to deliver absolute returns. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important.
Two funds might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on underlying markets and focus on skill-based strategies. I prefer calculating co-relation and association metrics not coRRelations. High correlations show the markets are even more inefficient. But REAL strategy diversification is what investors actually need.
Monday, December 13, 2010
Warren Buffett or George Soros?
Who's best? Warren Buffett or George Soros? Why risk hard-earned capital with managers who are not the best in the world at what they do? Warren runs the largest hedge fund but George is the top performer. They searched for successors only from hedge funds and all their liquid net worth is in absolute return strategies. The top sportspeople play in major leagues not minors and where do you find the best portfolio managers? George and Warren's edges were clear long ago so there was plenty of time to invest. Their success has brought major social benefits and secure retirements for clients.
Some even claim Warren isn't a hedge fund manager but his arbitrage, leverage, derivatives, event-driven and macro trading added much to returns and he short sold cocoa futures in a special situations deal as far back as 1954. George and Warren generated alpha from low frequency trading in various fund structures. Double Eagle - Quantum, Buffett Partnership - Berkshire Hathaway. Like many hedge funds, they don't report to databases. Neither has a PhD or CFA but both have exceptional quantitative skills. I have never found a good manager that doesn't even if they run "discretionary" styles. Skilled hedge funds do deliver reliable high returns at low risk. And prove that market prices are always wrong.
Portfolio performance is determined by MANAGER mix not ASSET mix. The more people believing in efficient markets the more inefficient markets become. Trillions in index funds creates more alpha capture opportunities for those with skill. Mid-career professionals like Warren and George are thriving while hedge fund managers aged under 80 are building up experience. Pensions worried about "longevity risk" can benefit from investment talent working longer. Over 41 years George has turned $1,000 into $14 million after fees and Warren to $3 million from his actively managed ETF. He charges LOWER fees than "cheap" unskilled long only funds.
George's track record is better but Warren is richer. Why? The snowball of POSITIVE compounding for longer. Both were born in August 1930 and Warren ran his hedge fund from 1957 but George didn't set up his until 1969. Warren was lucky to be in Omaha while Dzjchdzhe Shorash was in Budapest, more affected by WW2. But Warren got into currency trading and global philanthropy later. George's outperformance is due to stronger international diversification and because reflexivity is ignored. Value investing is copied more than reflexivity investing. The boom bust of Eurozone sovereign credits and subprime CDOs are quintessential examples of reflexivity. Crises are PREDICTABLE. And profitable if you have expertise.
Alpha thrives off beta. Warren ran the partnership from 1957-1969 and has since implemented his absolute return strategies via Berkshire Hathaway. He first bought BRKA shares in 1962 at $7.60 and now it's $120,000 for a 22% CAGR. But the Buffett Partnership did better with all 13 years positive. Gross returns of 29.5% were net 23.8% to investors after his 25% incentive fee on 6% hurdle. What if, instead of "retiring" in 1970, Warren had continued the partnership and performance had persisted? Investing $1,000 in 1957 would now be $100 million. Fees that Warren might have been "paid" for turning $1,000 into $100 million would be $1 billion. That's fine since I'd have $99.9 million more than wasting time gambling on "low cost" index funds.
Academics say Warren is just an ex-post lucky outlier but some talent spotters DID seed his fund ex-ante. The S&P 500 also began in 1957 but has performed poorly by comparison - $1,000 would now be $100,000, a huge opportunity cost. Investing for absolute return using competitive edges and outside the box thinking has existed for centuries. Long only relative return is the fad. Passive indexing is even newer. The trouble with owning dartboards is that you get the treble 20 and bullseye but you also tie up precious cash in 1s and 2s. With proper analysis, average hedge funds can be avoided just like average stocks. I prefer to identify the Phil Taylor of each strategy. How many darts must you throw to show skill? George and Warren have hit many treble 20s.
Hard to prove a conjecture but to disprove it ONE counterexample suffices. Warren, George and many others have destroyed efficient market hypotheses, random walk assumptions and the myth that long term policy asset allocation drives portfolio returns. BHB Brinson, Hood, Beebower, Singer and their acolytes have cost too many investors too much money and wrecked retirement plans. Prudent investors in fact want 100% of their capital in attractive opportunities. George and Warren's alpha capture from security selection worked better than static beta bets. No-one says it's easy but if you work hard enough it is possible. Such investment teams CAN be identified at an early stage and can charge whatever hedge fund fees clients are prepared to pay.
Some hedge funds shut due to SUCCESS. Warren closed his in 1969 despite a strong track record as Stanley Druckenmiller did recently with Duquesne. The Buffett Partnership was set up when Benjamin Graham decided to end his Graham-Newman hedge fund, operating decades before AW Jones' "first" hedge fund. Warren is correct that the best investment book ever written in English is the Intelligent Investor. The second best is Alchemy of Finance though fortunately hardly anyone else bothers to try to understand it. The top hedge fund book in any language is of course Fountain of Gold written by the best hedge fund manager ever. I re-read them all every year and every year my self-directed pension ends up with double-digit ABSOLUTE RETURNS. Coincidence?
Warren wants to be judged on book value not stock price but you can't eat book value and I evaluate fund managers by what investors really receive. Partnerships are marked at NAV but the switch to BRKA subjected clients to irrational public markets. In 2008 BRKA book value dropped -9.6% but shareholders lost -31.8%. George made money that allegedly "challenging" year. While the stock has returned more than book value due to the valuation premium, volatility has been high. Warren's actual Sharpe ratio is lower than book value "Sharpe ratio", dropping sharply from 1.4 to 0.6.
The Oracle of Omaha and the Brain of Budapest have "quit" before and been searching for "successors" for a long time. George has been hiring "replacements" since 1981 and the extent of his fund management involvement has fluctuated since though never without close knowledge of and implied oversight of the portfolio. For each Li Lu or Todd Combs there was a Jim Marquez or Stanley Druckenmiller. No man is an island and both sought out strong colleagues and talented employees from early on. Jim Rogers and Charlie Munger added significantly. Accredited investors - anyone with $80 - can access Warren and Charlie's abilities through BRKB, a listed closed-end hedge fund. The active stockpickers at benchmark construction firms missed 45 years of massive growth but then add it to their "unmanaged" index!
Would Warren and George have bothered managing outside money if they hadn't been incentivized to do so and perform? It's skill that adds value. No alpha, no incentive fee. George's partnership fees were lower than Warrens's for gross returns above 25%. Since George and Warren's gross performance was in excess of 25%, George's fee structure was actually cheaper. Jim Simons and team have outperformed both for the past 20 years with much higher fees but the net returns of Medallion Fund were superior. The technological and personnel infrastructure requirements for high frequency trading cost more than for low frequency. If you don't like the fees, don't invest in hedge funds. Capacity for a good strategy is limited and demand exceeds supply of alpha. But it's expensive and dangerous waiting to find out WHETHER bargain beta might one day deliver.
Those "outrageous" fees? George charged 1% and 20% no hurdle whereas Warren charged 0% and 25% on 6% hurdle, then offered his money management skills for FREE in return for permanent, leveraged capital. But you would have done much better going with Soros Fund Management in 1969 and paying those "high" fees than you would with BRKA. I am delighted for people to be well compensated for delivering what I need, ABSOLUTE ALPHA, from their RARE abilities. If someone turns $1,000 into $100 million from skill not luck or riding the market, they deserve $1 billion. Especially when manager interests are aligned with clients by them being the largest investor in their fund. When George or Warren has a bad month, they PERSONALLY lose more than any client. That INCENTIVIZES them to do their best to minimize the downside.
You CAN eat absolute returns and I'll take $100 million over $100,000 every time. I assume you would too. So what if the manager becomes a billionaire? They deserve it for the essential entrepreneurial service they offer. If clients get rich, it is fine by me if the manager gets richer. Plenty of "discount" funds are available but at what performance? Avoiding "high" fees for alpha is like saying to a Porsche dealer you will only pay $100 for a new car because that is what the raw materials cost. Or that Shakespeare was just a lucky fool who "randomly" chose words from the dictionary. I am writing this on Apple AAPL hardware using Microsoft MSFT software uploaded to a service owned by Google GOOG. Using those products may further enrich several people who are already billionaires. Does it matter?
The chart above assumes fees compound without the manager needing any profits to eat, live, pay employees, run the business etc. which of course they do. In recent years, with investor demands for larger teams, deep benches and operational infrastructure, fixed costs for hedge funds have risen to the 2 and 20 mode. Two people, a computer and a phone do not get institutional money today. Sad though to see an Omaha pension fund deep in a $600 million deficit when they could so easily have hired a local hedge fund run by Warren Buffett get them into surplus. The Hungary retirement system is not in good shape either but they could have invested with George Soros and would now be doing fine. Why avoid the top absolute return managers when you have ABSOLUTE LIABILITIES to fund?
No-one is forced to invest in hedge funds. Investors are free to make do with passive beta and relative return if they so choose. Some outliers even say alpha doesn't exist! For those "surprised" by the Euro crisis in Spain, Ireland, Greece, Belgium, Portugal etc., George saw the dangers long ago. Yet macroeconomic "stability" maven Robert Mundell keeps his "Nobel" Prize for now. Optimum currency areas aren't optimal so he should give it to George. If you flip a coin 10 times and get 8 heads it might be a fluke but NOT if you flip 1,000,000 coins and get 800,000 heads. Warren and George have flipped too many coins for their returns to be considered luck. They made their clients rich, deservedly got richer themselves and are giving their wealth away for the social benefit of the world. A rare financial win/win/win.
Some even claim Warren isn't a hedge fund manager but his arbitrage, leverage, derivatives, event-driven and macro trading added much to returns and he short sold cocoa futures in a special situations deal as far back as 1954. George and Warren generated alpha from low frequency trading in various fund structures. Double Eagle - Quantum, Buffett Partnership - Berkshire Hathaway. Like many hedge funds, they don't report to databases. Neither has a PhD or CFA but both have exceptional quantitative skills. I have never found a good manager that doesn't even if they run "discretionary" styles. Skilled hedge funds do deliver reliable high returns at low risk. And prove that market prices are always wrong.
Portfolio performance is determined by MANAGER mix not ASSET mix. The more people believing in efficient markets the more inefficient markets become. Trillions in index funds creates more alpha capture opportunities for those with skill. Mid-career professionals like Warren and George are thriving while hedge fund managers aged under 80 are building up experience. Pensions worried about "longevity risk" can benefit from investment talent working longer. Over 41 years George has turned $1,000 into $14 million after fees and Warren to $3 million from his actively managed ETF. He charges LOWER fees than "cheap" unskilled long only funds.
George's track record is better but Warren is richer. Why? The snowball of POSITIVE compounding for longer. Both were born in August 1930 and Warren ran his hedge fund from 1957 but George didn't set up his until 1969. Warren was lucky to be in Omaha while Dzjchdzhe Shorash was in Budapest, more affected by WW2. But Warren got into currency trading and global philanthropy later. George's outperformance is due to stronger international diversification and because reflexivity is ignored. Value investing is copied more than reflexivity investing. The boom bust of Eurozone sovereign credits and subprime CDOs are quintessential examples of reflexivity. Crises are PREDICTABLE. And profitable if you have expertise.
Alpha thrives off beta. Warren ran the partnership from 1957-1969 and has since implemented his absolute return strategies via Berkshire Hathaway. He first bought BRKA shares in 1962 at $7.60 and now it's $120,000 for a 22% CAGR. But the Buffett Partnership did better with all 13 years positive. Gross returns of 29.5% were net 23.8% to investors after his 25% incentive fee on 6% hurdle. What if, instead of "retiring" in 1970, Warren had continued the partnership and performance had persisted? Investing $1,000 in 1957 would now be $100 million. Fees that Warren might have been "paid" for turning $1,000 into $100 million would be $1 billion. That's fine since I'd have $99.9 million more than wasting time gambling on "low cost" index funds.
Academics say Warren is just an ex-post lucky outlier but some talent spotters DID seed his fund ex-ante. The S&P 500 also began in 1957 but has performed poorly by comparison - $1,000 would now be $100,000, a huge opportunity cost. Investing for absolute return using competitive edges and outside the box thinking has existed for centuries. Long only relative return is the fad. Passive indexing is even newer. The trouble with owning dartboards is that you get the treble 20 and bullseye but you also tie up precious cash in 1s and 2s. With proper analysis, average hedge funds can be avoided just like average stocks. I prefer to identify the Phil Taylor of each strategy. How many darts must you throw to show skill? George and Warren have hit many treble 20s.
Hard to prove a conjecture but to disprove it ONE counterexample suffices. Warren, George and many others have destroyed efficient market hypotheses, random walk assumptions and the myth that long term policy asset allocation drives portfolio returns. BHB Brinson, Hood, Beebower, Singer and their acolytes have cost too many investors too much money and wrecked retirement plans. Prudent investors in fact want 100% of their capital in attractive opportunities. George and Warren's alpha capture from security selection worked better than static beta bets. No-one says it's easy but if you work hard enough it is possible. Such investment teams CAN be identified at an early stage and can charge whatever hedge fund fees clients are prepared to pay.
Some hedge funds shut due to SUCCESS. Warren closed his in 1969 despite a strong track record as Stanley Druckenmiller did recently with Duquesne. The Buffett Partnership was set up when Benjamin Graham decided to end his Graham-Newman hedge fund, operating decades before AW Jones' "first" hedge fund. Warren is correct that the best investment book ever written in English is the Intelligent Investor. The second best is Alchemy of Finance though fortunately hardly anyone else bothers to try to understand it. The top hedge fund book in any language is of course Fountain of Gold written by the best hedge fund manager ever. I re-read them all every year and every year my self-directed pension ends up with double-digit ABSOLUTE RETURNS. Coincidence?
Warren wants to be judged on book value not stock price but you can't eat book value and I evaluate fund managers by what investors really receive. Partnerships are marked at NAV but the switch to BRKA subjected clients to irrational public markets. In 2008 BRKA book value dropped -9.6% but shareholders lost -31.8%. George made money that allegedly "challenging" year. While the stock has returned more than book value due to the valuation premium, volatility has been high. Warren's actual Sharpe ratio is lower than book value "Sharpe ratio", dropping sharply from 1.4 to 0.6.
The Oracle of Omaha and the Brain of Budapest have "quit" before and been searching for "successors" for a long time. George has been hiring "replacements" since 1981 and the extent of his fund management involvement has fluctuated since though never without close knowledge of and implied oversight of the portfolio. For each Li Lu or Todd Combs there was a Jim Marquez or Stanley Druckenmiller. No man is an island and both sought out strong colleagues and talented employees from early on. Jim Rogers and Charlie Munger added significantly. Accredited investors - anyone with $80 - can access Warren and Charlie's abilities through BRKB, a listed closed-end hedge fund. The active stockpickers at benchmark construction firms missed 45 years of massive growth but then add it to their "unmanaged" index!
Would Warren and George have bothered managing outside money if they hadn't been incentivized to do so and perform? It's skill that adds value. No alpha, no incentive fee. George's partnership fees were lower than Warrens's for gross returns above 25%. Since George and Warren's gross performance was in excess of 25%, George's fee structure was actually cheaper. Jim Simons and team have outperformed both for the past 20 years with much higher fees but the net returns of Medallion Fund were superior. The technological and personnel infrastructure requirements for high frequency trading cost more than for low frequency. If you don't like the fees, don't invest in hedge funds. Capacity for a good strategy is limited and demand exceeds supply of alpha. But it's expensive and dangerous waiting to find out WHETHER bargain beta might one day deliver.
Those "outrageous" fees? George charged 1% and 20% no hurdle whereas Warren charged 0% and 25% on 6% hurdle, then offered his money management skills for FREE in return for permanent, leveraged capital. But you would have done much better going with Soros Fund Management in 1969 and paying those "high" fees than you would with BRKA. I am delighted for people to be well compensated for delivering what I need, ABSOLUTE ALPHA, from their RARE abilities. If someone turns $1,000 into $100 million from skill not luck or riding the market, they deserve $1 billion. Especially when manager interests are aligned with clients by them being the largest investor in their fund. When George or Warren has a bad month, they PERSONALLY lose more than any client. That INCENTIVIZES them to do their best to minimize the downside.
You CAN eat absolute returns and I'll take $100 million over $100,000 every time. I assume you would too. So what if the manager becomes a billionaire? They deserve it for the essential entrepreneurial service they offer. If clients get rich, it is fine by me if the manager gets richer. Plenty of "discount" funds are available but at what performance? Avoiding "high" fees for alpha is like saying to a Porsche dealer you will only pay $100 for a new car because that is what the raw materials cost. Or that Shakespeare was just a lucky fool who "randomly" chose words from the dictionary. I am writing this on Apple AAPL hardware using Microsoft MSFT software uploaded to a service owned by Google GOOG. Using those products may further enrich several people who are already billionaires. Does it matter?
The chart above assumes fees compound without the manager needing any profits to eat, live, pay employees, run the business etc. which of course they do. In recent years, with investor demands for larger teams, deep benches and operational infrastructure, fixed costs for hedge funds have risen to the 2 and 20 mode. Two people, a computer and a phone do not get institutional money today. Sad though to see an Omaha pension fund deep in a $600 million deficit when they could so easily have hired a local hedge fund run by Warren Buffett get them into surplus. The Hungary retirement system is not in good shape either but they could have invested with George Soros and would now be doing fine. Why avoid the top absolute return managers when you have ABSOLUTE LIABILITIES to fund?
No-one is forced to invest in hedge funds. Investors are free to make do with passive beta and relative return if they so choose. Some outliers even say alpha doesn't exist! For those "surprised" by the Euro crisis in Spain, Ireland, Greece, Belgium, Portugal etc., George saw the dangers long ago. Yet macroeconomic "stability" maven Robert Mundell keeps his "Nobel" Prize for now. Optimum currency areas aren't optimal so he should give it to George. If you flip a coin 10 times and get 8 heads it might be a fluke but NOT if you flip 1,000,000 coins and get 800,000 heads. Warren and George have flipped too many coins for their returns to be considered luck. They made their clients rich, deservedly got richer themselves and are giving their wealth away for the social benefit of the world. A rare financial win/win/win.
Monday, December 6, 2010
Equity is a buy here, by Marc Faber
Equity Markets--Last month, Faber was somewhat cautious on US stocks, saying that sentiment was overly bullish and vulnerable to a correction. So far, we have seen a slight decline in stocks as the QE euphoria fades and worries mount in the PIIGS. Faber thinks the correction could continue as things in Europe worsen. However, he does not expect the market to fall below the 1010-1050 range on the S&P 500 because of the Bernanke. Of all the developed markets, Faber likes Japan the most. He thinks a declining yen will help Japanese equities. Furthermore, Japan is under owned by institutions.
Emerging Markets--Those who are investing in emerging markets are late to the party. The market has mostly priced emerging markets to perfection, which makes further gains difficult. Faber favors frontier markets (especially those levered to natural resources) whose valuations are more favorable. Faber even likes developed markets (US, Europe, Japan) more than he likes emerging markets right now.
Gold & Silver--Faber still likes gold and continues to accumulate ounces, but he says a correction to $1200 would not surprise him. Gold bull market remains intact as the majority of individual investors and institutions remain under invested.
Bonds--Continues to hate US government bonds.The risk versus reward is not favorable as Faber does not believe bond yields will make new lows. However, he does like Russian and Central Asian corporate bonds, even though he expects interest rates to rise in the future.
Currencies--Euro is going down against the dollar and will likely fall further because of the EU debt crisis. Generally, a higher dollar leads to lower stock prices. Long-term the dollar will weaken but for now it continues to benefit as the world reserve currency.
Overall, Faber expects world equity markets to remain well supported in the medium-longer term because people have nowhere else to put their money. Once bond yields start to rise, all of those people who piled into bonds will redeploy funds into equities. Also, all of those people sitting in cash are getting tired of zero percent returns and equities make the most sense.
There you have it: Faber's outlook for December. Good luck trading!
Emerging Markets--Those who are investing in emerging markets are late to the party. The market has mostly priced emerging markets to perfection, which makes further gains difficult. Faber favors frontier markets (especially those levered to natural resources) whose valuations are more favorable. Faber even likes developed markets (US, Europe, Japan) more than he likes emerging markets right now.
Gold & Silver--Faber still likes gold and continues to accumulate ounces, but he says a correction to $1200 would not surprise him. Gold bull market remains intact as the majority of individual investors and institutions remain under invested.
Bonds--Continues to hate US government bonds.The risk versus reward is not favorable as Faber does not believe bond yields will make new lows. However, he does like Russian and Central Asian corporate bonds, even though he expects interest rates to rise in the future.
Currencies--Euro is going down against the dollar and will likely fall further because of the EU debt crisis. Generally, a higher dollar leads to lower stock prices. Long-term the dollar will weaken but for now it continues to benefit as the world reserve currency.
Overall, Faber expects world equity markets to remain well supported in the medium-longer term because people have nowhere else to put their money. Once bond yields start to rise, all of those people who piled into bonds will redeploy funds into equities. Also, all of those people sitting in cash are getting tired of zero percent returns and equities make the most sense.
There you have it: Faber's outlook for December. Good luck trading!
Thursday, December 2, 2010
This time, the Oscar goes to.... ME
Take-Knowledge to Protect-Knowledge, the ever-evolving Technology
--mattewho
While the entire world is blaming Greenspan for bringing down the financial world single-handedly, I find myself having a soft spot for him. The poor guy was not only over-criticized; he was over-credited for his ability. It was the technology, the robust computers and sophisticated applications, which developed innovative derivative and structured products, that played a significant role in the 2008 financial tsunami. With 13 investment banks vanishing in six months, the long- standing US financial system, built by our founding fathers, and designed to be idiot-proof, was brought to the brink of collapse. Apparently, our genius didn’t foresee technology being the potential beast. In the middle of the crisis, I had lunch with a retired former colleague, who called computer “the sewing machine”; she was once ranked among the top 100 financial analysts on Wall Street. We were reverse engineering one derivative fund using rainbow option. She grasped the concept quickly and then bursted out: “This is too complex to calculate, how can one price it daily?” “Certainly not by your slide rule.” I replied. Of course, my rude comment almost cost us our friendship.
Not to challenge Einstein’s Twin Paradox, but time in Technology dimension does travel at a different speed. When I first joined the firm, the number of employees was about 35% of current size, but the number of servers was less than 1% of what we have now. Surprisingly, despite the fact we are an old fashion behind-the-curve investment firm, we had a State-Of-Art server at that time, a Net-FRAME server. (See news attached at bottom). The server was wrapped in large black steel; you would have to be a professional heavy weight wrestler to lift it. It had 128MB memory, and, not to scare you, 1GB hard drive! With the price tag at $30K of current money, it was the Holy Grail at the time. Fast forward 16 years, servers with 1000% more capacities are either invisible (virtualized) or built like a pizza box, and at fractional cost. Wall Street has classified the computer hardware sector as commodity. In a mere 16 years, the exquisite piece of Art in Sotheby has turned into the framed Art in Costco. It is quite an insult to the Industry; luckily, in a nice way.
The rapid growth of Internet since 1995 has become the vital force for the world economy; it has enabled business accessing, storing, and processing information, worldwide, all in split second; Aided by fast growing robust infrastructure, business was turning the vast amount of information collected from Internet into massive innovative products. By the same channel, it was marketing, selling, and distributing the products within real time of producing. In a nutshell, Internet and information technology have made information extremely fluid. As professionals in the financial industry, we all know how powerful the word “liquidity” is. In retrospect, financial service industry has benefited from Technology more than any other sectors of the world economy. Powerful combination of rapid growth infrastructure and sophisticated financial applications enabled firms to develop innovative, structured and highly complex products to meet customers’ needs. High-speed Internet pushed Finance into twenty-four-hour, seven-day-a-week global activity with vast sums flashing between markets. The ability to instantaneously interpret the financial markets and anticipate their movement has brought huge profits to Financial Service Industry.
Entering new millennium, as more information is disseminated electronically, the ability to manipulate is also growing, the vital force (Simultaneous Information sharing and transmission) that drove the world economy in the last decade, has recently started to show its dark side. After growing incidences of malicious virus attacks and identity theft, people’s sense of privacy and security is diminishing. A recent Wall Street Journal survey indicated that privacy is the issue that concerns Americans most in the twenty-first century, ahead of overpopulation, racial tensions, and global warming. Businesses can’t talk enough about privacy, and are rushing to pass laws to protect it; during an IT leader conference held in past May, the majority of the topics were about privacy regulations and security enforcement; technology for business productivity and innovation received little interest and mention. Obviously, technology is shifting towards a more defensive strategy: to secure data, to protect knowledge, and to reduce complexity.
One way to protect privacy is to set regulations. While I have no doubt about the necessity of regulations, I am less confident about the efficacy. Let’s take the corruption Index; it is higher in highly regulated countries. Let alone the lengthy process of regulation creation: Who picks and chooses the data to protect and not protect? What about information shared globally? Who would the new regulations apply to? What data are protected? What’s considered commerce? Lots of questions; few answers. This is surely just the beginning.
The other way to solve the problem of data security is to spend money on technology, for instance, applying secure web gateways to prevent employee exchange of web based email and postage on social network sites. The tools are useful, but only up to a certain degree, and to a certain point. You don’t have to be technologically savvy to register a free logmein account, which would enable you to connect to home PC from work and perform all the activities blocked by employer. So ultimately, the problem cannot be solved by technology alone because it is not purely technical in nature. Although technical defense is vital, systems are inherently vulnerable to both negligent and malicious acts by people. The real challenge for IT today is learning how to influence people’s behavior; security needs to shift towards being an influential mechanism. To achieve the approach, we need first to understand the business, and then enable the business to achieve its objectives in a way that is secure.
Every revolution has its challenges; that is part of the evolution. The original date of early human use of fire for cooking was about 1.6 million year ago, yet the evidence of their ability to control fire was dated only around 400,000 years ago. For over a million years, they faced the threat of fire but never gave up cooking. If history repeats itself, as it always does, we will find the solution for privacy and security successfully.
--mattewho
While the entire world is blaming Greenspan for bringing down the financial world single-handedly, I find myself having a soft spot for him. The poor guy was not only over-criticized; he was over-credited for his ability. It was the technology, the robust computers and sophisticated applications, which developed innovative derivative and structured products, that played a significant role in the 2008 financial tsunami. With 13 investment banks vanishing in six months, the long- standing US financial system, built by our founding fathers, and designed to be idiot-proof, was brought to the brink of collapse. Apparently, our genius didn’t foresee technology being the potential beast. In the middle of the crisis, I had lunch with a retired former colleague, who called computer “the sewing machine”; she was once ranked among the top 100 financial analysts on Wall Street. We were reverse engineering one derivative fund using rainbow option. She grasped the concept quickly and then bursted out: “This is too complex to calculate, how can one price it daily?” “Certainly not by your slide rule.” I replied. Of course, my rude comment almost cost us our friendship.
Not to challenge Einstein’s Twin Paradox, but time in Technology dimension does travel at a different speed. When I first joined the firm, the number of employees was about 35% of current size, but the number of servers was less than 1% of what we have now. Surprisingly, despite the fact we are an old fashion behind-the-curve investment firm, we had a State-Of-Art server at that time, a Net-FRAME server. (See news attached at bottom). The server was wrapped in large black steel; you would have to be a professional heavy weight wrestler to lift it. It had 128MB memory, and, not to scare you, 1GB hard drive! With the price tag at $30K of current money, it was the Holy Grail at the time. Fast forward 16 years, servers with 1000% more capacities are either invisible (virtualized) or built like a pizza box, and at fractional cost. Wall Street has classified the computer hardware sector as commodity. In a mere 16 years, the exquisite piece of Art in Sotheby has turned into the framed Art in Costco. It is quite an insult to the Industry; luckily, in a nice way.
The rapid growth of Internet since 1995 has become the vital force for the world economy; it has enabled business accessing, storing, and processing information, worldwide, all in split second; Aided by fast growing robust infrastructure, business was turning the vast amount of information collected from Internet into massive innovative products. By the same channel, it was marketing, selling, and distributing the products within real time of producing. In a nutshell, Internet and information technology have made information extremely fluid. As professionals in the financial industry, we all know how powerful the word “liquidity” is. In retrospect, financial service industry has benefited from Technology more than any other sectors of the world economy. Powerful combination of rapid growth infrastructure and sophisticated financial applications enabled firms to develop innovative, structured and highly complex products to meet customers’ needs. High-speed Internet pushed Finance into twenty-four-hour, seven-day-a-week global activity with vast sums flashing between markets. The ability to instantaneously interpret the financial markets and anticipate their movement has brought huge profits to Financial Service Industry.
Entering new millennium, as more information is disseminated electronically, the ability to manipulate is also growing, the vital force (Simultaneous Information sharing and transmission) that drove the world economy in the last decade, has recently started to show its dark side. After growing incidences of malicious virus attacks and identity theft, people’s sense of privacy and security is diminishing. A recent Wall Street Journal survey indicated that privacy is the issue that concerns Americans most in the twenty-first century, ahead of overpopulation, racial tensions, and global warming. Businesses can’t talk enough about privacy, and are rushing to pass laws to protect it; during an IT leader conference held in past May, the majority of the topics were about privacy regulations and security enforcement; technology for business productivity and innovation received little interest and mention. Obviously, technology is shifting towards a more defensive strategy: to secure data, to protect knowledge, and to reduce complexity.
One way to protect privacy is to set regulations. While I have no doubt about the necessity of regulations, I am less confident about the efficacy. Let’s take the corruption Index; it is higher in highly regulated countries. Let alone the lengthy process of regulation creation: Who picks and chooses the data to protect and not protect? What about information shared globally? Who would the new regulations apply to? What data are protected? What’s considered commerce? Lots of questions; few answers. This is surely just the beginning.
The other way to solve the problem of data security is to spend money on technology, for instance, applying secure web gateways to prevent employee exchange of web based email and postage on social network sites. The tools are useful, but only up to a certain degree, and to a certain point. You don’t have to be technologically savvy to register a free logmein account, which would enable you to connect to home PC from work and perform all the activities blocked by employer. So ultimately, the problem cannot be solved by technology alone because it is not purely technical in nature. Although technical defense is vital, systems are inherently vulnerable to both negligent and malicious acts by people. The real challenge for IT today is learning how to influence people’s behavior; security needs to shift towards being an influential mechanism. To achieve the approach, we need first to understand the business, and then enable the business to achieve its objectives in a way that is secure.
Every revolution has its challenges; that is part of the evolution. The original date of early human use of fire for cooking was about 1.6 million year ago, yet the evidence of their ability to control fire was dated only around 400,000 years ago. For over a million years, they faced the threat of fire but never gave up cooking. If history repeats itself, as it always does, we will find the solution for privacy and security successfully.
Monday, November 29, 2010
North Korea Attack Impact
Global stock markets have recovered after North Korea launched a barrage against South Korea on Tuesday. Yet military tensions are rising: the U.S. has dispatched warships into the Yellow Sea for exercises with its ally Seoul. What’s ahead for business relations between China, which has close political ties to North Korea, and South Korea?
We exchanged by email yesterday with, Yong-Tack Cho, an editor at Forbes Korea, the licensed Korean-language edition of Forbes magazine. Excerpts follow.
Q. Before this week’s attack on South Korea by the North, economic relations between South Korea and China had been expanding despite China’s close political ties to North Korea. Why have economic and business ties managed to grow despite China’s cozy relationship with the North?
A. Indeed, South Korea and China’s trade relations have developed greatly. Currently, 31% of South Korean exports are shipped to China. This is possible because both countries want to see their trade and political relations as two different things. China has wanted to grow its economy and has needed the investment and technology South Korea can provide. On the other hand, South Korea has wanted entry into the Chinese market and its natural resources. While the two countries do not share the same beliefs about North Korea diplomatically, it would have been unwise trade policy to let that get in the way of trade growth.
Q. What’s ahead for business between China and South Korea, in light of North Korea’s attack?
A. It is unlikely the recent attack will get in the way of trade between South Korea and China, as both governments do not wish for it to get in the way of business. If the situation does not escalate, the impact on economic and trade relations will be meager, as there is no proof or indication that China was involved in the attacks.
Q. What South Korean companies, if any, would be most affected by this week’s developments?
A. We expect that this week’s events will have a large impact on the tourism industry, especially from Japan and China. The Korea Tourism Organization held a meeting with its Japan and China offices on the 24th. While they deny any massive wave of travel cancelations, local travel agencies have been reporting significant losses and falling prices for travel packages to Korea. We expect prices to continue to fall for now.
Q. Before this week’s event, what would you say would likely be the outlook for China-Korean business and economic growth in 2011?
A. Before this week, China was seen as a great economic opportunity for Korea. “How to approach the Chinese economy?” was a question that local companies contemplated 10 years ago. (Since then,) Korean conglomerates such as Samsung, LG, Hyundai Motors, and Posco have regularly increased their investment and built production sites in the region. The two governments are currently formulating an FTA agreement. Even after the attack, we do not believe that it will overly impact our business outlook with China.
Q. What’s the outlook for South Korea’s stock market and currency in light of this week’s attacks?
A. The day after the Yeonpyeong Island attack, the KOSPI dropped 45.02 points (2.33%) in the morning. However, the KOSPI jumped back and closed only 2.96 points (0.15%) lower than the previous day. The Korean stock market has been able to regain its stability despite the attacks because we’ve learn from our past experiences. This isn’t the first time we’ve been attacked by North Korea, and foreign investors have been able to build a certain level of tolerance. As Lee Sung-Woo, an analyst from Daewoo Securities, says: “North Korea’s attack may have influenced the liquidity of the global market momentarily, but they can’t get in the way of a rising nation like South Korea from flourishing in the long haul.”
We exchanged by email yesterday with, Yong-Tack Cho, an editor at Forbes Korea, the licensed Korean-language edition of Forbes magazine. Excerpts follow.
Q. Before this week’s attack on South Korea by the North, economic relations between South Korea and China had been expanding despite China’s close political ties to North Korea. Why have economic and business ties managed to grow despite China’s cozy relationship with the North?
A. Indeed, South Korea and China’s trade relations have developed greatly. Currently, 31% of South Korean exports are shipped to China. This is possible because both countries want to see their trade and political relations as two different things. China has wanted to grow its economy and has needed the investment and technology South Korea can provide. On the other hand, South Korea has wanted entry into the Chinese market and its natural resources. While the two countries do not share the same beliefs about North Korea diplomatically, it would have been unwise trade policy to let that get in the way of trade growth.
Q. What’s ahead for business between China and South Korea, in light of North Korea’s attack?
A. It is unlikely the recent attack will get in the way of trade between South Korea and China, as both governments do not wish for it to get in the way of business. If the situation does not escalate, the impact on economic and trade relations will be meager, as there is no proof or indication that China was involved in the attacks.
Q. What South Korean companies, if any, would be most affected by this week’s developments?
A. We expect that this week’s events will have a large impact on the tourism industry, especially from Japan and China. The Korea Tourism Organization held a meeting with its Japan and China offices on the 24th. While they deny any massive wave of travel cancelations, local travel agencies have been reporting significant losses and falling prices for travel packages to Korea. We expect prices to continue to fall for now.
Q. Before this week’s event, what would you say would likely be the outlook for China-Korean business and economic growth in 2011?
A. Before this week, China was seen as a great economic opportunity for Korea. “How to approach the Chinese economy?” was a question that local companies contemplated 10 years ago. (Since then,) Korean conglomerates such as Samsung, LG, Hyundai Motors, and Posco have regularly increased their investment and built production sites in the region. The two governments are currently formulating an FTA agreement. Even after the attack, we do not believe that it will overly impact our business outlook with China.
Q. What’s the outlook for South Korea’s stock market and currency in light of this week’s attacks?
A. The day after the Yeonpyeong Island attack, the KOSPI dropped 45.02 points (2.33%) in the morning. However, the KOSPI jumped back and closed only 2.96 points (0.15%) lower than the previous day. The Korean stock market has been able to regain its stability despite the attacks because we’ve learn from our past experiences. This isn’t the first time we’ve been attacked by North Korea, and foreign investors have been able to build a certain level of tolerance. As Lee Sung-Woo, an analyst from Daewoo Securities, says: “North Korea’s attack may have influenced the liquidity of the global market momentarily, but they can’t get in the way of a rising nation like South Korea from flourishing in the long haul.”
Sunday, November 28, 2010
Devaluing History
Menzie Chinn goes after Paul Ryan’s challenge: “Name me a nation in history that has prospered by devaluing its currency.” But why go back to the 1930s?
How about:
-Britain, which recovered strongly from its early 90s doldrums after it devalued the pound against the mark in 1992. (At the time, some wags suggested putting a statue of George Soros in Trafalgar Square.)
- Sweden, which recovered from its early 90s banking crisis with an export boom, driven by a devalued kronor.
- South Korea, which roared back from the 1997-1998 crisis with an export boom, driven by a depreciated won.
- Argentina, which roared back from its 2002 crisis with an export boom, driven by a depreciated peso.
And more. The truth is that every recovery from financial crisis I know of since World War II was driven by currency depreciation. In fact, that’s the biggest reason for pessimism now: because of the global scope of this crisis, the usual exit is blocked.
Now, I’m sure that the goldbugs will come up with ways to explain away all of these events. But at that point we’re not learning from history; on the face of it, history seems to suggest many cases of countries prospering through devaluation.
So what’s going on with Ryan? First, it’s a good bet that he doesn’t actually know much about monetary history. Beyond that, though, what you often see among hard-money types is a sort of Lives of the Saints approach to history: they’ve got their iconic examples (Weimar Germany! Zimbabwe!) which they pull out on every occasion, while remaining utterly ignorant of all the examples that go the other way.
And no, it’s not symmetric: people like me have heard about hyperinflation, while people like Ryan apparently have never heard about post-crisis Korea or Argentina.
How about:
-Britain, which recovered strongly from its early 90s doldrums after it devalued the pound against the mark in 1992. (At the time, some wags suggested putting a statue of George Soros in Trafalgar Square.)
- Sweden, which recovered from its early 90s banking crisis with an export boom, driven by a devalued kronor.
- South Korea, which roared back from the 1997-1998 crisis with an export boom, driven by a depreciated won.
- Argentina, which roared back from its 2002 crisis with an export boom, driven by a depreciated peso.
And more. The truth is that every recovery from financial crisis I know of since World War II was driven by currency depreciation. In fact, that’s the biggest reason for pessimism now: because of the global scope of this crisis, the usual exit is blocked.
Now, I’m sure that the goldbugs will come up with ways to explain away all of these events. But at that point we’re not learning from history; on the face of it, history seems to suggest many cases of countries prospering through devaluation.
So what’s going on with Ryan? First, it’s a good bet that he doesn’t actually know much about monetary history. Beyond that, though, what you often see among hard-money types is a sort of Lives of the Saints approach to history: they’ve got their iconic examples (Weimar Germany! Zimbabwe!) which they pull out on every occasion, while remaining utterly ignorant of all the examples that go the other way.
And no, it’s not symmetric: people like me have heard about hyperinflation, while people like Ryan apparently have never heard about post-crisis Korea or Argentina.
Saturday, November 27, 2010
Top 10 Hedge Fund Blogs
FT Alphaville
Recent Posts from this Blog
Further reading
Swelling Spanish bond yields
Further reading
FiNTAG
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THE FINTAG NEWSLETTER @ 11 February 2009
THE FINTAG NEWSLETTER @ 12 March 2009
THE FINTAG NEWSLETTER @ 27 March 2009
Hedge Fund
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Correlated or diversified?
Stocks versus bonds?
Hedge fund investment?
Hedge Fund Law Blog
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GSEC to Stop Clearing for Small Hedge Funds
NFA Forex Alert
SEC Proposes “Family Office” Definition
Hedge Fund News
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Hedge Funds Attract $61 Billion So Far In 2010
Two Florida Hedge Fund Managers Accused In Petters Scheme
Rajaratnam Challenges Wiretap Evidence
HedgeCo.Net
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The Inefficient Market Theory
MIT: Peter Thiel, entrepreneur, hedge fund investor and philanthropist
11/16 – NYC – Alpha Gen: Leading Women in Hedge Funds
HedgeFundBlogger.com
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Family Office Database Selection Criteria for Capital Raising
John Kenealy Named Vice President of Prime Services Chicago
Hedge Fund Marketing Workshop Completed
HedgeWorld
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Ex-RBS Sempra Heads to Launch Physical Commodity Fund
FBI Arrests 2 Longtime Employees in Madoff Fraud
Sales Drop Rattles Sears Investors Before Holidays
Hedgefund$ Weblog
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Art Funds
Hedge Fund Competing To Buy British Bank
Hedge Fund Administrator of The Year
The Hedge Fund Implode-o-Meter
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Man U Player Of The Century Eric Cantona Appeals For Peaceful Revolution Against Banks, Calls For Europeans To Pull Their Money
Max Keiser: Congress Will Try -- By Secret Vote -- to Retroactively Legalize Foreclosure Fraud
DID THE FED JUST CONFIRM QE2 IS A BANK BAILOUT?
Recent Posts from this Blog
Further reading
Swelling Spanish bond yields
Further reading
FiNTAG
Recent Posts from this Blog
THE FINTAG NEWSLETTER @ 11 February 2009
THE FINTAG NEWSLETTER @ 12 March 2009
THE FINTAG NEWSLETTER @ 27 March 2009
Hedge Fund
Recent Posts from this Blog
Correlated or diversified?
Stocks versus bonds?
Hedge fund investment?
Hedge Fund Law Blog
Recent Posts from this Blog
GSEC to Stop Clearing for Small Hedge Funds
NFA Forex Alert
SEC Proposes “Family Office” Definition
Hedge Fund News
Recent Posts from this Blog
Hedge Funds Attract $61 Billion So Far In 2010
Two Florida Hedge Fund Managers Accused In Petters Scheme
Rajaratnam Challenges Wiretap Evidence
HedgeCo.Net
Recent Posts from this Blog
The Inefficient Market Theory
MIT: Peter Thiel, entrepreneur, hedge fund investor and philanthropist
11/16 – NYC – Alpha Gen: Leading Women in Hedge Funds
HedgeFundBlogger.com
Recent Posts from this Blog
Family Office Database Selection Criteria for Capital Raising
John Kenealy Named Vice President of Prime Services Chicago
Hedge Fund Marketing Workshop Completed
HedgeWorld
Recent Posts from this Blog
Ex-RBS Sempra Heads to Launch Physical Commodity Fund
FBI Arrests 2 Longtime Employees in Madoff Fraud
Sales Drop Rattles Sears Investors Before Holidays
Hedgefund$ Weblog
Recent Posts from this Blog
Art Funds
Hedge Fund Competing To Buy British Bank
Hedge Fund Administrator of The Year
The Hedge Fund Implode-o-Meter
Recent Posts from this Blog
Man U Player Of The Century Eric Cantona Appeals For Peaceful Revolution Against Banks, Calls For Europeans To Pull Their Money
Max Keiser: Congress Will Try -- By Secret Vote -- to Retroactively Legalize Foreclosure Fraud
DID THE FED JUST CONFIRM QE2 IS A BANK BAILOUT?
Thursday, November 25, 2010
Top 10 Business Etiquette
1. First and foremost, having good manners is a must. Please and thank you never go out of style. Common courtesy towards others should be second nature.
2. Be on time, or better yet be a little bit early. Be certain that you have allotted enough time for the meeting so you won't be concerned about another place that you have to be.
3. Dress appropriately. If you are uncertain of what to wear, it is always better to err on the conservative side. Business casual is generally the rule of thumb to follow.
4. Prepare yourself ahead of time for both things that you may want to contribute to the meeting, and any information that was given to you ahead of time to read or make notes on. Come prepared to participate in discussions and activities.
5. Upon entering the meeting, glance around the room and acknowledge other attendees. Familiarize yourself with colleagues and managers and make a note of the person who is chairing the meeting. Try to put names to faces if you've met previously and try to remember names of people who have been newly introduced to you.
6. Although it's hard to live without text messages, cell calls and emails, you can do it for the duration of a meeting. It is good etiquette to present the attitude that this meeting is the most important thing on your agenda right now. Leave word ahead of time with the necessary contacts that you will be in a meeting and then switch everything off when you arrive.
7. Don't interrupt the chair when the meeting is in progress. Take notes so you will be prepared to speak up when the time is right.
8. When you do speak out, be clear, concise, and stay on topic. Don't be afraid to present your point of view, but always be respectful of the point of view of others.
9. Information exchanged in a meeting is generally considered confidential among those attending the meeting. Unless you are certain that the subject matter is common knowledge, it is best not to discuss issues with those that were not in attendance.
10. Bring your positive attitude. You'll accomplish a lot more and gain a lot more respect than you will if you are negative and critical.
2. Be on time, or better yet be a little bit early. Be certain that you have allotted enough time for the meeting so you won't be concerned about another place that you have to be.
3. Dress appropriately. If you are uncertain of what to wear, it is always better to err on the conservative side. Business casual is generally the rule of thumb to follow.
4. Prepare yourself ahead of time for both things that you may want to contribute to the meeting, and any information that was given to you ahead of time to read or make notes on. Come prepared to participate in discussions and activities.
5. Upon entering the meeting, glance around the room and acknowledge other attendees. Familiarize yourself with colleagues and managers and make a note of the person who is chairing the meeting. Try to put names to faces if you've met previously and try to remember names of people who have been newly introduced to you.
6. Although it's hard to live without text messages, cell calls and emails, you can do it for the duration of a meeting. It is good etiquette to present the attitude that this meeting is the most important thing on your agenda right now. Leave word ahead of time with the necessary contacts that you will be in a meeting and then switch everything off when you arrive.
7. Don't interrupt the chair when the meeting is in progress. Take notes so you will be prepared to speak up when the time is right.
8. When you do speak out, be clear, concise, and stay on topic. Don't be afraid to present your point of view, but always be respectful of the point of view of others.
9. Information exchanged in a meeting is generally considered confidential among those attending the meeting. Unless you are certain that the subject matter is common knowledge, it is best not to discuss issues with those that were not in attendance.
10. Bring your positive attitude. You'll accomplish a lot more and gain a lot more respect than you will if you are negative and critical.
Wednesday, November 24, 2010
The Rise Of The Modern Investment Bank
From Clipper Ships to KKR
Adam Smith famously described capitalism as an invisible hand guiding the market in its allocation of goods and services. The financial engines of this hand during the 18th and 19th centuries were European merchant banks, such as Hope & Co., Baring Brothers and Morgan Grenfell. For a time, the Netherlands, and later Great Britain, ruled the waves of global commerce in far-flung ports of call such as India and Hong Kong. The merchant banking model then crossed the Atlantic and served as the inspiration for the financial firms founded by prominent families in what could perhaps be called the emerging market of the day - the United States. The structure and activities of early U.S. firms such as JP Morgan & Co. and Dillon Read and Drexel & Co. reflected those of their European counterparts and included financing new business opportunities through raising and deploying investment capital. (For related reading, see The Evolution Of Banking.)
Over time, two somewhat distinct models arose from this. The old merchant banking model was largely a private affair conducted among the privileged denizens of the clubby world of old European wealth. The merchant bank typically put up sizable amounts of its own (family-owned) capital along with that of other private interests that came into the deals as limited-liability partners. Over the 19th century, a new model came into popular use, particularly in the United States. Firms seeking to raise capital would issue securities to third-party investors, who would then have the ability to trade these securities in the organized securities exchanges of major financial centers such as London and New York. The role of the financial firm was that of underwriter - representing the issuer to the investing public, obtaining interest from investors and facilitating the details of the issuance. Firms engaged in this business became known as investment banks. (To learn more about these functions, read Brokerage Functions: Underwriting And Agency Roles.)
Firms like JP Morgan didn't limit themselves to investment banking, but established themselves in a variety of other financial businesses including lending and deposit taking (i.e. commercial banking). The stock market crash of 1929 and ensuing Great Depression caused the U.S. government to reach the conclusion that financial markets needed to be more closely regulated in order to protect the financial interests of average Americans. This resulted in the separation of investment banking from commercial banking (the Glass-Steagall Act of 1933). The firms on the investment banking side of this separation - such as Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston - went on to take a prominent role in the underwriting of corporate America during the postwar period; the largest gained fame as the so-called "bulge bracket". (For more on this, read What Was The Glass-Steagall Act?)
The term "merchant bank" came back into vogue in the late 1970s with the nascent private equity business of firms like Kohlberg, Kravis & Roberts (KKR). Merchant banking in its modern context refers to using one's own equity (often accompanied by external debt financing) in a private transaction, as opposed to underwriting a share issue via publicly traded securities on an exchange - the classic function of an investment bank. Many of the large global firms today conduct both merchant banking (private equity) and investment banking.
The Regulatory Infrastructure
In the United States, investment banks operate according to legislation enacted at the time of Glass-Steagall. The Securities Act of 1933 became a blueprint for how investment banks underwrite securities in the public markets. The act established the practices of due diligence, issuing a preliminary and final prospectus, and pricing and syndicating a new issue. The 1934 Securities Exchange Act addressed securities exchanges and broker-dealer organizations. The 1940 Investment Company Act and 1940 Investment Advisors Act established regulations for fiduciaries, such as mutual funds, private money managers and registered investment advisors. In Wall Street parlance, the investment banks represent the "sell side" (as they are mainly in the business of selling securities to investors), while mutual funds, advisors and others make up the "buy side".
Anatomy of an Offering
A company selects an investment bank to be lead manager of a securities offering; responsibilities include leading the due diligence and drafting the prospectus. The lead manager forms a team of third-party specialists, including legal counsel, accounting and tax specialists, financial printers and others.
In addition, the lead manager invites other banks into an underwriting syndicate as co-managers. The lead and co-managers will allot portions of the shares to be offered among themselves. Because their underwriting fees derive from how much of the issue they sell, the competition for lead manager and senior allotment positions is quite intense.
When a company issues publicly traded securities for the first time through an initial public offering (IPO), the lead manager appoints a research analyst to write a research report and begin ongoing coverage of the company. The report will contain an economic analysis of the business and its prospects given the market for its products and services, competition and other factors. Once the analyst initiates coverage, he or she will make ongoing recommendations to the bank's clients to buy, hold or sell shares based on the perceived fair value relative to current share price. (For more on this, read IPO Basics.)
Distribution begins with the book-building process. The underwriting syndicate builds a book of interest during the offering period, usually accompanied by a road show, in which the issuer's senior management and syndicate team members meet with potential investors (mostly institutional investors such as pension funds, endowments and insurance companies). Potential investors receive a red herring, a preliminary prospectus that contains all materially significant information about the issuer but omits the final issuing price and number of shares.
At the end of the road show, the lead manager sets the final offering price based on the prevailing demand. Underwriters seek to have the offering oversubscribed (create more demand than available shares). If they succeed, they will exercise a 15% overallotment option, called a greenshoe, which is named after the Green Shoe Company, the first issuer of such an option. This permits the underwriters to increase the number of new shares issued by up to 15% (from the number stated in the prospectus) without going through any additional registration.
The new issue market is called the primary market. The Securities and Exchange Commission (SEC) registers the securities prior to their primary issuance, then they start trading in the secondary market on the New York Stock Exchange, Nasdaq or other venue where the securities have been accepted for listing and trading. (To learn more about the primary and secondary market, read Markets Demystified.)
Wall Street's Chinese Wall
Investment banking is fraught with potential conflicts of interest. This problem has intensified through the consolidation that has swept through the financial services industry, to the point where a handful of large concerns - the fabled bulge bracket banks - account for a disproportionate share of business on both the buy and sell side.
The potential conflict arising from this is simple to understand. Buy-side agents - investment advisors and money managers - have a fiduciary obligation to act solely in the best interests of their investing clients, without regard for their own economic incentives to recommend one product or strategy versus another. Investment bankers on the sell side seek to maximize the results to their clients, the issuers. When a firm in which the main line of business is sell side, investment banking acquires a buy-side asset manager, and these incentives can be at odds.
Unfortunately for investors, the economics of the business are such that a disproportionate amount of an investment bank's profits derive from its underwriting and trading businesses. The competition for mandates is intense, and the pressure is high on all participants - the bankers, research analysts, traders and salespeople - to deliver results.
One example in particular is research. The research analyst is supposed to reach independent conclusions irrespective of the investment bankers' interests. Regulations mandate that banks enforce a separation between research and banking, popularly referred to as a Chinese Wall. In reality, however, many firms have tied research analysts' compensation to investment banking profitability. Scrutiny following the collapse of the dotcom bubble in 2000 has led to some attempts to reform some of these flawed practices. (To learn more, read The Chinese Wall Protects Investors Against Conflicts Of Interest.)
What About Compensation?
A discussion on investment banking wouldn't be complete without addressing the enormous sums of money that investment bankers are paid. Essentially, a bank's main income-producing assets walk out of the office building every evening. Deals are completed and money is made based solely on the relationships, experience and clever thinking of the professionals who work there.
As such, an investment bank has little to do with the profits it earns except to pay the folks who produced them. It is not unusual for 50% or more of top-line revenues to go into the salaries and bonuses for an investment bank's employees. Most of this goes to the principal architects of the deals, but is also goes to the associates and analysts who toil over discounted cash flow spreadsheets and comparables models until the early hours of every morning.
The catch is that most of this compensation is paid as bonuses. Fixed salaries are by no means modest, but the big seven-figure payoffs come through bonus distributions. The risk for an investment banker is that such payouts can quickly vanish if market conditions turn down or the firm has a bad year. (For more on the life of an investment banker, read Is Investment Banking For You?)
Investment bankers spend an inordinate amount of time trying to figure out new ways to make money - in good times and bad. Business areas like M&A, restructuring, private equity and structured finance, most of which were not part of an investment bank's repertoire prior to the mid to late 1970s, provide evidence of this profession's ability to continually find new ways to make money.
The Bottom Line
For all the mystery surrounding investment banks, the role they have played throughout the evolution of modern capitalism is fairly straightforward. These institutions provide the financial means to enable Adam Smith's invisible hand to function.
Investment banks have flourished in a variety of economies, from the merchant traders of 18th-century London and Amsterdam to the behemoths of today, whose influence spans the globe. As long as there is a market economy, there are likely to be investment bankers coming up with new ways to make money, while the rest of us marvel at how they manage to do it.
Adam Smith famously described capitalism as an invisible hand guiding the market in its allocation of goods and services. The financial engines of this hand during the 18th and 19th centuries were European merchant banks, such as Hope & Co., Baring Brothers and Morgan Grenfell. For a time, the Netherlands, and later Great Britain, ruled the waves of global commerce in far-flung ports of call such as India and Hong Kong. The merchant banking model then crossed the Atlantic and served as the inspiration for the financial firms founded by prominent families in what could perhaps be called the emerging market of the day - the United States. The structure and activities of early U.S. firms such as JP Morgan & Co. and Dillon Read and Drexel & Co. reflected those of their European counterparts and included financing new business opportunities through raising and deploying investment capital. (For related reading, see The Evolution Of Banking.)
Over time, two somewhat distinct models arose from this. The old merchant banking model was largely a private affair conducted among the privileged denizens of the clubby world of old European wealth. The merchant bank typically put up sizable amounts of its own (family-owned) capital along with that of other private interests that came into the deals as limited-liability partners. Over the 19th century, a new model came into popular use, particularly in the United States. Firms seeking to raise capital would issue securities to third-party investors, who would then have the ability to trade these securities in the organized securities exchanges of major financial centers such as London and New York. The role of the financial firm was that of underwriter - representing the issuer to the investing public, obtaining interest from investors and facilitating the details of the issuance. Firms engaged in this business became known as investment banks. (To learn more about these functions, read Brokerage Functions: Underwriting And Agency Roles.)
Firms like JP Morgan didn't limit themselves to investment banking, but established themselves in a variety of other financial businesses including lending and deposit taking (i.e. commercial banking). The stock market crash of 1929 and ensuing Great Depression caused the U.S. government to reach the conclusion that financial markets needed to be more closely regulated in order to protect the financial interests of average Americans. This resulted in the separation of investment banking from commercial banking (the Glass-Steagall Act of 1933). The firms on the investment banking side of this separation - such as Morgan Stanley, Goldman Sachs, Lehman Brothers and First Boston - went on to take a prominent role in the underwriting of corporate America during the postwar period; the largest gained fame as the so-called "bulge bracket". (For more on this, read What Was The Glass-Steagall Act?)
The term "merchant bank" came back into vogue in the late 1970s with the nascent private equity business of firms like Kohlberg, Kravis & Roberts (KKR). Merchant banking in its modern context refers to using one's own equity (often accompanied by external debt financing) in a private transaction, as opposed to underwriting a share issue via publicly traded securities on an exchange - the classic function of an investment bank. Many of the large global firms today conduct both merchant banking (private equity) and investment banking.
The Regulatory Infrastructure
In the United States, investment banks operate according to legislation enacted at the time of Glass-Steagall. The Securities Act of 1933 became a blueprint for how investment banks underwrite securities in the public markets. The act established the practices of due diligence, issuing a preliminary and final prospectus, and pricing and syndicating a new issue. The 1934 Securities Exchange Act addressed securities exchanges and broker-dealer organizations. The 1940 Investment Company Act and 1940 Investment Advisors Act established regulations for fiduciaries, such as mutual funds, private money managers and registered investment advisors. In Wall Street parlance, the investment banks represent the "sell side" (as they are mainly in the business of selling securities to investors), while mutual funds, advisors and others make up the "buy side".
Anatomy of an Offering
A company selects an investment bank to be lead manager of a securities offering; responsibilities include leading the due diligence and drafting the prospectus. The lead manager forms a team of third-party specialists, including legal counsel, accounting and tax specialists, financial printers and others.
In addition, the lead manager invites other banks into an underwriting syndicate as co-managers. The lead and co-managers will allot portions of the shares to be offered among themselves. Because their underwriting fees derive from how much of the issue they sell, the competition for lead manager and senior allotment positions is quite intense.
When a company issues publicly traded securities for the first time through an initial public offering (IPO), the lead manager appoints a research analyst to write a research report and begin ongoing coverage of the company. The report will contain an economic analysis of the business and its prospects given the market for its products and services, competition and other factors. Once the analyst initiates coverage, he or she will make ongoing recommendations to the bank's clients to buy, hold or sell shares based on the perceived fair value relative to current share price. (For more on this, read IPO Basics.)
Distribution begins with the book-building process. The underwriting syndicate builds a book of interest during the offering period, usually accompanied by a road show, in which the issuer's senior management and syndicate team members meet with potential investors (mostly institutional investors such as pension funds, endowments and insurance companies). Potential investors receive a red herring, a preliminary prospectus that contains all materially significant information about the issuer but omits the final issuing price and number of shares.
At the end of the road show, the lead manager sets the final offering price based on the prevailing demand. Underwriters seek to have the offering oversubscribed (create more demand than available shares). If they succeed, they will exercise a 15% overallotment option, called a greenshoe, which is named after the Green Shoe Company, the first issuer of such an option. This permits the underwriters to increase the number of new shares issued by up to 15% (from the number stated in the prospectus) without going through any additional registration.
The new issue market is called the primary market. The Securities and Exchange Commission (SEC) registers the securities prior to their primary issuance, then they start trading in the secondary market on the New York Stock Exchange, Nasdaq or other venue where the securities have been accepted for listing and trading. (To learn more about the primary and secondary market, read Markets Demystified.)
Wall Street's Chinese Wall
Investment banking is fraught with potential conflicts of interest. This problem has intensified through the consolidation that has swept through the financial services industry, to the point where a handful of large concerns - the fabled bulge bracket banks - account for a disproportionate share of business on both the buy and sell side.
The potential conflict arising from this is simple to understand. Buy-side agents - investment advisors and money managers - have a fiduciary obligation to act solely in the best interests of their investing clients, without regard for their own economic incentives to recommend one product or strategy versus another. Investment bankers on the sell side seek to maximize the results to their clients, the issuers. When a firm in which the main line of business is sell side, investment banking acquires a buy-side asset manager, and these incentives can be at odds.
Unfortunately for investors, the economics of the business are such that a disproportionate amount of an investment bank's profits derive from its underwriting and trading businesses. The competition for mandates is intense, and the pressure is high on all participants - the bankers, research analysts, traders and salespeople - to deliver results.
One example in particular is research. The research analyst is supposed to reach independent conclusions irrespective of the investment bankers' interests. Regulations mandate that banks enforce a separation between research and banking, popularly referred to as a Chinese Wall. In reality, however, many firms have tied research analysts' compensation to investment banking profitability. Scrutiny following the collapse of the dotcom bubble in 2000 has led to some attempts to reform some of these flawed practices. (To learn more, read The Chinese Wall Protects Investors Against Conflicts Of Interest.)
What About Compensation?
A discussion on investment banking wouldn't be complete without addressing the enormous sums of money that investment bankers are paid. Essentially, a bank's main income-producing assets walk out of the office building every evening. Deals are completed and money is made based solely on the relationships, experience and clever thinking of the professionals who work there.
As such, an investment bank has little to do with the profits it earns except to pay the folks who produced them. It is not unusual for 50% or more of top-line revenues to go into the salaries and bonuses for an investment bank's employees. Most of this goes to the principal architects of the deals, but is also goes to the associates and analysts who toil over discounted cash flow spreadsheets and comparables models until the early hours of every morning.
The catch is that most of this compensation is paid as bonuses. Fixed salaries are by no means modest, but the big seven-figure payoffs come through bonus distributions. The risk for an investment banker is that such payouts can quickly vanish if market conditions turn down or the firm has a bad year. (For more on the life of an investment banker, read Is Investment Banking For You?)
Investment bankers spend an inordinate amount of time trying to figure out new ways to make money - in good times and bad. Business areas like M&A, restructuring, private equity and structured finance, most of which were not part of an investment bank's repertoire prior to the mid to late 1970s, provide evidence of this profession's ability to continually find new ways to make money.
The Bottom Line
For all the mystery surrounding investment banks, the role they have played throughout the evolution of modern capitalism is fairly straightforward. These institutions provide the financial means to enable Adam Smith's invisible hand to function.
Investment banks have flourished in a variety of economies, from the merchant traders of 18th-century London and Amsterdam to the behemoths of today, whose influence spans the globe. As long as there is a market economy, there are likely to be investment bankers coming up with new ways to make money, while the rest of us marvel at how they manage to do it.
Madoff Trustee Sues UBS For $2 billion
Irving Picard, the court-appointed trustee for Bernard Madoff’s bogus investment firm, has gone after a big bank in his expensive two-year quest to retrieve funds for some Madoff investors.
Picard filed a complaint against UBS in Manhattan’s federal bankruptcy court yesterday, accusing the Swiss bank of fraud and misconduct in connection with feeder funds that funneled investor cash into the Ponzi scheme. The lawsuit seeks to recover at least $2 billion.
In a press release, Picard claims UBS actively assisted the Madoff Ponzi scheme by sponsoring and administrating Luxalpha SICAV and Groupement Financier, two feeder funds. Picard says that UBS’s own due diligence revealed “indicia of fraud” with the UBS feeder funds, but that UBS nevertheless made Bernard Madoff the subcustodian of the feeder fund assets, allowing Madoff to “run the operation with no checks and balances.” Picard says that UBS enabled Madoff to be the “only source of information for valuing the funds.”
In the complaint, Picard claims the UBS-sponsored feeder funds withdrew $1.12 billion in the six years before the the Ponzi scheme collapsed and resulted in a bankrtupcy filing, making those funds potentially recoverable under federal bankruptcy and state law. Picard claims UBS and its affiliates made some $80 million in fees from the feeder funds.
“Madoff’s scheme could not have been accomplished unless UBS had agreed not only to look the other way, but also to pretend that they were truly ensuring the existence of assets and trades when in fact they were not and never did,” David Sheehan, Picard’s lawyer, said in a statement.
Sheehan said that Picard has “battled” with UBS over disclosure of information regarding Bernard Madoff Investment Securities.
The lawsuit is the latest effort in Picard’s controversial effort, which has included attempts to clawback funds from some of Madoff’s victims. So far Picard has recovered some $1.5 billion, but the vast majority of that sum was simply recovered by grabbing the cash that remained on hand in Madoff’s investment company following the exposure of the fraud. It has been a rich business for Picard and his firm, Baker Hostetler, yielding more than $85 million in fees.
But Picard and Sheehan claim they are on the right track. Said Sheehan: “Without UBS’s serving as promoter, custodian, manager and administrator for the feeder funds, [Madoff] would have been deprived of more than a billion dollars in investments, and Madoff’s fraud would have been diminished.”
Picard filed a complaint against UBS in Manhattan’s federal bankruptcy court yesterday, accusing the Swiss bank of fraud and misconduct in connection with feeder funds that funneled investor cash into the Ponzi scheme. The lawsuit seeks to recover at least $2 billion.
In a press release, Picard claims UBS actively assisted the Madoff Ponzi scheme by sponsoring and administrating Luxalpha SICAV and Groupement Financier, two feeder funds. Picard says that UBS’s own due diligence revealed “indicia of fraud” with the UBS feeder funds, but that UBS nevertheless made Bernard Madoff the subcustodian of the feeder fund assets, allowing Madoff to “run the operation with no checks and balances.” Picard says that UBS enabled Madoff to be the “only source of information for valuing the funds.”
In the complaint, Picard claims the UBS-sponsored feeder funds withdrew $1.12 billion in the six years before the the Ponzi scheme collapsed and resulted in a bankrtupcy filing, making those funds potentially recoverable under federal bankruptcy and state law. Picard claims UBS and its affiliates made some $80 million in fees from the feeder funds.
“Madoff’s scheme could not have been accomplished unless UBS had agreed not only to look the other way, but also to pretend that they were truly ensuring the existence of assets and trades when in fact they were not and never did,” David Sheehan, Picard’s lawyer, said in a statement.
Sheehan said that Picard has “battled” with UBS over disclosure of information regarding Bernard Madoff Investment Securities.
The lawsuit is the latest effort in Picard’s controversial effort, which has included attempts to clawback funds from some of Madoff’s victims. So far Picard has recovered some $1.5 billion, but the vast majority of that sum was simply recovered by grabbing the cash that remained on hand in Madoff’s investment company following the exposure of the fraud. It has been a rich business for Picard and his firm, Baker Hostetler, yielding more than $85 million in fees.
But Picard and Sheehan claim they are on the right track. Said Sheehan: “Without UBS’s serving as promoter, custodian, manager and administrator for the feeder funds, [Madoff] would have been deprived of more than a billion dollars in investments, and Madoff’s fraud would have been diminished.”
Tuesday, November 23, 2010
George Soros Raises InterOil (IOC) Stake
Soros Fund Management just filed an amended 13G with the SEC regarding their position in InterOil (IOC). Per activity on October 25th, George Soros' hedge fund now shows an 11.9% ownership stake in IOC with 5,257,422 shares. This comes after we just disclosed that Soros boosted stakes in two other positions.
Of this total, 1,200,000 shares are represented by call options. Since the second quarter ended, Soros has increased their position size by 53.5%. Interestingly enough, InterOil just yesterday afternoon announced that they would offer convertible senior notes due 2015 and common shares to raise proceeds of up to $280 million.
InterOil has been somewhat of a controversial stock in the hedge fund world. While Soros has amassed a hefty long position, Whitney Tilson's hedge fund T2 Partners has been an ardent detractor of the company as they are short IOC. Soros has clearly been the winner on this play thus far and we'll have to see what happens in the future.
Taken from Google Finance, InterOil is "an integrated energy company operating in Papua New Guinea and its surrounding Southwest Pacific region. The Company operates in four business segments: upstream, midstream, downstream and corporate."
Of this total, 1,200,000 shares are represented by call options. Since the second quarter ended, Soros has increased their position size by 53.5%. Interestingly enough, InterOil just yesterday afternoon announced that they would offer convertible senior notes due 2015 and common shares to raise proceeds of up to $280 million.
InterOil has been somewhat of a controversial stock in the hedge fund world. While Soros has amassed a hefty long position, Whitney Tilson's hedge fund T2 Partners has been an ardent detractor of the company as they are short IOC. Soros has clearly been the winner on this play thus far and we'll have to see what happens in the future.
Taken from Google Finance, InterOil is "an integrated energy company operating in Papua New Guinea and its surrounding Southwest Pacific region. The Company operates in four business segments: upstream, midstream, downstream and corporate."
Thank the Pilgrims for eBay
The story of the Pilgrims' first years in America shows how a change from common ownership to private property led to the feasting celebrated today at Thanksgiving. Similar tales of expanding harvests and benevolence are told wherever people can keep the fruits of their labor and trade them as they please.
The story illuminates why eBay and Chicago Mercantile Exchange Holdings, the owner of the Chicago Mercantile Exchange, were among the two best-performing stocks in their class during each of the last two years, and it provides a useful signal that other markets now preparing to go public might be good investments.
After landing at Plymouth in November 1620, the Pilgrims endured a cold, hungry winter during which half of them died. Promised supplies failed to arrive from London. The 1621 harvest wasn't as big as hoped, nor was the 1622 harvest. More famine seemed inevitable.
And then the colony began to talk through the problem. The London merchants who financed the Pilgrims' settlement specified "that all such persons as are of this colony are to have their meat, drink, apparel, and all provisions out of the common stock and goods of the said colony." In 1621, the Pilgrims planted 26 acres, according to Judd W. Patton, an economics professor at Bellevue University in Nebraska. In 1622, they planted 60 acres, but that wasn't enough to keep hunger away.
People began to steal by night and day, "although many were well whipped," Gov. William Bradford reported.
The system made no sense to anyone. The hard-working subsidized the slackers. The young and ambitious didn't want to do work for anyone else and get nothing for their trouble. The wives of some of the men objected to be commanded to wash clothes, dress meat or do other tasks for other men.
As Bradford would later write in "Of Plymouth Plantation 1620-1647," "At length, after much debate of things, the Governor (with the advice of the chiefest amongst them) gave way that they should set corn every man for his own particular, and in that regard trust to themselves, in all other things to go on in the general way as before."
In what's known today as the Land Division of 1623, each family was allotted land at the rate of one acre per family member and told to go out and produce. More than 184 acres were planted that year. And, Bradford reported, "This had very good success, for it made all hands very industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use, and saved him a great deal of trouble, and gave far better content. The women now went willingly into the field, and took their little ones with them to set corn."
What is apparent from this history is what we all know from our experience: When you can benefit from working hard, you work harder. Under the system of common ownership, there was stealing, shirking and malevolence. Under the incentive system, there was good feeling, hard work and benevolence.
News of the success at Plymouth and other settlements like it attracted more and more immigrants to the New World. And everyone who lives in America today has a personal story that is part of that great continuing tale.
The impulse to improve one's conditions through greater effort and trade is as natural as breathing, and this has been so since the beginning. New York University economist Haim Ofek, in "Second Nature: Economics Origins of Human Evolution, argues that trade helped spur the growth of the brain.
"Exchange requires certain levels of dexterity in communication, quantification, abstraction, and orientation in time and space, all of which depend on the lingual, mathematical and even artistic faculties of the human mind," Ofek writes in the introduction to his 2001 book. "Exchange, therefore, is a pervasive human predisposition with obvious evolutionary implications."
Relatively flexible and acute people had an edge in trading. They survived and prospered, they had bigger, healthier families, and their descendants became dominant.
The success of eBay since its founding in 1995 shares many similarities with the Pilgrim story. Now a public company with a market value of around $75 billion, eBay has created an electronic network of niche markets that takes account of the infinity of human tastes and aptitudes and specializations. The stock is up 72-fold since its September 1998 IPO, from a price-adjusted initial price of $1.50 to $109.42 as of Nov. 15. That is after a 77% drop in the tech crash of 2000.
Like the Pilgrims, eBay gives each of its sellers a piece of land (though in virtual space) to carry out his or her business. A spirit of benevolence is apparent in the company's feedback system; in almost half the transactions, both buyer and seller rate each other, with almost all them highly favorable. But to us, there is one overriding reason for eBay's success: It unleashes the desire and provides a forum for buyers and sellers to improve themselves by trade in a million ways every day.
The CME, odd as it sounds, also bears some similarities to Plymouth Colony. Founded in 1897 as a member-owned organization, the Merc started out as a market for the trading of foodstuffs. Its activities and goals were torn between the interests of the members and the interests of the public. A low point was reached in 1989, when a widely publicized sting operation uncovered conflicts of interest and failures to give the public a fair shake.
For years, the Merc had been content to play a sleepy second fiddle to the Chicago Board of Trade both in volume and number of products traded. In 1972, an inspirational governor — in this case, Leo Melamed — decided it was in everyone's interest to match members' interests with the growing public interest in financial products such as currencies, Treasury bills, Eurodollars and stock market futures. Growth exploded in 2000 as the CME prepared for the shift to public ownership by converting members' interests to shares. Since the Merc went public in December 2002 with its shares listed on the New York Stock Exchange, the stock has risen nearly six-fold, and it has stayed in the top 10 of NYSE performers.
In effect, the CME transformed itself from a tradition-bound club with the image of a raucous den where men shouted at each other to get an edge on the public in trading pork bellies. Instead, it became a pioneering company that lets hardly a week go by without introducing a new electronic product designed to give the public more ability to improve and hedge their ownership of stocks and debt.
The table below shows how acreage planted and revenues grew at Plymouth, the CME and eBay.The Plymouth, Chicago Merc and eBay experiences
Year Plymouth acres planted CME revenue* eBay revenue*
(1621/2000) 26 $226.6 $431.4
(1622/2001) 60 $387.2 $749.8
(1623/2002) 184 $453.2 $1,214.1
(2003) $526.1 $2,165
(2004)** $743.8 $3,260
* In millions **Analysts' estimates
The Pilgrims originally agreed with the London merchants who financed their settlement to hold their land and its products in common, a sort of forced socialism, much as the communists imposed on Russia after the 1917 revolution.
And the Pilgrims learned, as the Russians would, that the system led to misery and poverty. Whenever trade and its rewards are permitted, well-being and output improve across the board. The principle is so mundane that it's hard to believe that it could ever be forgotten. But it was. The Soviet economy broke down because people had no incentive to reduce costs, to produce a quality product, to provide the kind of gracious service that an American expects from even a humdrum retailer.
If it weren't for those who risked death — literally — to start private enterprises on the black market, the Soviet system would have collapsed long before it finally did.
Everyone knows a million examples of how people respond to incentives. It's no accident that when President Bush won a reduction in taxes on capital gains and stock dividends in May 2003, the S&P 500 ($INX) responded with a 27% rise. Incentives to buy stock increased, so prices rose. The after-tax returns from stocks increased, so the public decided to place more dollars into stocks versus the alternatives.
In Plymouth, thanks to the gift of the Land Division of 1623, trade was created, and it did what it has always done:
It allowed economic freedom. The Pilgrims borrowed the money to start their colony. Their decision to redistribute the land allowed rapid repayment and the freedom to practice their beliefs as they wished.
It financed new enterprises. The Virginia Company of Plymouth served its own interests by lending to farmers, giving the company a chance to increase its agricultural imports.
It increased output. When each Pilgrim family gained the freedom to labor as they wished in exchange for the freedom to keep their crop, yields increased.
We believe the successes of the Pilgrims, the CME and eBay are not anomalies. And we will predict success for any company or country that lets people trade as they are predisposed to do by instinct and common sense. If the International Securities Exchange and Chicago Board of Trade follow through on plans to offer shares to the public and if the New York Stock Exchange ever goes public, we'd recommend buying those stocks.
The story illuminates why eBay and Chicago Mercantile Exchange Holdings, the owner of the Chicago Mercantile Exchange, were among the two best-performing stocks in their class during each of the last two years, and it provides a useful signal that other markets now preparing to go public might be good investments.
After landing at Plymouth in November 1620, the Pilgrims endured a cold, hungry winter during which half of them died. Promised supplies failed to arrive from London. The 1621 harvest wasn't as big as hoped, nor was the 1622 harvest. More famine seemed inevitable.
And then the colony began to talk through the problem. The London merchants who financed the Pilgrims' settlement specified "that all such persons as are of this colony are to have their meat, drink, apparel, and all provisions out of the common stock and goods of the said colony." In 1621, the Pilgrims planted 26 acres, according to Judd W. Patton, an economics professor at Bellevue University in Nebraska. In 1622, they planted 60 acres, but that wasn't enough to keep hunger away.
People began to steal by night and day, "although many were well whipped," Gov. William Bradford reported.
The system made no sense to anyone. The hard-working subsidized the slackers. The young and ambitious didn't want to do work for anyone else and get nothing for their trouble. The wives of some of the men objected to be commanded to wash clothes, dress meat or do other tasks for other men.
As Bradford would later write in "Of Plymouth Plantation 1620-1647," "At length, after much debate of things, the Governor (with the advice of the chiefest amongst them) gave way that they should set corn every man for his own particular, and in that regard trust to themselves, in all other things to go on in the general way as before."
In what's known today as the Land Division of 1623, each family was allotted land at the rate of one acre per family member and told to go out and produce. More than 184 acres were planted that year. And, Bradford reported, "This had very good success, for it made all hands very industrious, so as much more corn was planted than otherwise would have been by any means the Governor or any other could use, and saved him a great deal of trouble, and gave far better content. The women now went willingly into the field, and took their little ones with them to set corn."
What is apparent from this history is what we all know from our experience: When you can benefit from working hard, you work harder. Under the system of common ownership, there was stealing, shirking and malevolence. Under the incentive system, there was good feeling, hard work and benevolence.
News of the success at Plymouth and other settlements like it attracted more and more immigrants to the New World. And everyone who lives in America today has a personal story that is part of that great continuing tale.
The impulse to improve one's conditions through greater effort and trade is as natural as breathing, and this has been so since the beginning. New York University economist Haim Ofek, in "Second Nature: Economics Origins of Human Evolution, argues that trade helped spur the growth of the brain.
"Exchange requires certain levels of dexterity in communication, quantification, abstraction, and orientation in time and space, all of which depend on the lingual, mathematical and even artistic faculties of the human mind," Ofek writes in the introduction to his 2001 book. "Exchange, therefore, is a pervasive human predisposition with obvious evolutionary implications."
Relatively flexible and acute people had an edge in trading. They survived and prospered, they had bigger, healthier families, and their descendants became dominant.
The success of eBay since its founding in 1995 shares many similarities with the Pilgrim story. Now a public company with a market value of around $75 billion, eBay has created an electronic network of niche markets that takes account of the infinity of human tastes and aptitudes and specializations. The stock is up 72-fold since its September 1998 IPO, from a price-adjusted initial price of $1.50 to $109.42 as of Nov. 15. That is after a 77% drop in the tech crash of 2000.
Like the Pilgrims, eBay gives each of its sellers a piece of land (though in virtual space) to carry out his or her business. A spirit of benevolence is apparent in the company's feedback system; in almost half the transactions, both buyer and seller rate each other, with almost all them highly favorable. But to us, there is one overriding reason for eBay's success: It unleashes the desire and provides a forum for buyers and sellers to improve themselves by trade in a million ways every day.
The CME, odd as it sounds, also bears some similarities to Plymouth Colony. Founded in 1897 as a member-owned organization, the Merc started out as a market for the trading of foodstuffs. Its activities and goals were torn between the interests of the members and the interests of the public. A low point was reached in 1989, when a widely publicized sting operation uncovered conflicts of interest and failures to give the public a fair shake.
For years, the Merc had been content to play a sleepy second fiddle to the Chicago Board of Trade both in volume and number of products traded. In 1972, an inspirational governor — in this case, Leo Melamed — decided it was in everyone's interest to match members' interests with the growing public interest in financial products such as currencies, Treasury bills, Eurodollars and stock market futures. Growth exploded in 2000 as the CME prepared for the shift to public ownership by converting members' interests to shares. Since the Merc went public in December 2002 with its shares listed on the New York Stock Exchange, the stock has risen nearly six-fold, and it has stayed in the top 10 of NYSE performers.
In effect, the CME transformed itself from a tradition-bound club with the image of a raucous den where men shouted at each other to get an edge on the public in trading pork bellies. Instead, it became a pioneering company that lets hardly a week go by without introducing a new electronic product designed to give the public more ability to improve and hedge their ownership of stocks and debt.
The table below shows how acreage planted and revenues grew at Plymouth, the CME and eBay.The Plymouth, Chicago Merc and eBay experiences
Year Plymouth acres planted CME revenue* eBay revenue*
(1621/2000) 26 $226.6 $431.4
(1622/2001) 60 $387.2 $749.8
(1623/2002) 184 $453.2 $1,214.1
(2003) $526.1 $2,165
(2004)** $743.8 $3,260
* In millions **Analysts' estimates
The Pilgrims originally agreed with the London merchants who financed their settlement to hold their land and its products in common, a sort of forced socialism, much as the communists imposed on Russia after the 1917 revolution.
And the Pilgrims learned, as the Russians would, that the system led to misery and poverty. Whenever trade and its rewards are permitted, well-being and output improve across the board. The principle is so mundane that it's hard to believe that it could ever be forgotten. But it was. The Soviet economy broke down because people had no incentive to reduce costs, to produce a quality product, to provide the kind of gracious service that an American expects from even a humdrum retailer.
If it weren't for those who risked death — literally — to start private enterprises on the black market, the Soviet system would have collapsed long before it finally did.
Everyone knows a million examples of how people respond to incentives. It's no accident that when President Bush won a reduction in taxes on capital gains and stock dividends in May 2003, the S&P 500 ($INX) responded with a 27% rise. Incentives to buy stock increased, so prices rose. The after-tax returns from stocks increased, so the public decided to place more dollars into stocks versus the alternatives.
In Plymouth, thanks to the gift of the Land Division of 1623, trade was created, and it did what it has always done:
It allowed economic freedom. The Pilgrims borrowed the money to start their colony. Their decision to redistribute the land allowed rapid repayment and the freedom to practice their beliefs as they wished.
It financed new enterprises. The Virginia Company of Plymouth served its own interests by lending to farmers, giving the company a chance to increase its agricultural imports.
It increased output. When each Pilgrim family gained the freedom to labor as they wished in exchange for the freedom to keep their crop, yields increased.
We believe the successes of the Pilgrims, the CME and eBay are not anomalies. And we will predict success for any company or country that lets people trade as they are predisposed to do by instinct and common sense. If the International Securities Exchange and Chicago Board of Trade follow through on plans to offer shares to the public and if the New York Stock Exchange ever goes public, we'd recommend buying those stocks.
Sunday, November 21, 2010
Five Megathemes That Will Dominate Indian Economics Over The Next Five Years
Lately it seems that the entire world has forgotten that in addition to China, the EMs are also the BRI - Brazil, Russia and India. However, now that Brazil is outright hostile toward US policies (not so much toward China), and Russia continues to be Crazy Ivan, the only relevant other overheating economy appears to be India. The reason why India has not attained much media attention in recent years, is that unlike China, the country has been doing its thing and not engaging in overt or covert conflict with the developed world. And as China's inflationary star may be waning, we believe ever more investors will continue looking toward India. Which is why, courtesy of Ambit, we present an analysis of what the investment bank believes will be the five key megathemes which will dominate the Indian economy over the next five years.
Megatheme 1: Structurally high inflation
Supply constraints in India’s manufacturing sector have historically caused core inflation to spike every time the economy expands rapidly (see Exhibit A on the left). Limited access to finance, hard infrastructure deficits and labour market issues have and will prevent timely supply responses in this demand powerhouse thus driving manufacturing inflation higher. Furthermore, a growing and young population with rising incomes will cause food demand to grow rapidly, while supply responses continue to be weak. This supply-demand mismatch will drive food prices higher over the next decade.
High inflation has historically been a negative for stock market returns (see Exhibit B on the left) as it crunches companies’ margins through higher input costs. Financial services’ companies emerge as being the most inflation-immune due to their limited exposure to employee costs as well as to raw material costs. Commodity-driven sectors emerge as an obvious hedge against higher commodities’ prices. IT and other labour-intensive export-facing sectors appear to be the most vulnerable to high inflation as higher domestic wages erode their price competitiveness.
Megatheme 2: the rise of the “aspirational” consumer
As a country’s per capita incomes rise, the consumption basket of its citizens changes away from food (see Exhibit C on the left) and essentials to non-food and aspirational items (such as cosmetics, motorbikes and jewellery). India’s consumption basket has been undergoing just this sort of change. Given the structural drivers of this trend (rising incomes, high share of youth and urbanisation), investors should focus on aspirational product manufacturers vis-Ã -vis essentials within India’s broader consumption story. Exhibit 25 on pg19 gives a list of aspirational stocks. Exhibit 23 & 24 on pg 19 show the outperformance of aspirational stock vis-Ã -vis consumer essentials.
Megatheme 3: a capex boom in the making
The experience of India’s Asian neighbours suggests that a high GDP growth rate coupled with the investment:GDP ratio hitting 33% triggers a surge in capex (see Exhibit D below). These trigger points along with India’s infrastructure deficit and the Government’s desire to address this deficit has set the scene for a seven year surge in capex. History suggests that the Indian Capital Goods sector stands to gain most, both from profitability and from a stock price perspective, from this impending surge in capex.
Megatheme 4: The coming of age of financial intermediation
India’s per capita income in PPP terms recently breached the $ 3K and its savings to GDP ratio stands at a healthy 32%. Cross country experience suggests that India’s savings ratio should touch ~40% in FY15(see Exhibit E on the left) and will continue to rise until India’s per capita income reaches $ 8 K (in PPP terms) and will max out only at 46%. The disproportionate rise in the quantum of India’s savings over the next decade heralds tremendous opportunities for financial intermediaries as the Indian saver looks to channelize these savings into not just bank accounts but into stocks and bonds as well.
Megatheme 5: India will become a hotbed of conflicts
Whilst the ongoing and widespread conflict in central India between the Indian establishment and Maoists generates headlines, we see a broader theme in these stray instances of conflict and expect their intensity to trend upwards over the next decade as inequalities persist.
As corroborated by cross country experience, the unequal distribution of gains of economic development across social groups and individuals will be the main driver of this trend (see Exhibit F on the left). A vast and stratified populace with a youth bulge will add to the conflict risk.
The escalation of the Maoist movement, indisputably the biggest threat to internal security will pose challenges for the Metal and Mining Sector (refer to Exhibit 59 on pg 36 for details of company-level exposure to Maoism). Security costs for the corporate sector as a whole will rise as crime rates and the frequency of conflict trends upwards. Indirect costs in terms of political donations, bribes and CSR initiatives will be the other head under which costs will rise. Additionally, the corporate sector will continue to partially fund the Government’s fiscal transfers directed at rural India. FMCG and aspirational product companies stand to gain from these transfer payments.
Megatheme 1: Structurally high inflation
Supply constraints in India’s manufacturing sector have historically caused core inflation to spike every time the economy expands rapidly (see Exhibit A on the left). Limited access to finance, hard infrastructure deficits and labour market issues have and will prevent timely supply responses in this demand powerhouse thus driving manufacturing inflation higher. Furthermore, a growing and young population with rising incomes will cause food demand to grow rapidly, while supply responses continue to be weak. This supply-demand mismatch will drive food prices higher over the next decade.
High inflation has historically been a negative for stock market returns (see Exhibit B on the left) as it crunches companies’ margins through higher input costs. Financial services’ companies emerge as being the most inflation-immune due to their limited exposure to employee costs as well as to raw material costs. Commodity-driven sectors emerge as an obvious hedge against higher commodities’ prices. IT and other labour-intensive export-facing sectors appear to be the most vulnerable to high inflation as higher domestic wages erode their price competitiveness.
Megatheme 2: the rise of the “aspirational” consumer
As a country’s per capita incomes rise, the consumption basket of its citizens changes away from food (see Exhibit C on the left) and essentials to non-food and aspirational items (such as cosmetics, motorbikes and jewellery). India’s consumption basket has been undergoing just this sort of change. Given the structural drivers of this trend (rising incomes, high share of youth and urbanisation), investors should focus on aspirational product manufacturers vis-Ã -vis essentials within India’s broader consumption story. Exhibit 25 on pg19 gives a list of aspirational stocks. Exhibit 23 & 24 on pg 19 show the outperformance of aspirational stock vis-Ã -vis consumer essentials.
Megatheme 3: a capex boom in the making
The experience of India’s Asian neighbours suggests that a high GDP growth rate coupled with the investment:GDP ratio hitting 33% triggers a surge in capex (see Exhibit D below). These trigger points along with India’s infrastructure deficit and the Government’s desire to address this deficit has set the scene for a seven year surge in capex. History suggests that the Indian Capital Goods sector stands to gain most, both from profitability and from a stock price perspective, from this impending surge in capex.
Megatheme 4: The coming of age of financial intermediation
India’s per capita income in PPP terms recently breached the $ 3K and its savings to GDP ratio stands at a healthy 32%. Cross country experience suggests that India’s savings ratio should touch ~40% in FY15(see Exhibit E on the left) and will continue to rise until India’s per capita income reaches $ 8 K (in PPP terms) and will max out only at 46%. The disproportionate rise in the quantum of India’s savings over the next decade heralds tremendous opportunities for financial intermediaries as the Indian saver looks to channelize these savings into not just bank accounts but into stocks and bonds as well.
Megatheme 5: India will become a hotbed of conflicts
Whilst the ongoing and widespread conflict in central India between the Indian establishment and Maoists generates headlines, we see a broader theme in these stray instances of conflict and expect their intensity to trend upwards over the next decade as inequalities persist.
As corroborated by cross country experience, the unequal distribution of gains of economic development across social groups and individuals will be the main driver of this trend (see Exhibit F on the left). A vast and stratified populace with a youth bulge will add to the conflict risk.
The escalation of the Maoist movement, indisputably the biggest threat to internal security will pose challenges for the Metal and Mining Sector (refer to Exhibit 59 on pg 36 for details of company-level exposure to Maoism). Security costs for the corporate sector as a whole will rise as crime rates and the frequency of conflict trends upwards. Indirect costs in terms of political donations, bribes and CSR initiatives will be the other head under which costs will rise. Additionally, the corporate sector will continue to partially fund the Government’s fiscal transfers directed at rural India. FMCG and aspirational product companies stand to gain from these transfer payments.
Wednesday, November 17, 2010
The Pot Again Calls The Kettle Red Republicans Democrats The Fed and QE2
Some conservatives are attacking current U.S. monetary policy as being too expansionary, as likely to lead to excessive inflation and debauchment of the currency. The Weekly Standard is promoting a letter to Fed Chairman Ben Bernanke that urges a reversal of its policy of QE2, its new round of monetary easing. The letter is signed by a list of conservatives, most of whom are well-known Republican economists, some associated with political candidates. Apparently the driving force is David Malpass, who was an official in the Reagan Treasury, and he is taking out newspaper ads later this week. This follows similar attacks on the Fed by politicians Sarah Palin, Mike Pence, and Paul Ryan.
If the National Journal, Wall Street Journal and Politico are right that the Republicans are trying to stake out a position that Democrats are pursuing inflationary monetary policy, they are on shaky ground. I will leave it to others to make the important point of substance: the risk of excessive inflation is low now compared to the risk of an alarming Japan-style deflation, with the economy having only begun to recover from its nadir of early 2009. Or to acknowledge that Quantitative Easing is only a second best policy response to high unemployment. (Fiscal policy would be much more likely to succeed at this task, if it were not for the constraints in Congress.)
I will, rather, respond to the political component of the National Journal’s question by pointing out some insufficiently understood history:
1.Republican President Nixon successfully pushed Fed Chairman Arthur Burns into an excessively easy monetary policy in the early 1970s — leading to high inflation which the White House tried to address with wage-price controls. Nixon, of course, also devalued the dollar, and took it off gold, thereby ending the Bretton Woods system.
2.Republican Presidents Ronald Reagan and George H.W. Bush tried aggressively to push Fed Chairmen Paul Volcker and Alan Greenspan into easier monetary policy, especially in election years. This is documented in Bob Woodward’s 2000 book Maestro. The White House succeeded in making life unpleasant enough for inflation-slayer Volcker that he eventually declined to be reappointed, prompting James Baker to exult “We got the son of a bitch!” (p.24).
3.Democratic Presidents Jimmy Carter and Bill Clinton are the two presidents in the last four decades who have refrained from pushing their Fed Chairmen (Volcker and Greenspan, respectively) into inflationary monetary policy.
4.Under Republican President G.W.Bush, monetary policy once again became excessively easy, during 2003-06, contributing substantially to the housing bubble and subsequent crash.
Thus if the other party were to accuse Democrats of pursuing excessively inflationary monetary policy, it would be akin to them accusing Democrats of pursuing excessively expansionary fiscal policy. Perhaps such accusations will strike some who don’t pay close attention as superficially plausible, even after all these years. But they nonetheless fly in the face of history. Another case of the pot calling the kettle “red.” Yes, I know, the usual saying is about the color black. But red is the color of deficits, overheating, … and Republicans.
If the National Journal, Wall Street Journal and Politico are right that the Republicans are trying to stake out a position that Democrats are pursuing inflationary monetary policy, they are on shaky ground. I will leave it to others to make the important point of substance: the risk of excessive inflation is low now compared to the risk of an alarming Japan-style deflation, with the economy having only begun to recover from its nadir of early 2009. Or to acknowledge that Quantitative Easing is only a second best policy response to high unemployment. (Fiscal policy would be much more likely to succeed at this task, if it were not for the constraints in Congress.)
I will, rather, respond to the political component of the National Journal’s question by pointing out some insufficiently understood history:
1.Republican President Nixon successfully pushed Fed Chairman Arthur Burns into an excessively easy monetary policy in the early 1970s — leading to high inflation which the White House tried to address with wage-price controls. Nixon, of course, also devalued the dollar, and took it off gold, thereby ending the Bretton Woods system.
2.Republican Presidents Ronald Reagan and George H.W. Bush tried aggressively to push Fed Chairmen Paul Volcker and Alan Greenspan into easier monetary policy, especially in election years. This is documented in Bob Woodward’s 2000 book Maestro. The White House succeeded in making life unpleasant enough for inflation-slayer Volcker that he eventually declined to be reappointed, prompting James Baker to exult “We got the son of a bitch!” (p.24).
3.Democratic Presidents Jimmy Carter and Bill Clinton are the two presidents in the last four decades who have refrained from pushing their Fed Chairmen (Volcker and Greenspan, respectively) into inflationary monetary policy.
4.Under Republican President G.W.Bush, monetary policy once again became excessively easy, during 2003-06, contributing substantially to the housing bubble and subsequent crash.
Thus if the other party were to accuse Democrats of pursuing excessively inflationary monetary policy, it would be akin to them accusing Democrats of pursuing excessively expansionary fiscal policy. Perhaps such accusations will strike some who don’t pay close attention as superficially plausible, even after all these years. But they nonetheless fly in the face of history. Another case of the pot calling the kettle “red.” Yes, I know, the usual saying is about the color black. But red is the color of deficits, overheating, … and Republicans.
Tuesday, November 16, 2010
Lessons I learned in my trading days
Having read Liz'a article, made me think about lessons I learned in my trading days.
1. Hedge fund is all about risk control, which includes counter trend protection and margin management, without that, you will see yourself in square one some time in next twenty years.
2. Never, ever read commentators, just remember, they don't have to make a living by writing market comments if they know how to invest/trade.
3. Do follow Pundits, do subscribe Barron's, if you have money, subscribe value line, that two will keep you occupied for your reading time. Take the most bullish call from prime bearish pundits, and take the most bearish call from prime bullish pundits. You won't make much mistake following that.
4. Discipline, discipline, discipline.
5. After a dear friend of mine calls me "worry bug", I realized the true reason I quit trading: No Guts and worry too much!
1. Hedge fund is all about risk control, which includes counter trend protection and margin management, without that, you will see yourself in square one some time in next twenty years.
2. Never, ever read commentators, just remember, they don't have to make a living by writing market comments if they know how to invest/trade.
3. Do follow Pundits, do subscribe Barron's, if you have money, subscribe value line, that two will keep you occupied for your reading time. Take the most bullish call from prime bearish pundits, and take the most bearish call from prime bullish pundits. You won't make much mistake following that.
4. Discipline, discipline, discipline.
5. After a dear friend of mine calls me "worry bug", I realized the true reason I quit trading: No Guts and worry too much!
The Biggest Lesson I Learned from Running a Hedge Fund
In the late 90s, I ran a hedge fund.
Correction—I was the CEO for the hedge fund, responsible for marketing the fund and growing the business. I was not the portfolio manager and I had no responsibility for buying and selling the investments.
Despite that fact, and despite the fact that our fund followed a long term “buy and hold” strategy where we committed to selling less than a quarter of the investments each year and aspired to keep portfolio turnover below 10%, I had CNBC on constantly—watching the latest market news, obsessed with how stock price changes impacted the value of our portfolio.
I look back now and wish I could get those hours back. I wonder how much more effective I would have been if I shut the TV off and redirected my attention to things that really mattered, where I had some degree of control over the outcome.
Would I have been a better, wiser, more balanced leader if I calmly accepted that the value of our portfolio would change constantly—sometimes randomly—based on rumors, large trades, and missed “whisper numbers” (what the “street” thinks the earnings will be despite the fact that the management team estimated lower—a strange game of poker where you think you know the cards better than the person holding them)? I think so.
One of our investors said it best when I asked why he never called me when the market was down as most of our other investors did. “What does the value of the Dow on Tuesday at 10:58 AM have to do with my long-term financial goals? Absolutely nothing.”
Here’s what I (eventually) learned:
The daily stock market news is just noise. Distracting, disconcerting, and to the extent you act on this information rashly, it can be deadly from a financial perspective. (Fortunately I didn’t have trading authority so this didn’t happen with our fund, but it happens every moment of every day to individual investors.)
Investing in stocks is investing in a business. What CEO or business owner calculates the book value of the company on a daily basis? It would be a complete waste of time. The CEO or business owner focuses their time on building the business, studying the industry and the competition. So why would investors care about the daily price? It is very misleading. The daily stock market news cycle is partly to blame for the short-term focus.
Even respected business journalist Maria Bartiromo, who gained fame by reporting on the floor of the New York Stock Exchange, states that investing for the long term is the best way to create wealth, and that watching reports such as the ones she gave for years makes little difference. Gary Belsky, former financial journalist and author of Why Smart People Make Big Money Mistakes and How to Correct Them, told us that he left financial reporting to become an editor at ESPN because once he understood behavioral finance he no longer felt right about reporting on the daily or even monthly goings-on in the market.
Here are three ideas on where to redirect your attention:
Watch the news, not the market.
Keeping up on general economic trends as well as industry news on the investments you own is a much better place to spend your time than watching the 24-hour news cycle. As an investor, I have always been interested in how business leaders think. To me, learning about their leadership style and focusing on where they can grow the business is what is important. The information gathered from watching industry and company specific news is much more valuable in making investment decisions than watching an endless stream of ticker symbols.
Don’t follow the herd.
The average investor gets in at the wrong time and, of course, follows that with selling at the wrong time. In fact, there used to be a popular indicator of when to buy and sell called the “odd lot” theory. The premise was that small investors who normally trade in small amounts of less than 100 shares often made poor investment decisions. Today, small investors generally trade in mutual funds, but this theory is very telling as you’ll see in the next point. Remember the herd is watching the same cable TV program you are.
Buy and hold – don’t time the market.
According to a Dalbar study, access to market information may actually hurt the returns of the individual investor. You would think with more information investors would have better returns and beat the market, but that was not the case. According to the study, which covered the 20-year period from 1988-2007, the S&P 500 had annualized returns of 11.81%, while investment-grade bonds returned 7.56%. The average equity fund investor had returns of only 4.48% — worse than Treasury bills which returned 4.49% annually for the same time period. The reason: Most individual investors are overly sensitive to market swings and end up buying high (feeling they need to get in the game after seeing the market rise significantly) and selling low (out of fear that the market is going to plummet further).
Investors would be better off ignoring the day-to-day market changes and studying the words of great investors like Warren Buffett, David Dreman, and Benjamin Graham. Instead of news anchors reporting the daily market quotes, I’d like to see them reporting successful financial strategies. With the poor state of financial literacy in this country, what we need is less “noise” and more helpful information that people can actually use.
Correction—I was the CEO for the hedge fund, responsible for marketing the fund and growing the business. I was not the portfolio manager and I had no responsibility for buying and selling the investments.
Despite that fact, and despite the fact that our fund followed a long term “buy and hold” strategy where we committed to selling less than a quarter of the investments each year and aspired to keep portfolio turnover below 10%, I had CNBC on constantly—watching the latest market news, obsessed with how stock price changes impacted the value of our portfolio.
I look back now and wish I could get those hours back. I wonder how much more effective I would have been if I shut the TV off and redirected my attention to things that really mattered, where I had some degree of control over the outcome.
Would I have been a better, wiser, more balanced leader if I calmly accepted that the value of our portfolio would change constantly—sometimes randomly—based on rumors, large trades, and missed “whisper numbers” (what the “street” thinks the earnings will be despite the fact that the management team estimated lower—a strange game of poker where you think you know the cards better than the person holding them)? I think so.
One of our investors said it best when I asked why he never called me when the market was down as most of our other investors did. “What does the value of the Dow on Tuesday at 10:58 AM have to do with my long-term financial goals? Absolutely nothing.”
Here’s what I (eventually) learned:
The daily stock market news is just noise. Distracting, disconcerting, and to the extent you act on this information rashly, it can be deadly from a financial perspective. (Fortunately I didn’t have trading authority so this didn’t happen with our fund, but it happens every moment of every day to individual investors.)
Investing in stocks is investing in a business. What CEO or business owner calculates the book value of the company on a daily basis? It would be a complete waste of time. The CEO or business owner focuses their time on building the business, studying the industry and the competition. So why would investors care about the daily price? It is very misleading. The daily stock market news cycle is partly to blame for the short-term focus.
Even respected business journalist Maria Bartiromo, who gained fame by reporting on the floor of the New York Stock Exchange, states that investing for the long term is the best way to create wealth, and that watching reports such as the ones she gave for years makes little difference. Gary Belsky, former financial journalist and author of Why Smart People Make Big Money Mistakes and How to Correct Them, told us that he left financial reporting to become an editor at ESPN because once he understood behavioral finance he no longer felt right about reporting on the daily or even monthly goings-on in the market.
Here are three ideas on where to redirect your attention:
Watch the news, not the market.
Keeping up on general economic trends as well as industry news on the investments you own is a much better place to spend your time than watching the 24-hour news cycle. As an investor, I have always been interested in how business leaders think. To me, learning about their leadership style and focusing on where they can grow the business is what is important. The information gathered from watching industry and company specific news is much more valuable in making investment decisions than watching an endless stream of ticker symbols.
Don’t follow the herd.
The average investor gets in at the wrong time and, of course, follows that with selling at the wrong time. In fact, there used to be a popular indicator of when to buy and sell called the “odd lot” theory. The premise was that small investors who normally trade in small amounts of less than 100 shares often made poor investment decisions. Today, small investors generally trade in mutual funds, but this theory is very telling as you’ll see in the next point. Remember the herd is watching the same cable TV program you are.
Buy and hold – don’t time the market.
According to a Dalbar study, access to market information may actually hurt the returns of the individual investor. You would think with more information investors would have better returns and beat the market, but that was not the case. According to the study, which covered the 20-year period from 1988-2007, the S&P 500 had annualized returns of 11.81%, while investment-grade bonds returned 7.56%. The average equity fund investor had returns of only 4.48% — worse than Treasury bills which returned 4.49% annually for the same time period. The reason: Most individual investors are overly sensitive to market swings and end up buying high (feeling they need to get in the game after seeing the market rise significantly) and selling low (out of fear that the market is going to plummet further).
Investors would be better off ignoring the day-to-day market changes and studying the words of great investors like Warren Buffett, David Dreman, and Benjamin Graham. Instead of news anchors reporting the daily market quotes, I’d like to see them reporting successful financial strategies. With the poor state of financial literacy in this country, what we need is less “noise” and more helpful information that people can actually use.
Marc Faber: The Developing World Should Be Thanking Bernanke, Not Yelling At Him
Notes: I received many emails asking why I like Marc Faber so much. as he is so dark, so bearish, so crazy. I agree he is but he is also extremely talented. As a prime bear, the first thing Marc says is always the same: I am ultra bearish on everything. It is the same as we say: in the end, we all die. To read Marc, you should skip all bearish comments and only pick his action calls, which 90% are mid term correct. He has been calling for bond to dip for a while and I do agree it's going down hill.
Marc Faber spoke to CNBC this morning about U.S. monetary policy decisions and the threat of an emerging markets bubble. He was joined by Frank Berlarge of Multilateral Partners Global Advisory Group.
0:30 Faber: The cause of the crisis is excessive monetary growth leading to excessive debt growth to the NASDAQ bubble to the housing bubble to over consumption in the U.S. A symptom of overconsumption is a trade deficit, which then exports production overseas.
1:20 Faber: The developing world should send a thank-you note to Mr. Bernanke.
Frank Berlarge of Multilateral Partners Global Advisory Group talks about the importance of foreign inflows to the U.S….
3:35 Faber:A dream to think the U.S. can double its exports in the manufacturing sector, but the U.S. can export more in the agricultural sector.
Berlarge then argues that the U.S. can grow its exports; doesn't see a doubling without tax policy.
5:15 Faber: Criticism from emerging economies towards the Fed is all about worries over bubbles forming "too much of a good thing." When those currencies deflate, people jump in, and asset prices surge. The excess liquidity is running into emerging economies and precious metals.
Berlarge talks about how we're not going to be get out of this mess without inflation, and Bernanke is acting as a janitor, cleaning up the mess. The threat is to the banking industry, and that's why he's trying to prop up housing markets.
Marc Faber spoke to CNBC this morning about U.S. monetary policy decisions and the threat of an emerging markets bubble. He was joined by Frank Berlarge of Multilateral Partners Global Advisory Group.
0:30 Faber: The cause of the crisis is excessive monetary growth leading to excessive debt growth to the NASDAQ bubble to the housing bubble to over consumption in the U.S. A symptom of overconsumption is a trade deficit, which then exports production overseas.
1:20 Faber: The developing world should send a thank-you note to Mr. Bernanke.
Frank Berlarge of Multilateral Partners Global Advisory Group talks about the importance of foreign inflows to the U.S….
3:35 Faber:A dream to think the U.S. can double its exports in the manufacturing sector, but the U.S. can export more in the agricultural sector.
Berlarge then argues that the U.S. can grow its exports; doesn't see a doubling without tax policy.
5:15 Faber: Criticism from emerging economies towards the Fed is all about worries over bubbles forming "too much of a good thing." When those currencies deflate, people jump in, and asset prices surge. The excess liquidity is running into emerging economies and precious metals.
Berlarge talks about how we're not going to be get out of this mess without inflation, and Bernanke is acting as a janitor, cleaning up the mess. The threat is to the banking industry, and that's why he's trying to prop up housing markets.
Sunday, November 14, 2010
Long Term Stock Market Cycle: Where Are We Now?
This morning, Market Folly's quote of week focused on wisdom from value investor Joel Greenblatt. A few sentences in particular stuck out where Greenblatt says:
"Over the long term, despite significant drops from time to time, stocks (especially an intelligently selected stock portfolio) will be one of your best investment options. The trick is to GET to the long term. Think in terms of 5 years, 10 years and longer."
Given his commentary, the chart below is a perfect illustration of "the long term." This chart, courtesy of DecisionPoint (via Cynical Advisor) depicts how the stock market has traded in 16-18 year bull/bear cycles ever since 1932.
Currently, the market appears to be in the bear cycle where it essentially chops sideways via wild oscillations every few years. By the chart's calculations, this means the market will be stuck in its current cycle for another 5-7 years before entering another bull cycle. This of course assumes the current trend of alternating cycles remains in tact. Focusing on the drawn-in trendline, a break below the level of 500 on the S&P would obviously be quite a negative signal jeopardizing the multi-decade trend.
In the end, this chart simply illustrates Greenblatt's notion of "long term." In a day and age when everyone is so focused on short-term performance, hopefully this forces you to take a step back and examine things from a multi-decade perspective. While the current trend is choppy to say the least, the long term trend is most definitely up. The problem for most investors though is the lack of ability to remain on course. Whether it be poor market timing or succumbing to emotion, investors have time and time again found a way to deviate offtrack.
"Over the long term, despite significant drops from time to time, stocks (especially an intelligently selected stock portfolio) will be one of your best investment options. The trick is to GET to the long term. Think in terms of 5 years, 10 years and longer."
Given his commentary, the chart below is a perfect illustration of "the long term." This chart, courtesy of DecisionPoint (via Cynical Advisor) depicts how the stock market has traded in 16-18 year bull/bear cycles ever since 1932.
Currently, the market appears to be in the bear cycle where it essentially chops sideways via wild oscillations every few years. By the chart's calculations, this means the market will be stuck in its current cycle for another 5-7 years before entering another bull cycle. This of course assumes the current trend of alternating cycles remains in tact. Focusing on the drawn-in trendline, a break below the level of 500 on the S&P would obviously be quite a negative signal jeopardizing the multi-decade trend.
In the end, this chart simply illustrates Greenblatt's notion of "long term." In a day and age when everyone is so focused on short-term performance, hopefully this forces you to take a step back and examine things from a multi-decade perspective. While the current trend is choppy to say the least, the long term trend is most definitely up. The problem for most investors though is the lack of ability to remain on course. Whether it be poor market timing or succumbing to emotion, investors have time and time again found a way to deviate offtrack.
Saturday, November 13, 2010
Interview With The Mad Hedge Fund Trader
Here's a recent interview Ilene from Phil's Stock World recently did with the Mad Hedge Fund Trader. Enjoy:
Mad Hedge Fund Trader began his career in finance by moving to Japan and working at Dai Nana Securities as a research analyst in 1974. In 1976 he was named the Tokyo correspondent for The Economist magazine and the Financial Times, which then shared an office. He traveled the world interviewing famous people, such as Ronald Reagan and Margaret Thatcher. In 1982, he was named the US editor of Euromoney magazine, and in 1983 he built a new division in international equities for Morgan Stanley. After moving to London in 1985, Mad Hedge supervised sales and trading in Japanese equity derivatives. In 1989, he became a director of the Swiss Bank Corp, responsible for Japanese equity derivatives. A year later, he set up an international hedge fund which he sold in 1999.
I haven’t even covered all of Mad Hedge’s adventures, such as his latent movie star career (as an extra in the 1979 epic war film, Apocalypse Now), and who knows what else. But now, missing the adrenaline-surging excitement of active trading, Mad Hedge has returned to the hedge fund business, set up an educational website, and is busy keeping up with the demands of newsletter writing.. So let’s begin our interview with Mad Hedge by exploring his current thoughts on the markets.
Interview
Ilene: Hi Mad Hedge. You’ve had a fascinating career having little to do with your major in biochemistry. A brief review of your newsletter shows that your recommendations early in 2009 have appreciated by an average of around 400%. You’ve been writing your daily market thoughts and investment strategies at your website - www.madhedgefundtrader.com - which it’s terrific, by the way. What are your goals with this site?
Mad Hedge: This whole thing started out as a letter to investors in my hedge fund, to tell them my thinking behind my positions. Then I thought, why not post this on the web and see what happens? Six months later it is now going out to 50,000 readers a day, mostly to portfolio managers, financial advisors, and traders. The growth has been explosive.
Ilene: Who are your readers?
I seemed to have stumbled on a market that I describe as “semi-professionals.” If you are a big hedge fund, with a staff of 600 and a huge in-house research department, I’m not going to tell you anything you don’t already know. But there appear to be a few million people out there who trade their own accounts, or invest their own IRA’s. They have never worked on Wall Street, but have taught themselves a lot about markets and investing. My letter gives them the 30,000 foot view on global stock, bond, currency, commodity, and real estate markets which they can’t find at their online broker. About half of them are from abroad. When I get up in the morning now, there are five e-mails waiting for me from China and India asking what to do about natural gas. I also try to make the letter funny and entertaining. Not all financial publications have to be dreary reading. It’s not always about the next stock to buy.
Ilene: In a recent letter you wrote that one of your favorite ETF’s is the Proshares Ultra Short Treasury Trust (TBT). Why is that?
Mad Hedge: TBT is a 200% leveraged bet that long Treasury bonds will go down. While the Fed keeps short rates low, it doesn’t directly control long rates. As the supply of government bonds increases exponentially, their eventual collapse is inevitable. All Ponzi schemes must come to an end, and the US government is no exception. We currently have the greatest liquidity driven market of all time, and the ten year is eking out a mere 3.30% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%. If the yield goes back to 5%, that will take the TBT from $45 to $70. The TBT could perform even better if Treasuries lose their triple “A” rating, which I think is a real possibility.
Historically, bonds are not a good buy in a low interest rate, deflationary environment. If long rates move from 3% back to the 12% we saw in the early eighties, bond holders will get slaughtered, and the TBT could exceed $200. Even if inflation stays low, the sheer weight of supply and credit concerns will crater government bond prices.
Ilene: What’s the worst case scenario for the bond market?
Mad Hedge: Debt service is currently 11% of the budget. If interest rates rise sharply, that could double to 22%. Then you get a downward spiral like you saw in Latin America in the eighties, when higher debt service creates more borrowing, and more borrowing creates a higher debt service, until the whole thing blows up. At some point China, Japan, the Middle Eastern countries may stop buying our debt. There are only so many “greater fools” out there.
The only way out of this is for the economy to return to a long term 3%-4% growth rate. That’s obviously what Obama is hoping for with his programs. He’s taking big risks, but he doesn’t have much choice. He really did inherit a bad hand. If he did nothing, we’d be in a depression by now, with 25% unemployment. He understands what he’s doing and understands the risks. He has great economic advisors.
Obama couldn’t have allowed the banking system to collapse. We need banks as the economy’s lynchpin. A year ago we could have lost the entire financial system over a weekend. Ships were being turned around at sea and going back home because their letters of credit were failing. The freeze up in credit could have gone on for years.
The stock market is up 50% since Obama took office, so it likes the uneasy stability that we have now. Credit markets have recovered tremendously, and IPOs are coming to the market again. Junk bond funds are up, confidence is returning. There’s greater willingness to lend, though only at high interest rates. But it’s a big improvement over last year.
Ilene: What do you expect for mortgage rates in the next few months? Years?
Mad Hedge: You shouldn’t touch real estate, as I think it will be dead money for another decade. Rent, don’t buy. If you have to buy, then get a 30 year fixed rate mortgage now at 5%, because rates are going up a lot in the future. When I bought my first home in New York in the early eighties, I got nailed with a 17% interest rate on my mortgage. We may revisit those levels.
Houses will continue to move lower, maybe another 10% or so. We have another wave of foreclosures hitting the system soon, triggered by the option arm readjustments. I see support for prices when the cost of owning and the cost of renting are more in line. Home ownership may have to become cheaper than renting, because of perceived risk to the principle, for the real estate market sell-off to finish. However, expecting houses to drop a lot from here is like shorting Citibank at $3. We’ve basically had the big move already. Due to poor demographic factors, the demand for houses is going to take a long time to come back. While 80 million baby boomers are trying to sell their houses to 65 million gen Xer’s, don’t expect a recovery in prices, especially when the gen Xer’s are still living in your basement.
Ilene: You mentioned you missed the rally in financials, but still have concerns about the financial sector.
Mad Hedge: With financials, I knew they would rebound, but didn’t imagine the extensive move we’ve seen. It was the greatest dead cat bounce and short covering rally of all time. But the financial sector will have troubles for years. If I had to buy U.S. stocks, I’d buy big tech stocks like Microsoft (MSFT), Oracle (ORCL), Intel, (INTC) and Cisco (CSCO), because for the most part they have tons of cash and little debt. Tech stocks didn’t have the problems that were plaguing the other sectors. For example, they have no troubled assets, and no regulatory clamp down on their business. The credit crisis didn’t affect them directly because they finance their operations through cash flow and tend not to borrow. Of course, they’re hurt indirectly when the customers have credit problems.
Credit markets are now seeing a huge differentiation in terms. Lenders are much more discriminating about who they lend to. American consumers are very constrained, but foreign consumers are not as constrained. They are not returning to frugality as we are because they didn’t share our excesses in the first place. You don’t see many black Cadillac Escalades with chrome wheels in China. If I had to buy stocks, I would buy equity in foreign companies where the growth will be in the coming years. In March, you could have bought anything and had a great trade, as the rising tide lifted all boats. But stocks in emerging markets outperformed US stocks by over a two to one margin.
Ilene: Would you be buying stocks now?
Mad Hedge: No, I sold most of my positions in June. The risk was low in March, but not so low in June, and it’s even greater now. The PE multiple on the S&P 500 has just jumped from 10 to 20 in six months. Historically, a 20 multiple is a terrible time to enter the market. Markets are discounting a “V”-shaped recovery, which we are not going to get. I think we’ll get more of a “square root” shaped recovery, a “V” followed by sideways to a gradually upward sloping grind. We’ve already had the “V”. Markets are overpriced. I don’t see how we can have huge economic growth with capital-constrained banks, catatonic consumers, and commercial real estate troubles up the wazoo. One of the only positives is the weak dollar, which makes everything we sell to the rest of the world cheaper. This is good for our multi-national companies, good for our exporters. So far, the dollar is on a grinding, controlled move down, which is good. But if the dollar’s fall accelerates, it would not be good. A real dollar panic would lead to the widespread dumping of dollar assets, and commodity prices would explode. Then we’ll get to $2,000 for gold and $40 for silver very quickly.
Ilene: You spent several years wildcatting for natural gas in Texas and Colorado, which has given you a unique insight into the energy space. What are your current thoughts on natural gas and oil?
Mad Hedge: Stay away from natural gas. The volatility will kill you. If you are a masochist, then buy it only when it’s cheap, on big dips, in the $3/MBTU range. In the last three years, thanks to the new “fracting” technology used in oil shales, we have discovered a 100 year supply of natural gas sitting under the US, and the producers have not been able to cut back fast enough. So now we have a supply glut, and we are almost out of storage. This is what took us down from $13 to $2.40 in 18 months. The lack of hurricanes has not helped demand either. Producers have been cutting back like crazy, trying to balance supply and demand, with a breakeven point of $2. They need a cold winter to help bring things back into balance. If the industry gets organized, then gas can become the 20 year bridge we need, until energy alternatives kick in. That makes me a big supporter of the “Pickens Plan.”
Oil is much more interesting. It overshot to downside in January to $32. Crude is now at $70 climbing out of the recession. Imagine how high it will get when all economies are functioning again. The financial crisis hurt the ability of big oil companies to get financing for large development projects in oil. These projects can take five to ten years to bring online. That means we will get higher oil prices sooner. We may get a pull back to the $50s, but the $30’s would be a stretch. The $32 low was an artificial one caused by a complete absence of liquidity in all markets. I don’t think we’ll see those lows again.
Ilene: Where do you see the price of oil going in the distant future?
Mad Hedge: I think it may dip into the 50s, then up, perhaps skyrocketing to $300 before dropping back down to $3 after alternatives take over and demand vanishes. But that’s at best 20 years out. If we can wean ourselves off oil in 20 years, it would be a huge accomplishment.
Ilene: I noticed you speak a little about politics in your essays; do you have a leaning one way or another?
Mad Hedge: I’m politically neutral. I’m getting bashed by the right these days because I’ve said that the Republicans have no ability to affect the legislative process now. But we need to adjust our portfolios to reflect the current political realities. No matter how much you love Obama, you can’t dispute the fact that the massive issuance of government bonds he is proposing is terrible for the bond market and the dollar, but great for precious metals and commodities. Obama won by a big margin, so the Democrats will be around for a while. Of course, if my “square root” scenario doesn’t pan out, and we get a serious “W” recession instead, all bets are off. People will only give him the benefit of the doubt for so long.
Ilene: Where do you think the stock market’s going to go over the next few years?
Mad Hedge: I think there’s a 1 in 3 chance for new lows. That’s the “W” scenario. But with Lehman, Bear Stearns, Merrill Lynch, and Washington Mutual gone, we have run out of companies that can suddenly go under and trigger a new financial crisis. The big survivors are partially government owned, and of course zero interest rates help a lot. More banks are going under, but they will be smaller, regional banks with excessive exposure to commercial real estate.
Ilene: How does this affect your actions in the markets?
Mad Hedge: The best and least risky trades were in the early part of the year. Now, there’s a lot more risk in all markets. I’m neutral right now. If stocks dropped from here, I might be a buyer, but only in energy, commodities, and technology, and of course in emerging markets like Brazil, India, China, Korea, and Vietnam. Gold, silver and commodities have all had huge runs. My inner wimp has me in cash, waiting for better opportunities. I haven’t been playing the short side, because it’s a nightmare trying to short a liquidity driven market with interest rates at zero. There is no return on low risk investments now. Capital always moves to risky assets when interest rates are zero. Just look at Japan in the 1980s. There PE multiples soared from 10 to 100 purely driven by liquidity. For the last three years of that run the fundamental analysts were left twisting slowly in the wind. Artificially low interest rates boost asset prices to artificially high prices. It always ends in tears, but can play out for a while. You want to have an asymmetric risk reward metric in your favor, as we did in March of this year. Now, we don’t have that.
The next downward move in the markets will more likely be due to disappointing economic data, earning misses, etc., not due to a total collapse of the system. We may sell off, but I don’t think it will be to new lows. It’s hard to see new lows with interest rates at zero. Instead, I see the “square root” recovery scenario mentioned earlier. The market may start drifting lower as people start seeing this possibility. That might set up a trading range for the S&P 500 which could last for years, something like 800-1,200. During the nineties, Japan peaked at ¥39,000, then traded in a ¥20,000-¥25,000 range for five years, before the final collapse to ¥7,000. That’s one scenario for the US.
Ilene: You’ve had an amazing career. Let me ask you about some of the people you’ve interviewed. What was Ronald Reagan like?
Mad Hedge: Although I never agreed with him politically, you couldn’t help but like the guy. He always had a joke ready. He was a lot smarter than he let on.
Ilene: And Margaret Thatcher, the prime minister of Britain?
Mad Hedge: Her nickname as “The Iron Lady” was well deserved. She could stare holes right through you. She treated journalists like a disapproving school teacher, which of course, she was.
Ilene: How about the terrorist leader, Yassir Arafat, of the PLO?
Mad Hedge: His body guards almost shot me when I reached to turn over a cassette in my tape recorder. I always thought he was a terrible leader. That is why the Palestinians never got anywhere, and why the Israelis left him alone.
Ilene: Meeting China’s Deng Xiaoping must have been amazing.
Mad Hedge: I am 6’4” and he was only 4’9”, so of course there were plenty of opportunities for humor. I could never envision this guy going on the Long March. He had a tremendous wit. Someone asked him why China kept its borders closed, and wasn’t this an imposition on human rights. He said if he opened the borders, the surrounding countries would get flooded with people. He asked “How many Chinese do you want? 20 million? 30 million?” I also met Zhou Enlai during the Cultural Revolution. He was a brilliant man, the last man on a bell shaped curve of 500 million.
Ilene: I read somewhere that you interviewed four US Secretaries of the Treasury.
Yes, Miller Reagan, Schultz, and Brady. And I visited the French chateau of a fifth, C. Douglas Dillon. I keep a collection of dollar bills they signed.
My goal in life was always to get in the way of history, and let it run me over. It’s been an amazing life. I wouldn’t trade it for anything.
Ilene: What about Apocalypse Now?
Mad Hedge: I happened to be in town to interview Ferdinand Marcos, the president of the Philippines. If you look hard, I’m in the USO scene. Most of the other “GI’s” in that scene were European and Australian hippies rounded up from the Youth Hostels of Manila by Francis Ford Coppola’s agents. Good luck, though. I was a lot younger and thinner then.
Ilene: Thanks a lot. It’s been great talking to you.
Mad Hedge Fund Trader began his career in finance by moving to Japan and working at Dai Nana Securities as a research analyst in 1974. In 1976 he was named the Tokyo correspondent for The Economist magazine and the Financial Times, which then shared an office. He traveled the world interviewing famous people, such as Ronald Reagan and Margaret Thatcher. In 1982, he was named the US editor of Euromoney magazine, and in 1983 he built a new division in international equities for Morgan Stanley. After moving to London in 1985, Mad Hedge supervised sales and trading in Japanese equity derivatives. In 1989, he became a director of the Swiss Bank Corp, responsible for Japanese equity derivatives. A year later, he set up an international hedge fund which he sold in 1999.
I haven’t even covered all of Mad Hedge’s adventures, such as his latent movie star career (as an extra in the 1979 epic war film, Apocalypse Now), and who knows what else. But now, missing the adrenaline-surging excitement of active trading, Mad Hedge has returned to the hedge fund business, set up an educational website, and is busy keeping up with the demands of newsletter writing.. So let’s begin our interview with Mad Hedge by exploring his current thoughts on the markets.
Interview
Ilene: Hi Mad Hedge. You’ve had a fascinating career having little to do with your major in biochemistry. A brief review of your newsletter shows that your recommendations early in 2009 have appreciated by an average of around 400%. You’ve been writing your daily market thoughts and investment strategies at your website - www.madhedgefundtrader.com - which it’s terrific, by the way. What are your goals with this site?
Mad Hedge: This whole thing started out as a letter to investors in my hedge fund, to tell them my thinking behind my positions. Then I thought, why not post this on the web and see what happens? Six months later it is now going out to 50,000 readers a day, mostly to portfolio managers, financial advisors, and traders. The growth has been explosive.
Ilene: Who are your readers?
I seemed to have stumbled on a market that I describe as “semi-professionals.” If you are a big hedge fund, with a staff of 600 and a huge in-house research department, I’m not going to tell you anything you don’t already know. But there appear to be a few million people out there who trade their own accounts, or invest their own IRA’s. They have never worked on Wall Street, but have taught themselves a lot about markets and investing. My letter gives them the 30,000 foot view on global stock, bond, currency, commodity, and real estate markets which they can’t find at their online broker. About half of them are from abroad. When I get up in the morning now, there are five e-mails waiting for me from China and India asking what to do about natural gas. I also try to make the letter funny and entertaining. Not all financial publications have to be dreary reading. It’s not always about the next stock to buy.
Ilene: In a recent letter you wrote that one of your favorite ETF’s is the Proshares Ultra Short Treasury Trust (TBT). Why is that?
Mad Hedge: TBT is a 200% leveraged bet that long Treasury bonds will go down. While the Fed keeps short rates low, it doesn’t directly control long rates. As the supply of government bonds increases exponentially, their eventual collapse is inevitable. All Ponzi schemes must come to an end, and the US government is no exception. We currently have the greatest liquidity driven market of all time, and the ten year is eking out a mere 3.30% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%. If the yield goes back to 5%, that will take the TBT from $45 to $70. The TBT could perform even better if Treasuries lose their triple “A” rating, which I think is a real possibility.
Historically, bonds are not a good buy in a low interest rate, deflationary environment. If long rates move from 3% back to the 12% we saw in the early eighties, bond holders will get slaughtered, and the TBT could exceed $200. Even if inflation stays low, the sheer weight of supply and credit concerns will crater government bond prices.
Ilene: What’s the worst case scenario for the bond market?
Mad Hedge: Debt service is currently 11% of the budget. If interest rates rise sharply, that could double to 22%. Then you get a downward spiral like you saw in Latin America in the eighties, when higher debt service creates more borrowing, and more borrowing creates a higher debt service, until the whole thing blows up. At some point China, Japan, the Middle Eastern countries may stop buying our debt. There are only so many “greater fools” out there.
The only way out of this is for the economy to return to a long term 3%-4% growth rate. That’s obviously what Obama is hoping for with his programs. He’s taking big risks, but he doesn’t have much choice. He really did inherit a bad hand. If he did nothing, we’d be in a depression by now, with 25% unemployment. He understands what he’s doing and understands the risks. He has great economic advisors.
Obama couldn’t have allowed the banking system to collapse. We need banks as the economy’s lynchpin. A year ago we could have lost the entire financial system over a weekend. Ships were being turned around at sea and going back home because their letters of credit were failing. The freeze up in credit could have gone on for years.
The stock market is up 50% since Obama took office, so it likes the uneasy stability that we have now. Credit markets have recovered tremendously, and IPOs are coming to the market again. Junk bond funds are up, confidence is returning. There’s greater willingness to lend, though only at high interest rates. But it’s a big improvement over last year.
Ilene: What do you expect for mortgage rates in the next few months? Years?
Mad Hedge: You shouldn’t touch real estate, as I think it will be dead money for another decade. Rent, don’t buy. If you have to buy, then get a 30 year fixed rate mortgage now at 5%, because rates are going up a lot in the future. When I bought my first home in New York in the early eighties, I got nailed with a 17% interest rate on my mortgage. We may revisit those levels.
Houses will continue to move lower, maybe another 10% or so. We have another wave of foreclosures hitting the system soon, triggered by the option arm readjustments. I see support for prices when the cost of owning and the cost of renting are more in line. Home ownership may have to become cheaper than renting, because of perceived risk to the principle, for the real estate market sell-off to finish. However, expecting houses to drop a lot from here is like shorting Citibank at $3. We’ve basically had the big move already. Due to poor demographic factors, the demand for houses is going to take a long time to come back. While 80 million baby boomers are trying to sell their houses to 65 million gen Xer’s, don’t expect a recovery in prices, especially when the gen Xer’s are still living in your basement.
Ilene: You mentioned you missed the rally in financials, but still have concerns about the financial sector.
Mad Hedge: With financials, I knew they would rebound, but didn’t imagine the extensive move we’ve seen. It was the greatest dead cat bounce and short covering rally of all time. But the financial sector will have troubles for years. If I had to buy U.S. stocks, I’d buy big tech stocks like Microsoft (MSFT), Oracle (ORCL), Intel, (INTC) and Cisco (CSCO), because for the most part they have tons of cash and little debt. Tech stocks didn’t have the problems that were plaguing the other sectors. For example, they have no troubled assets, and no regulatory clamp down on their business. The credit crisis didn’t affect them directly because they finance their operations through cash flow and tend not to borrow. Of course, they’re hurt indirectly when the customers have credit problems.
Credit markets are now seeing a huge differentiation in terms. Lenders are much more discriminating about who they lend to. American consumers are very constrained, but foreign consumers are not as constrained. They are not returning to frugality as we are because they didn’t share our excesses in the first place. You don’t see many black Cadillac Escalades with chrome wheels in China. If I had to buy stocks, I would buy equity in foreign companies where the growth will be in the coming years. In March, you could have bought anything and had a great trade, as the rising tide lifted all boats. But stocks in emerging markets outperformed US stocks by over a two to one margin.
Ilene: Would you be buying stocks now?
Mad Hedge: No, I sold most of my positions in June. The risk was low in March, but not so low in June, and it’s even greater now. The PE multiple on the S&P 500 has just jumped from 10 to 20 in six months. Historically, a 20 multiple is a terrible time to enter the market. Markets are discounting a “V”-shaped recovery, which we are not going to get. I think we’ll get more of a “square root” shaped recovery, a “V” followed by sideways to a gradually upward sloping grind. We’ve already had the “V”. Markets are overpriced. I don’t see how we can have huge economic growth with capital-constrained banks, catatonic consumers, and commercial real estate troubles up the wazoo. One of the only positives is the weak dollar, which makes everything we sell to the rest of the world cheaper. This is good for our multi-national companies, good for our exporters. So far, the dollar is on a grinding, controlled move down, which is good. But if the dollar’s fall accelerates, it would not be good. A real dollar panic would lead to the widespread dumping of dollar assets, and commodity prices would explode. Then we’ll get to $2,000 for gold and $40 for silver very quickly.
Ilene: You spent several years wildcatting for natural gas in Texas and Colorado, which has given you a unique insight into the energy space. What are your current thoughts on natural gas and oil?
Mad Hedge: Stay away from natural gas. The volatility will kill you. If you are a masochist, then buy it only when it’s cheap, on big dips, in the $3/MBTU range. In the last three years, thanks to the new “fracting” technology used in oil shales, we have discovered a 100 year supply of natural gas sitting under the US, and the producers have not been able to cut back fast enough. So now we have a supply glut, and we are almost out of storage. This is what took us down from $13 to $2.40 in 18 months. The lack of hurricanes has not helped demand either. Producers have been cutting back like crazy, trying to balance supply and demand, with a breakeven point of $2. They need a cold winter to help bring things back into balance. If the industry gets organized, then gas can become the 20 year bridge we need, until energy alternatives kick in. That makes me a big supporter of the “Pickens Plan.”
Oil is much more interesting. It overshot to downside in January to $32. Crude is now at $70 climbing out of the recession. Imagine how high it will get when all economies are functioning again. The financial crisis hurt the ability of big oil companies to get financing for large development projects in oil. These projects can take five to ten years to bring online. That means we will get higher oil prices sooner. We may get a pull back to the $50s, but the $30’s would be a stretch. The $32 low was an artificial one caused by a complete absence of liquidity in all markets. I don’t think we’ll see those lows again.
Ilene: Where do you see the price of oil going in the distant future?
Mad Hedge: I think it may dip into the 50s, then up, perhaps skyrocketing to $300 before dropping back down to $3 after alternatives take over and demand vanishes. But that’s at best 20 years out. If we can wean ourselves off oil in 20 years, it would be a huge accomplishment.
Ilene: I noticed you speak a little about politics in your essays; do you have a leaning one way or another?
Mad Hedge: I’m politically neutral. I’m getting bashed by the right these days because I’ve said that the Republicans have no ability to affect the legislative process now. But we need to adjust our portfolios to reflect the current political realities. No matter how much you love Obama, you can’t dispute the fact that the massive issuance of government bonds he is proposing is terrible for the bond market and the dollar, but great for precious metals and commodities. Obama won by a big margin, so the Democrats will be around for a while. Of course, if my “square root” scenario doesn’t pan out, and we get a serious “W” recession instead, all bets are off. People will only give him the benefit of the doubt for so long.
Ilene: Where do you think the stock market’s going to go over the next few years?
Mad Hedge: I think there’s a 1 in 3 chance for new lows. That’s the “W” scenario. But with Lehman, Bear Stearns, Merrill Lynch, and Washington Mutual gone, we have run out of companies that can suddenly go under and trigger a new financial crisis. The big survivors are partially government owned, and of course zero interest rates help a lot. More banks are going under, but they will be smaller, regional banks with excessive exposure to commercial real estate.
Ilene: How does this affect your actions in the markets?
Mad Hedge: The best and least risky trades were in the early part of the year. Now, there’s a lot more risk in all markets. I’m neutral right now. If stocks dropped from here, I might be a buyer, but only in energy, commodities, and technology, and of course in emerging markets like Brazil, India, China, Korea, and Vietnam. Gold, silver and commodities have all had huge runs. My inner wimp has me in cash, waiting for better opportunities. I haven’t been playing the short side, because it’s a nightmare trying to short a liquidity driven market with interest rates at zero. There is no return on low risk investments now. Capital always moves to risky assets when interest rates are zero. Just look at Japan in the 1980s. There PE multiples soared from 10 to 100 purely driven by liquidity. For the last three years of that run the fundamental analysts were left twisting slowly in the wind. Artificially low interest rates boost asset prices to artificially high prices. It always ends in tears, but can play out for a while. You want to have an asymmetric risk reward metric in your favor, as we did in March of this year. Now, we don’t have that.
The next downward move in the markets will more likely be due to disappointing economic data, earning misses, etc., not due to a total collapse of the system. We may sell off, but I don’t think it will be to new lows. It’s hard to see new lows with interest rates at zero. Instead, I see the “square root” recovery scenario mentioned earlier. The market may start drifting lower as people start seeing this possibility. That might set up a trading range for the S&P 500 which could last for years, something like 800-1,200. During the nineties, Japan peaked at ¥39,000, then traded in a ¥20,000-¥25,000 range for five years, before the final collapse to ¥7,000. That’s one scenario for the US.
Ilene: You’ve had an amazing career. Let me ask you about some of the people you’ve interviewed. What was Ronald Reagan like?
Mad Hedge: Although I never agreed with him politically, you couldn’t help but like the guy. He always had a joke ready. He was a lot smarter than he let on.
Ilene: And Margaret Thatcher, the prime minister of Britain?
Mad Hedge: Her nickname as “The Iron Lady” was well deserved. She could stare holes right through you. She treated journalists like a disapproving school teacher, which of course, she was.
Ilene: How about the terrorist leader, Yassir Arafat, of the PLO?
Mad Hedge: His body guards almost shot me when I reached to turn over a cassette in my tape recorder. I always thought he was a terrible leader. That is why the Palestinians never got anywhere, and why the Israelis left him alone.
Ilene: Meeting China’s Deng Xiaoping must have been amazing.
Mad Hedge: I am 6’4” and he was only 4’9”, so of course there were plenty of opportunities for humor. I could never envision this guy going on the Long March. He had a tremendous wit. Someone asked him why China kept its borders closed, and wasn’t this an imposition on human rights. He said if he opened the borders, the surrounding countries would get flooded with people. He asked “How many Chinese do you want? 20 million? 30 million?” I also met Zhou Enlai during the Cultural Revolution. He was a brilliant man, the last man on a bell shaped curve of 500 million.
Ilene: I read somewhere that you interviewed four US Secretaries of the Treasury.
Yes, Miller Reagan, Schultz, and Brady. And I visited the French chateau of a fifth, C. Douglas Dillon. I keep a collection of dollar bills they signed.
My goal in life was always to get in the way of history, and let it run me over. It’s been an amazing life. I wouldn’t trade it for anything.
Ilene: What about Apocalypse Now?
Mad Hedge: I happened to be in town to interview Ferdinand Marcos, the president of the Philippines. If you look hard, I’m in the USO scene. Most of the other “GI’s” in that scene were European and Australian hippies rounded up from the Youth Hostels of Manila by Francis Ford Coppola’s agents. Good luck, though. I was a lot younger and thinner then.
Ilene: Thanks a lot. It’s been great talking to you.
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