Overrated

I was a Duke student before Coach K came on board. Duke basketball was a big deal on campus then, but its aura was very different.  We weren’t remotely a juggernaut or a national name.  In fact, within just a 25-mile radius, we were well behind both UNC and NC State in terms of basketball history and regard.  But we were very good fans, filling the seats and supporting our team.  We were aggressive too.  Our shtick was not just to be loud and intimidating but also to try to be funny and snide so as to unnerve our opponents.  Sometimes we were even offensive. Imagine that.

We invented the “Airball!” chant in 1979 for an opponent’s shot that misses everything. Thank you, Rich Yonaker. After I graduated it was chanted in German at future NBA star Detlef Schrempf who was, of course, German. We greeted the visiting USC Trojans by throwing condoms on the court in 1978. We always urged NC State’s then coach to “Have a drink, Norm Sloan, have a drink” because he had commented in the press about the alleged insobriety of Duke students in the stands.  We jangled car keys during his free throws in an otherwise silent Cameron Indoor Stadium at State guard Clyde Austin, later imprisoned for a Ponzi scheme, who was being investigated for having no job but two luxury cars, supposedly given to him by his bank teller girlfriend.  Pizzas were delivered to a State huddle because a Wolfpack player was in trouble for hassling a pizza guy.  When Maryland coach Lefty Dreisell (Duke, 1954) and his Terps visited, Lefty was greeted with a big sign and these words: “Richard Nixon [Duke Law, 1937]: Duke’s second biggest mistake. Welcome Lefty!”

A regular chant in our rotation was reserved for when a very highly regarded team or player visited Cameron and didn’t perform up to reputation. “OV-ER-RAT-ED!”  Sadly, and by any reasonable measure, it is impossible to conclude that the financial services industry is anything other than wildly overrated.  Chant away. 

Advertisement

The End of the Bond Limbo Party (“How low can you go?”)

We should always be skeptical when someone claims that “this time is different” in the markets.  New paradigms come around, of course, but not nearly as often as claimed. You’re much safer betting on ”old always” rather than on a “new normal” unless and until the new, new thing has proven out over time and is demonstrable based upon actual evidence and data. 

With that carefully rendered predicate out in the open, it’s worthwhile — and perhaps significant — to note that we will eventually see something truly new in the markets.  We’d all do well to be prepared for when the bond limbo party finally ends.

FOBOR or FUBAR?

In a no-yield world, many perceive themselves as “forced buyers of risk” (FOBOR). By way of example, the Financial Times reported the following note from BofA Merrill Lynch:

In a world of zero rates, where $19.4 trillion of government bonds (that’s 48% of the total market) is trading below 1%, it’s little wonder the “lust for yield” is as strong as it is. Last week Rwanda offered 6.875% 10-year bonds to borrow $400mn, an amount equivalent to 5.5% of its 2012 GDP. The offer was 9-10X oversubscribed. And Panama successfully issued a $750mn 40-year bond with a 4.3% coupon (note that in the past 50 years the US 30-year Treasury bond has traded below 4.3% for just 10% of the period).

In what universe does it make sense for people to fight to loan Rwanda money at 6 7/8 percent?

My Top Posts for 2012

The following dozen Above the Market posts were read, quoted and linked the most during 2012 and are listed below in order of popularity.  I think they provide a pretty good cross-section of this site and what I am about.  I trust that you will enjoy each of them again or enjoy them afresh if you may have missed them the first time around.  I am most appreciative of all the attention and support I have received.  Thank you all very much.

• Investors’ 10 Most Common Behavioral Biases
• My Investing Checklist
• CFA Conference: James Montier
• Leading Investment Indicators
• What Will 2030 Look Like?
• Reckoning with Risk
• Get a Good Pitch to Hit
• The Greatest Risk of All
• We Suck at Math
• Leverage
• Gaming the System
• The Long Cycle

A Chart is Worth a Thousand Words

 

Source:  Political Calculations

Per PC, the current national debt burden per U.S. household is roughly $131,113. Over the last four years, that’s up by $49,129 per U.S. household from the $81,984 per U.S. household figure set in 2008. It should be obvious, but note that these numbers are pre-QE3.

A Cautionary Tale for our Times

It’s rarely a good thing when one’s local school district and its finances — in this case the district which has graduated my three children, which employs my wonderful wife as a teacher and which generally has remarkable common purpose — is covered in The New York Times. As the Times reports (in a story broken by a local blog), the Poway Unified School District borrowed money at 6.8 percent tax-exempt despite its Aa2/AA- ratings last year via a bond which provided for no debt service payments for more than two decades.   These so-called “capital appreciation bonds,” which raised $105 million in 2011 for needed improvements to district facilities, will require $877 million in interest payments between 2033 and 2051.  To make matters worse, the bonds are non-callable; to add call provisions would have added about $100 million in costs due to the higher coupon the bond would be required to offer. 

No one should be surprised that the local community is not happy with this turn of events.

In a statement attempting to justify the deal, the district noted that the bond issue was the fifth part of a plan to modernize the 24 oldest schools in the district and argued that while this particular bond “has a total repayment ratio of 9.3 times the principal amount,” the overall borrowing program has a repayment ratio of 4.2 (for every dollar borrowed, $3.20 in interest will be paid). In that context it doesn’t sound so bad overall until one recalls that a typical 30-year mortgage at the same 6.8 percent interest rate would require $1.35 in lifetime interest payments for each dollar borrowed, or a repayment ratio of 2.35 and that a more normal tax-exempt bond deal would have required barely 4 percent in interest payments. Moreover, the district’s statement (and a subsequent presentation at a School Board meeting) skirts the issue of why this particular (and particularly rich) bond was deemed necessary and appropriate. “Our job is to educate these children, to make sure they have a future,” said District Superintendent John Collins, as if that settled the matter.

In California, unlike most of the rest of the country, schools are largely financed at the state level, with only certain construction costs among the things funded locally.  What this bond measure means is that someone living in a home with an assessed value (the median market value is closer to $500,000) of $300,000, who currently pays about $165 per year in SFID (School Facility Improvement District)property taxes, will see those taxes rise to $710 per year by 2033 and $842 by 2051.  That’s a huge increase.

So what happened? The district seems to have made a Faustian bargain by following the letter of the law (but not the spirit) to achieve what was deemed necessary but unavailable otherwise.

In 2008, voters gave the district permission to borrow more money to finish a modernization plan that had been begun earlier but which was under-funded because (surprise!) it took longer and cost more than expected.  It was the “planning fallacy” on full display.  But that approval came with a major promise and commitment from the duly elected school board:  no tax increases.  It was clear at the time that no matter how badly the work was needed (and many of the schools were dreadfully run-down and in desperate need of repair), the electorate would not fix the problems if it meant higher taxes (prior such bond measures were repeatedly voted down).  If you think that sounds like our state-wide and federal situation — demands for no tax increases and even tax cuts but no reduction or even an increase in services — you’re onto something, Captain Obvious. 

By the time the last of the financings needed to complete the project in 2011 was on tap, it became clear that without increasing taxes, the district couldn’t afford to borrow money conventionally. The creative solution invoked involved these capital appreciation bonds with no clear statement to the voters of what was going on. This bond structure — no payments for over 20 years — means that no new taxes were needed (we’ll see about 2033, when other bonds are paid off but the extremely high debt service on the new bonds goes on-line).  The full 2,200-word ballot statement from 2008 makes no mention of capital appreciation bonds and provides little detail about the nature of the financing.  The bond measure even received an endorsement from the San Diego County Taxpayers Association, which now regrets having done so and says it was misled.

What we have here is a cautionary tale for these difficult times. The lack of planning that underlies the whole situation is typical but unacceptable. The lack of transparency as well as the lack of full and clear disclosure is shady and disappointing.  The willingness to “kick the can down the road” and foist our problems onto future generations is disgusting.  But in a political environment where more and more is demanded from government but where tax increases are not permitted, the district’s actions are perfectly understandable while, at the same time, being utterly deplorable.

As I noted earlier today in another context, we need more responsible government at every level.  We need a responsible citizenry just as badly.  Tragically, neither seems to exist, especially in this instance.

UPDATE (8.27.12): Barry Ritholtz (The Big Picture) added some additional, excellent commentary here.

A Chart is Worth a Thousand Words

A Chart is Worth a Thousand Words

Source:  Political Calculations

 

Is it News?

On a day with a big data announcement, like today, one might expect that the various news outlets might generally agree on what’s moving the markets.

Not so much.

According to CNBC (please overlook the dreadful prose), “[s]tocks opened lower [today] after the monthly government non-farm payroll rose less than expected and as traders continued to closely monitor events in the euro zone as the G20 Summit in France took place.”  Fox Business agreed:  “Stocks were off to a gloomy start in the last trading day in what has been a volatile week for Wall Street as traders mulled fresh data on the jobs market and continuous developments on Europe’s debt crisis.”   Bloomberg’s spin was slightly different:  “Stocks, the euro and Italian bonds fell as a disagreement on boosting the International Monetary Fund’s resources to fight Europe’s debt crisis overshadowed a drop in the U.S. jobless rate.”  The Street‘s headline focused on NFP and said that “Stocks Fall on Lackluster Jobs Data.”  CNN emphasized jobs too:  “U.S. stocks opened slightly lower Friday following a disappointing jobs report.”

Which was it — NFP or Europe?  The answer is both and neither.  On more ordinary days, what’s going on is even more elusive.

I’ve sat on enough fixed income trading desks to know that there are always many reasons why people trade and those reasons are often unknown and concealed.  I have no reason to believe that equity traders are any more forthcoming.  Obfuscation is common — in all directions.  Even flow trading desks never have a great handle on what’s driving whom. 

One common objection to the complete digitization of trading is the difficulty of monitoring “flow” and the reasons for it without the human connection.  And there is certainly value in that for traders.  But that value is easily overstated. 

A big trade after a big number might be in response to the number.  But it might also have been planned before and delayed to get past the risk of the number.  Or it might simply reflect redemptions due to poor performance, or something else.

Back in the days when I was routinely asked about flow and called upon to interpret what’s driving whom on a day-to-day and sometimes moment-to-moment basis, I was careful to talk to traders, read the latest news and collect whatever other information I could before opining.  But, even at best, the information I offered had to be treated very tentatively. 

Information is cheap but meaning is expensive.

The traders I talked with might not be seeing all the flows.  Or they might be longer (or shorter) than they’d like and are biasing their commentary accordingly.  Or maybe they’re distracted about something.  Or perhaps they’re angry with me for not pushing what they had to sell hard enough and freezing me out from the best intel they had. Everybody has an ax to grind.

Obvious takeaways:

1.  For investors, these headlines are essentially all noise and can readily be ignored.

2.  For traders, these headlines (and any claim to trading “news”) are — at best — only a small piece of the puzzle of what’s going on.

_________________________

A version of this post appears at Business Insider — here.

Value

I grew up in this business in the early 90s at what was then Merrill Lynch.  My decade of legal work in and around the industry didn’t prepare me for big-time Wall Street trading.  I’d ride the train to Hoboken early in the morning, hop on a ferry across the Hudson, walk straight into the World Financial Center, enter an elevator, and press 7. Once there, I’d walk into the fixed income trading floor, a ginormous open room, two stories high, with well over 500 seats and more than twice that number of computer terminals and telephones.  When it was hopping, as it typically was, especially after a big number release (like today’s non-farm payroll data), it was a cacophonous center of (relatively) controlled hysteria.  

It was a culture of trading, which makes sense since it was, after all, a trading floor.  Most discussions, even trivial ones, had a trading context.  One guy (and they were almost all guys) is a seller of a lunch suggestion.  Another likes the fundamentals of the girl running the coffee cart.  Bets were placed (of varying sorts) and fortunes were made and lost, even though customers did most of the losing because we were careful to take a spread on every trade.  The focus was always on what was rich and what was cheap and the what if possibilities of and from every significant event (earthquake in Russia – buy potato futures).  The objective was always to make the most money possible, the sooner the better.

Interestingly, value was almost never at issue.  The idea was to exploit inefficiencies and – especially – the weaknesses of whoever is on the other side of the trade right now.  Michael Lewis’s wonderful first book, Liar’s Poker, re-issued in 2010 and finally being made into a movie, captures this culture (in his case, at Salomon Brothers) pitch perfect.

Now that the focus of what I do has changed, I am primarily consumed with finding value through investing – which must be distinguished from trading.  As Barry Ritholtz put it recently, “[t]rading (as opposed to investing) is more about laying out probabilities of risk versus reward; investing is about valuations within the longer secular macro picture.”  I would suggest that trading is about selling what is rich and buying what is cheap while investing is about finding, acquiring and holding on to value.  That distinction is, I think, the key to why so many analysts misapprehend the market relevance of another terrific Michael Lewis book (which has been made into a recent movie), Moneyball (nicely satirized here).

Moneyball focuses on the 2002 season of the Oakland Athletics, a team with one of the smallest budgets in baseball.  At the time, the A’s had lost three of their star players to free agency because they could not afford to keep them.  A’s General Manager Billy Beane, armed with reams of performance and other statistical data, his interpretation of which was rejected by “traditional baseball men” (and also armed with three terrific young starting pitchers), assembled a team of seemingly undesirable players on the cheap that proceeded to win 103 games and the divisional title. 

Unfortunately, much of the analysis of Moneyball from an investment perspective is focused upon the idea of looking for cheap assets and outwitting the opposition in trading for those assets.  Instead, the crucial lesson of Moneyball relates to finding value via underappreciated assets (some assets are cheap for good reason) by way of a disciplined, data-driven process.  Instead of looking for players based upon subjective factors (a “five-tool guy,” for example) and who perform well according to traditional statistical measures (like RBIs and batting average, as opposed to on-base percentage and OPS, for example), Beane sought out players that he could obtain cheaply because their actual (statistically verifiable) value was greater than their generally perceived value. 

In some cases, the value difference is relatively small.  But compounded over a longer-term time horizon, small enhancements make a huge difference.  In a financial context, over 25 years, $100,000 at 5%, compounded daily, returns $349,004.42 while it returns nearly $100,000 more ($448,113.66) at 6%.

We live in a world that doesn’t appreciate value.  In the investment community, indexers are convinced that value doesn’t exist and most other would-be investors don’t have a good process for analyzing the data and are too focused on trading to recognize value when they see it.  While proper diversification across investments can mitigate risk and smooth returns within a portfolio, too much portfolio diversification (“protection against ignorance,” in Warren Buffett’s words) requires that value cannot be extracted. 

Similarly, behavioral finance shows us how difficult it is for us to be able to ascertain value.  Our various foibles and biases make us susceptible to craving the next shiny object that comes into view and our emotions make it hard for us to trade successfully and extremely difficult to invest successfully over the longer-term.  Recency bias and confirmation bias – to name just two – conspire to inhibit our analysis and subdue investment performance.  Investing successfully is really hard.

In another context, stockholders are not demanding value from the executives of the companies in which they invest and are frequently acquiescing to their being paid far more than they are worth.  For example, Stan O’Neil, the guy who ran my old firm Merrill Lynch into the ground, was rewarded with an astonishing $161 million for doing so. Ken Blanchard, who lives one neighborhood over from me, said in church just last week that the ridiculous explosion in executive pay is wrong but it’s the way the score is kept.  We’re nuts for allowing it.

To expand the idea (perhaps to the point of breaking), we must always resist the urge to trade – even a good trade – when investing makes more sense.  While I don’t mean to suggest that a one-off trip to Vegas for a week-end of fun can never be a good idea, too many trips like that can come between you and your goals and can thus be antithetical to a rewarding future.  My ongoing analysis of human nature suggests that we are not just subject to the whims of our emotions.  We are also meaning-makers, for whom long-term value (when achieved) can be fulfilling and empowering.  It simply (it is simple, but not easy) requires the process and the discipline to get there.  What we really need is not always what we expect or want at the time.

This point was driven home to me anew by the terrific movie, 50/50, written by Will Reiser about his ordeal with cancer.  As Sean Burns noted in Philadelphia Weekly, Reiser’s best friend was the kind of slovenly loudmouth that you’d usually find played in the movies by Seth Rogen, except that his best friend really was Seth Rogen.  Rogen’s fundamental, unexpected decency and supportive love grows more quietly moving as the film progresses.  Rogen was undervalued generally and his love and support provided great value to Reiser. 

As the cliché goes, nobody lies on his deathbed wishing he’d spent more time at the office.  We appreciate meaning and value more in the sometimes harsh reality of the rear-view mirror rather than in our mystical (and usually erroneous) projections into an unknown future.

Are you looking for value or just the next trade?