Lehman And Meritocracy

Following on the Lehman thread (one year anniversary and all), here is Andy Kessler writing in Forbes:

Part of the charm of Wall Street, and what scares most reasonable people away, is that it is as close to a meritocracy as exists on this earth. It’s dog eat dog. It’s sink or swim. You do a trade and it makes money, then you’re a hero (for a moment anyway) and deserve a bonus. You bring in a deal, you get paid. You lasso more clients’ assets under your firm’s roof, you’re a hitter. I once discovered some good news on the stocks I followed before the rest of the Street, and mentioned it to the sales force at a morning meeting and moved markets in New York, Tokyo and London. I had the head of global equities pat my head on the elevator ride up the next morning. Pat my head! I was told he never does that.

The flip side, of course, is what makes Wall Street so dangerous. You lose money for the firm and you’re a heel. Do it again and you don’t get paid that year. Do it a third time and you’re out of a job. Just like that. Gone. I’ve seen it happen to friends and acquaintances at just about every firm up and down Wall Street. There is no tenure on Wall Street, no job security, no long-term guarantees. Ten- and 20-year careers end in a flash. Happens all the time, and everybody who works in the business knows this.

…But the crude reality is that Lehman Brothers is a classic Wall Street story. Inside and outside, it was a meritocracy. They wanted to one up on Goldman Sachs, generate as good a return on equity and earnings growth so they could win the meritocracy game and get paid in spades. How dare Bear Stearns’ CEO make more than ours! Let’s lever this sucker up with mortgage-backeds and create a trillion-dollar balance sheet. If not us, who? And by the way, very few people at Lehman really understood how upper management was playing this meritocracy game with the rest of Wall Street with the rank and files’ careers.

Read the full article here

Andy Kessler: Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score

It’s Not “Liquidity” Driving the Market

What’s that? You need more cowbell David Rosenberg? Here’s Rosie in his daily letter explaining how it’s not liquidity that’s driving the market:

You can always rest assured that a peak is at hand when you read and hear about how “liquidity” is driving the market.  For one, nobody even has a clue as to how “liquidity” is even defined.  It’s basically a catch-all term for “I don’t know”.  But what we do know is that short covering remains an important source of buying power for equities as the bears bail out — short interest on the NYSE, for example, shrunk 2.4% in the second half of August, and was down 2.9% on the Nasdaq.  Just in case you were wondering how it was that the S&P 500 managed to advance 20 points in the second half of the month.

The truth of the matter is that investment grade corporate bonds have outperformed the S&P 500 by 70 basis points so far this year — income at a reasonable price remains a primary theme.  The problem with the equity market is that dividends no longer comprise a critical part of the total return pie as it used to.  The reliance now is almost purely on capital appreciation, which can be secured when unit labour costs are falling at annual rate of at least 5%, as has been the case over the last two quarters.  However, that rate of decline cannot possibly be sustained.  But what can be sustained, and likely will be, is the deflationary backdrop in private sector demand, which influences the revenue line.  Take note that 250 S&P 500 companies cut their dividends in 2Q, the highest number in over 50 years (and as per the WSJ, stock buybacks have declined now for six quarters in a row).

Take note that the Fed is now pumping reserves aggressively into the banking system again, with the monetary base accelerating at a 141% annual rate over the past four weeks.  But the money multiplier is still contracting — over this time frame, M1 has contracted at a 28.7% annual rate; M2 has fallen at a 4.9% annual rate; and MZM has shrunk at a 6.2% annual rate.  In other words, and with all deference to the excitement that a 50%+ bear market rally can engender in the media, the credit system is still … broken.  When the investment community eventually figures out that the economy is not in, or even is it entering, a V-shaped recovery there will undoubtedly be a new round of deflated price discovery, followed by years of anemic economic growth, persistently high unemployment, ongoing consumer frugality, rising savings rates, and a prolonged period in which portfolios will move further towards strategies that provide income and preservations of capital rather than a focus on aggressive capital appreciation potential.

Rosenberg: A Vote for Bonds Over U.S. Stocks

This is from an interview with Rosie in Barron’s:

The equity market is de facto priced for 4% real GDP growth. The corporate-bond market is priced for 2% real GDP growth. So in terms of asset mix, it’s pretty clear that you have more downside protection in corporate bonds right now than you have in equities. And if you can tolerate the risk, you can pick up a 12% coupon in the high-yield market. But if you are a more cautious investor, you have an array of solid investment-grade securities in the A-rated universe where you can pick up a 6% yield. With a negative 2% inflation backdrop, that equates to an 8% real yield — a very juicy rate of return. In the equity market, you have a 4% earnings yield plus a 2% dividend yield, and you are in a riskier part of the capital structure. Corporate bonds are priced for the sort of recovery I have in my forecast.

We are in a post-bubble credit-collapse environment, and what is critical is capital preservation and income. Asset mix is extremely important. We at Gluskin Sheff have a cautious view toward U.S. equities. We’re more positive on Canadian equities, given that the banks are stable and the commodity market is in a bull phase. We’ve been big fans of corporate bonds, though, admittedly, a good part of the low-hanging fruit is behind us. But they will be relative outperformers.

The rally in the U.S. equity market has been so pronounced that it is no longer just pricing in the end of the recession. It is pricing in two years of recovery. At this stage, there is a little too much risk. If the S&P 500 were to correct back to around 840 or 850, versus 1025 recently, I would be much more interested.

Read the full interview here

Wall Street’s Math Wizards Forgot a Few Variables

From the NYT:

IN the aftermath of the great meltdown of 2008, Wall Street’s quants have been cast as the financial engineers of profit-driven innovation run amok. They, after all, invented the exotic securities that proved so troublesome.

But the real failure, according to finance experts and economists, was in the quants’ mathematical models of risk that suggested the arcane stuff was safe.

The risk models proved myopic, they say, because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn’t sufficiently take into account was human behavior, specifically the potential for widespread panic. When lots of investors got too scared to buy or sell, markets seized up and the models failed.

That failure suggests new frontiers for financial engineering and risk management, including trying to model the mechanics of panic and the patterns of human behavior.

“What wasn’t recognized was the importance of a different species of risk — liquidity risk,” said Stephen Figlewski, a professor of finance at the Leonard N. Stern School of Business at New York University. “When trust in counterparties is lost, and markets freeze up so there are no prices,” he said, it “really showed how different the real world was from our models.”

In the future, experts say, models need to be opened up to accommodate more variables and more dimensions of uncertainty.

The drive to measure, model and perhaps even predict waves of group behavior is an emerging field of research that can be applied in fields well beyond finance.

Financial markets, like online communities, are social networks. Researchers are looking at whether the mechanisms and models being developed to explore collective behavior on the Web can be applied to financial markets. A team of six economists, finance experts and computer scientists at Cornell was recently awarded a grant from the National Science Foundation to pursue that goal.

“The hope is to take this understanding of contagion and use it as a perspective on how rapid changes of behavior can spread through complex networks at work in financial markets,” explained Jon M. Kleinberg, a computer scientist and social network researcher at Cornell.

Read the full article here

Analysts’ recommendations ‘beat most funds’

From the Financial Times:

Broker stock picks can help investors outperform most mutual funds, research by one of the largest hedge funds has suggested.

While most asset managers have long dismissed analysts’ recommendations as anything but reliable, traders and academics at GLG – the $21.5bn London hedge fund manager – have found otherwise.

Based on a database of the daily recommendations it received from European brokers for the past four years, the hedge fund found that a portfolio following analysts’ tips, and holding them for three months, would outperform 75 per cent of mutual funds.

Such a portfolio delivered annualised returns of between 2.8 per cent and 6.4 per cent above benchmarks and after fees in each of those four years.

GLG said the research was some of the first to be conducted into the value of equity analysts’ calls since the scandals and subsequent reforms that rocked brokerages after the telecoms and tech bubble.

“When you look at the returns the average active manager tries to beat benchmarks by, we think the outperformance of recommendations is reasonably good,” said Sandy Rattray, an asset manager at the fund.

GLG’s findings were based on all the recommendations from salespeople at a range of European brokerages it had received since 2005, based on a single daily “pick” given to the fund from each.

Read the full story here

Rosenberg: Five Points on the Markets, Earnings and Economy

The always insightful David Rosenberg makes the following five observations:

Five Points Worth Making on the Markets, Earnings, and the Economy

1. This remains a hope-based rally (with strong technicals). I say that because during this six-month 50%+ rally in the S&P 500, the U.S. economy has shed 2.4 million jobs, which is almost as many as we lost during the entire 2001-02 tech wreck — in just six months. The market’s ability to shrug off the loss of 2.4 million jobs is either a sign that it is treating this as old news or sees the cost-cutting as good news for profits. Either way, what we are seeing transpire is without precedent — the magnitude of the employment slide versus the magnitude of the market advance. Truly fascinating stuff.
2. Companies have not really been beating their earnings estimates — only the very final estimates heading into the reporting quarter. For example, the consensus view for 3Q EPS at the start of the year was $21.00, last we saw the estimates were down to just over $14.00. But there is a deeply rooted belief that earnings are coming in better than expected. This is a psychology that is difficult to break. It is completely unknown (for some reason) that corporate revenues are running at a -25% YoY rate, which compares to the -10% we saw at the worst part of the 2001-02 bear market and the -3% trend at the most negative point in 1991.
3. Valuation is a poor timing device but even on “normalized” trailing 10-year earnings, the S&P 500 is trading near 18x, which is now above the historical average of 16x.
4. All the growth we are seeing globally this year is due to fiscal stimulus; not just here in Canada and the U.S., but also in Korea, China, the U.K., and Continental Europe too. For 2010, the government’s share of global growth, by our estimates, will be 80%. In other words, there are still very few signs that organic private sector activity is stirring. For a Keynesian, government stimulus is necessary, but the question for an investor is the multiple one attaches to a global economy that is still relying on a defibrillator. The problem is that governments do not create income or wealth, and today’s stimulus is really a future tax liability. Curiously, that future tax liability is likely going to pose a roadblock for the return to a “normalized” $80 operating EPS estimate that strategists are now starting to pen in for 2011.
5. While Mr. Market may be pricing in a fine future for the U.S. , but when the 3-month Treasury-bill yield is 13bps north of zero, which is completely abnormal, you know that there are still substantial fundamental imbalances that need to be worked through.

Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail

Bloomberg has a great (long) piece on missing the lessons of last year’s financial collapse. Below is an excerpt from the article:

Of all the quakes of 2008 — the fall of Bear Stearns Cos. in March, the takeover of mortgage buyers Fannie Mae and Freddie Mac and the salvaging of American International Group Inc. in September — the failure to account for the effects of Lehman’s demise was the most critical because its aftershocks came closest to wrecking the world economy.

“They put the entire financial system at risk, and they didn’t have to,” said Harvey R. Miller, a partner at Weil Gotshal & Manges LLP in New York who represented Lehman in the bankruptcy, referring to government officials. “They were warned. I told them, ‘Armageddon is coming. You don’t know what the consequences will be.’ Their response was, ‘We have it covered.’”

Paulson and Geithner, who succeeded him as Treasury secretary, both declined to comment.

Inviting ‘Catastrophe’

One year later, policymakers haven’t learned the lesson of the bankruptcy, said Richard Bernstein, CEO of Richard Bernstein Capital Management LLC in New York and former chief investment strategist for Merrill Lynch.

Rather than break up institutions such as Bank of America Corp. and Citigroup Inc., or limit their expansion, the U.S. has given them billions of dollars in tax incentives and loan guarantees that enabled them to grow even bigger. To protect against a bank collapse touching off another freefall, President Barack Obama has proposed regulatory changes that rely on the wisdom of bankers and government overseers — the same people who created the conditions that led to Lehman’s bankruptcy and were unable to foresee its consequences.

“Designating certain institutions as too big to fail, and not having a thorough regulatory process to match, practically invites another catastrophe,” Bernstein said.

Rescue efforts exposed a financial system with so many moving parts that U.S. regulators and the world’s top bankers couldn’t keep track of them all. A reconstruction of the meetings at the New York Fed that preceded Lehman’s bankruptcy, drawn from more than a dozen interviews with participants, reveals a failure to understand the importance of commercial paper and how that market would be affected by the collapse of the New York investment bank.

Ice-Nine

It turned out to be a $3.6 trillion blind spot.

Like the fictitious substance ice-nine in Kurt Vonnegut Jr.’s 1963 novel “Cat’s Cradle,” a seed of which set off a chain reaction that transformed all the world’s water into ice, Lehman’s failure froze credit markets, said Simon H. Johnson, a former chief economist at the International Monetary Fund.

“Ice-nine was invented by a crackpot scientist, and it was unleashed by mistake,” said Johnson, now a professor of finance at the Massachusetts Institute of Technology’s Sloan School of Management in Cambridge. “How did the financial system get so fragile that this could happen? What were the guys overseeing it doing?”

The bankers and regulators who met at the New York Fed unwittingly dropped the first seed.

Great stuff. You can read the whole article here.

Is The Market Rational?

This article ran in Fortune in 2002. If you never read it before, you should. If you have read it, it’s worth your time to read it again. It’s written by Justin Fox. He went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. You can read the exchange below. Also, from this article, Justin wrote a recently published book that you should read. It’s called The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it.
By Justin Fox
December 9, 2002

Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name “efficient markets.”

“In an efficient market,” wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, “prices ‘fully reflect’ available information.” That is, in an efficient market you can’t beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama’s teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

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Why Is September Bad for Stocks?

From Morningstar Advisor:

The answer to this question lies in Nassim Taleb’s bestseller Fooled by Randomness. If you haven’t read it (you should), let me sum up the book in one sentence: We humans have this amazing ability to see a pattern where there is none.

The three worst stock market crashes all happened in October. Do you see a pattern here? If you do, you are fooled by randomness. A sample size of three signifies nothing statistically. That does not prevent us from associating October with market crashes.

Now that this “pattern” is public knowledge, thanks to the financial media, guess what investors do in September? They sell. That’s why September is the worst month for stocks on average, even worse than the supposedly crash-prone October.

Credit Rating Agencies Took “Bribes” for Higher Ratings

Alternative title: How the Fed Contributes to Crises

Hat tip to Washington’s Blog for bringing this story to my attention. Morningstar Advisor posted a great piece back in June when they held a conversation with Ed Kane, Martin Mayer, and Walker Todd–three people who have great depth and experience in understanding the plumbing, history, and effects of the regulatory infrastructure of our financial markets. Below are some highlights:

[Finance professor Ed] Kane: One has to remember that these are profit-making institutions. Issuers will would pay more money for a good rating than a bad one, and issuers are very clear what kind of ratings they want. This is a straight-forward way to pay bribes without ever violating the law, it appears, and the credit rating organizations do not take formal responsibility for their incompetence or negligence.

[Prolific financial journalist, Brookings Institution scholar, and the author of more than 30 books on financial market issues Martin] Mayer: One of the untold scandals of this country is that our museums are stuffed with fake old masters because the people who authenticated paintings for the Mellons and Morgans of this world were paid a percentage of the price for the authentication. If they said it was no good, they got a few hundred bucks. If they said it was great, they got $100,000. Same story in the credit-rating organizations.

[Former Federal Reserve attorney and economist Walker] Todd: Right. They also drop the ball. I’ve been around failing banks and financial crises since 1974, and the rating agencies have dropped the ball almost every time. They were always at best late to the party.

Mayer: John Heimann [former comptroller of the currency] used to say that the function of the ratings agency is to go on the battlefield after the battle is over and shoot the wounded.

Read the whole Morningstar discussion after the jump…

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