The latest GMO quarterly letter was recently released.*
Below, I've highlighted some of Jeremy Grantham's thoughts on efficient markets, bubbles, and the 2013 Nobel Prize in Economic Sciences from his section of the letter:
"Economics is a very soft science but it has delusions of hardness or what has been called physics envy. One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt that economics had lost sight of its job to be useful to society, having lost its way in a maze of econometric formulas, which placed elegance over accuracy.
At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fi t the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).
We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history."
To me, this latest letter is Grantham at his best.
(His section begins on page 6.)
Well worth reading in its entirety.
Grantham goes on to describe the four bubbles that, for many, will hardly be unfamiliar:
1) Bubble in Japanese Stocks - By 1989 stocks were selling at 65 times earnings (on what may be not so great accounting). Grantham points out, before that, stocks had never peaked at more than 25 times earnings. Japanese stocks would go on to fall 90%.
2) Japanese Land Bubble - This bubble peaked a couple of years later in 1991. Grantham describes it this way:
"This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor's Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efficient to me..."
3) U.S. Equity Bubble in 2000 - This one peaked at 35 times earnings but that doesn't even begin to describe how expensive certain stocks had become. For perspective, earnings peaked at 21 times earnings in 1929.
4) The Housing Bubble - According to Grantham this was the first bubble that was truly global.
Grantham notes that, according to EMH, these annoying real world occurrences should happen something like once every 10,000 years.
He also makes the point that "this efficient market nonsense" certainly didn't hurt value managers like himself.
"...so I should find time to thank all those involved for producing and passionately promoting the idea. During the 1970s and 1980s I am convinced it helped reduce the number of quantitatively-talented individuals entering the money management business."
Warren Buffett has previously made a similar point.
Max Planck understood well the resistance of the human mind, even among those who happen to be very smart, to new ideas. He understood how that tendency impacted scientific advancement.
Buffett has said the same applies to finance.
Well, one of the more disappointing -- even if unfortunately not exactly surprising -- aspects of what has happened over these past decades is this:
"...the proponents of the EMH not only promoted their theory, but via the academic establishment the high priests badgered academic researchers into leaving, resigning themselves to non-tenure, or getting religion, as it were."
Much later in the letter, Grantham talks more specifically about the 2013 Nobel Prize in Economic Sciences:
"So, economics has been more or less threadbare for 50 years. Pity then the plight of the Bank of Sweden with all that money to give away in honor of Alfred Nobel and in envy, perhaps, of the harder sciences. If you had $1.2 million to give away but few worthy recipients, what would you do? I would suggest making it a once-every-three-year event..."
His primary reason?
To make it more likely that only "the Real McCoys" win the prize and to prevent "so many ordinary soldiers" from getting it.
That's unlikely to happen anytime soon, but that doesn't make it any less unfortunate that the Bank of Sweden did the following:
"...to further prove how completely they have lost the plot, they gave two-thirds of the prize to two economists who attempted to prove market inefficiency and one-third to another who claimed it was efficient and seriously efficient at that. What a farce. And to read all these genteel descriptions, or rather rationalizations, as to why this made sense is to realize to what extent the establishment is respected, regardless of its competence level."
The economists he is referring to are Eugene Fama, Robert Shiller, and Lars Peter Hansen.
"Robert Shiller at least served society – Kenneth Boulding would have approved – by loudly warning us of impending doom from the Tech Bubble with his superbly timed book Irrational Exuberance in the spring of 2000. Not bad! He also warned us well in advance of the much more dangerous housing bubble..."
Grantham is, not surprisingly, not quite so complimentary of Fama:
"As for Fama, who conversely provided a rationale for all of us to walk off the cliff with confidence, the less said the better. For believers in market efficiency and all the assumptions that go along with it, the real world really is merely an annoying special case."
Grantham has mentioned this so-called "special case" before.
Now, to get an idea how Eugene Fama looks at bubbles, consider what he said back in 2010 in this interview.
When Fama was presented with the following:
"Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst."
He responded this way:
"I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning."
That comment from Fama just might help begin to explain how such bad ideas and assumptions have been able to maintain their widespread -- and rather more than a little bit damaging -- influence for so long.
From later in the same interview:
But you are skeptical about the claims about how irrationality affects market prices?
Fama's response:
"It's a leap. I'm not saying you couldn't do it, but I'm an empiricist. It's got to be shown."
Naturally, there's nothing inherently wrong with needing it "to be shown", but somehow, at least for Fama, insufficient evidence has been supplied by these recent bubbles.
So this means Fama continues to think, more or less, that coldly rational efficient markets exist in the real world.
Shiller, of course, does not.
Fama, in fact, seems to have an almost unflappable confidence that EMH (and related) provides a useful way to understand how financial markets work.
Not long after their Nobel Prize was announced Shiller was interviewed on CNBC. In the interview, Shiller called Fama the "father" of efficient markets as a theory and most responsible for popularizing it over the years.
Shiller also said the following about Fama's rather consistent, if nothing else, view that markets are mostly quite efficient and rational:
"When you hatch a theory, you don't easily let go, that's where he [Fama) is. I think he's a -- he's a brilliant man...but he's rather involved in this theory."
CNBC Video: Robert Shiller on Eugene Fama
Maybe, just maybe, the reason Fama doesn't see the empirical evidence relates, in part, to Shiller's explanation.
In fact, that doesn't really seem a stretch at all.
I happen to be rather convinced that the influence of efficient markets -- and the many related ideas and assumptions that have descended from EMH -- have been anything but a good thing for civilization.
To me, the sooner they lose their influence the better.
Well, in any case, these three empiricists have won a big prize.
It's the Data, Stupid!
No doubt winning it involved lots of hard work by what are well-intentioned and smart people.
Maybe, down the road, it will become more obvious how much at least some of these recently honored contributions will be of benefit to world.
I'd certainly like to see their work prove to be useful but, at least for now, consider me a bit skeptical much of it will end up having a truly significant and favorable impact.
Others might have a more optimistic view.
Adam
Related posts:
Efficient Markets - Part II
Risk and Reward Revisited
Efficient Markets
Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
Buffett on Risk and Reward
Beta, Risk, & the Inconvenient Real World Special Case
Black-Scholes and the Flat Earth Society
Buffett: Indebted to Academics
Superinvestors: Galileo vs The Flat Earth
Max Planck: Resistance of the Human Mind
* Also published in Barron's.
Showing posts with label Economics. Show all posts
Showing posts with label Economics. Show all posts
Friday, November 22, 2013
Friday, August 23, 2013
Market Freezes Up
Those watching business news yesterday had to listen to talking heads acting like -- if not the end of the world -- that not being able to trade Nasdaq stocks for a few hours was yet another blow to market participant confidence.
Nasdaq market paralyzed by three hour shutdown
Well that may be the case but a marketable stock is, first and foremost, partial ownership of an operating business.
"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett
So, if the market system happens to malfunction from time to time -- as it seems almost certain to do, and maybe to a much greater extent than this most recent episode -- it doesn't change the per share intrinsic value of that underlying operating business. Those with an investment time horizon were fine; traders maybe less so.
(In the flash crash certain stocks temporarily were significantly impacted. That event similarly had no impact on underlying business value. An investor who did nothing, or maybe even bought shares they liked that became a bit cheaper, was just fine.)
Now, as Charlie Munger pointed out in a conversation at Harvard-Westlake back in early 2010, there is a real benefit to knowing one can sell, relatively easily, part or all of an investment that they've made; that those risking capital become more apt to invest if they feel certain they'll generally have, when the appropriate times comes along, a straightforward, low cost, way to sell.
As Munger says: "It's not like buying a restaurant in the wrong place."
That doesn't logically mean one must be able to sell their shares every second, minute, and hour of every trading day. The beneficial aspects of this ease of conversion -- from one investment to another -- exists as long as what should be an advantage isn't turned into a disadvantage by doing lots of unnecessary trading.
Actual investment (as opposed to trading price action) just doesn't require all that much buying and selling.*
Certainly not anywhere near the amount that our hyperactive modern market system allows participants to theoretically do.
In fact, in many ways, capital formation and investment is undoubtedly negatively impacted by this hyperactivity and other forms of short-termism.
Closing a market for five years may be extremely unlikely, but it's true that a few hours should matter little to the true investor.
It's what the business does over an investment horizon that matters.
Nasdaq Flash Freeze Called 'Inexcusable'
Nasdaq OMX connectivity disaster highlights stumbling markets
Words like "inexcusable" and "disaster" may apply in some ways but, if anything, the problem seems more that we have too many market participants focused on frenetically trading in and out of marketable stocks (not to mention their derivatives). Adding layers of activity and related costs with mostly no particular enduring value added (and, as we've seen from the financial crisis, some of it plainly destructive).
It's renting price action -- what is a zero-sum game before the frictional costs -- instead of owning pieces of businesses then benefiting from what they produce over the long haul.
Profiting from speculation on near-term price action depends upon cleverly timed trades to get good results.
In contrast, the primary drivers of investment returns come from changes to intrinsic value and the discipline to not overpay in the first place.**
An actual investment is definitely not zero sum; it depends not upon brilliant trading.
Considering the power of long run compounding effects, it seems foolish to no allow those forces to work for the investor. What initially seems like a minor tailwind becomes anything but with the benefit of longer time frames. Well, all this frenetic trading and resultant frictional costs can only, in aggregate, subtract from the magic of compounding returns.
(John Bogle calls this "the tyranny of compounding cost".)
There has certainly been lots of scientific and technological advancements that have enabled all this market hyperactivity.
James Grant once said that in science and engineering more generally (i.e. not just as it relates to finance and financial systems), progress tends to be cumulative.
Unfortunately, that's not really the case in finance.
"Progress is cumulative in science and engineering, but cyclical in finance." - James Grant in Money of the Mind
Grant put it the following way in his latest letter:
"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.
Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013
Apparently, when scientific and technological progress meets financial progress, it is the latter's inherent cyclicality that wins.
(Cyclical in the sense that the same, or at least similar, mistakes seem to be repeated but the size of the financial sector as a percentage of U.S. GDP has been anything but cyclical -- especially since the 1940s.)
The systems have certainly become more sophisticated and technically complex. Whether, as a result, it's serving us better in most of the important ways seems debatable at best.
A market freeze up certainly matters for someone who has funds exposed to the market that are needed in the near term. Of course, funds needed in the near or even intermediate term shouldn't really be exposed to equities in the first place.
(Investment is ideally measured in decades, not years, but the appropriate time horizon is necessarily imprecise and unique to each situation. 2-3 years may seem long-term to some folks but, in my book, that kind of time horizon is simply not an investment horizon.)
A market disturbance like the one yesterday no doubt can pose real problems for the active trader. Yet Buffett and Munger explained back in May of this year why these sort of events should be of little concern to the long-term investor.
During such similar disturbances, the long-term investor who bought (via a marketable stock) part of a quality business at a reasonable valuation in the first place isn't hurt (again, even if the quoted price is temporarily an unpleasant one).
In fact, if it ended up being more than a short-term event, the reduced price should also not bother the long-term owner.
Why?
Well, it not only allows that owner to buy more shares cheap over time, it also allows the funds being allocated to share buybacks to go further. The highest quality businesses generally will throw off excess cash at a high return on capital. So a long-term investor focused on per share intrinsic business value should logically prefer lower stock prices in the near-term (and, for that matter, even the intermediate-term...the longer the low price persists the more powerful a buyback becomes when consistently executed below per share intrinsic value) while the business itself remains, at least, relatively sound.
Naturally an investor should want the earning power of a business to do well over the long haul but, as Warren Buffett has previously explained, a stock price that temporarily (or longer) lags is hardly a problem for the long-term investor.
Investment is about what the business itself produces over time.
Why Buffett Wants IBM's Shares "To Languish"
The intrinsic value of a productive asset (in this case a business that happens to be partially owned via a publicly traded marketable stock), especially one with durable advantages, just will not generally change nearly as much in underlying value as the daily quoted prices might otherwise suggest. There's inevitably lots of noise and, well, emotion in the short-term "votes" of a publicly traded company. A private business owner has no such noise and emotion to consider. With no daily quoted prices to distract, a long-term oriented private business owner can theoretically just focus on making sure the business is being run in a way that creates enduring value.
(Still, even with this longer term focus many businesses will do poorly or fail, of course.)
It need be no different for owners of a high quality business that happens to be publicly traded.
So these almost-certain-to-occur-from-time-to-time market disturbances matter a whole bunch for traders but not so much for investors. When justifiably confident in per share value, the investor focused on long-term effects is not going to mind if something bought at a discount temporarily gets an even bigger discount.
Highly volatile, unpredictable markets (whether due to self-inflicted instability/uncertainty -- market structure, poor system design -- or an external shock) can impact the real economy if severe enough to damage business and consumer confidence.
This can also keep investors who otherwise might participate in the capital markets from doing so.
That's quite a different but potentially very real problem.
Yesterday seemed pretty mild, but I don't doubt that the more serious versions of these kind of events adversely impacts confidence. Yet a more deeply embedded -- culturally and systemically -- longer term perspective among a greater proportion of participants just might mitigate this. Some education -- the development of an alternative trained response to market fluctuations -- and the right incentives can take us a long way toward material improvement in this regard.
So both a cultural shift and systemic changes will certainly be necessary. Well, I think it's fair to say that this kind of fundamental shift is unlikely to happen fast even in the best of circumstances.
In any case, for those with a longer investment horizon, the markets should be made as welcoming as possible.
For pure near-term speculation on price action, markets should be made a less welcoming place.
That'd make for a better balance than what's currently in place.
In the meantime, a long-term investor can still do just fine if they follow sound investment principles.
Buy only what is well understood.***
Focus on underlying business value.
Always have a margin of safety.
Ignore the near-term noise.
In fact, even better yet, is allowing the inevitable market fluctuations resulting from disturbances both small -- as in what happened yesterday -- and large -- as in the financial crisis -- to work for the investor.
The right temperament goes a long way in investing.
Adam
* Charlie Munger also points out -- using Alan Greenspan as an example but there are many others, of course -- some economists are in a camp that thinks "if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization." He also adds that some "presumably are looking forward to trillions" of shares being traded and then says:
"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously..."
Munger states that Alan Greenspan's view of the world when he was leading the Federal Reserve was the the result of having "overdosed on Ayn Rand." Greenspan's views may have changed since (or, maybe, directly as a result of) the financial crisis but were a real factor at the time. At the very least he has seemingly been willing to modify his world view in light of what happened. Others appear less inclined to do so.
** It's buying shares of well understood businesses, with a margin of safety, and for the most part judging correctly -- within a range -- the core long-term economics. False precision in investing just leads to trouble. Act accordingly. It's recognizing what can't be reliably known or predicted. Margin of safety can be seen as just the humble acceptance of one's own limits; the understanding that an inevitably uncertain world exists. Overconfidence in one's own ability to forecast future outcomes will likely lead to more risks taken for less reward over the long haul. When an investor always strives to pay a price that requires nothing great to happen to get a good result, there should be few complaints if things go better than expected. This requires patience, discipline, and often a fair amount of work, but eventually the market usually offers an attractive price of something that is well understood. When it does decisive action is required. Easier said than done if not impossible. When an investor protects against permanent capital loss by employing sufficient margin of safety, the good news is it then also allows unforeseen (or unforeseeable) upside to remain a possibility.
*** Naturally, whether an investment can be understood well is necessarily unique to each investor. Those who make a particular investment because someone else thinks it has attractive long-term prospects (i.e. without having come to that conclusion via their own analysis) just aren't likely to have the conviction needed to hang in there -- or, well, to not hang in there if a mistake was made -- when the price action goes the wrong way. Stick with what you know.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Nasdaq market paralyzed by three hour shutdown
Well that may be the case but a marketable stock is, first and foremost, partial ownership of an operating business.
"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett
So, if the market system happens to malfunction from time to time -- as it seems almost certain to do, and maybe to a much greater extent than this most recent episode -- it doesn't change the per share intrinsic value of that underlying operating business. Those with an investment time horizon were fine; traders maybe less so.
(In the flash crash certain stocks temporarily were significantly impacted. That event similarly had no impact on underlying business value. An investor who did nothing, or maybe even bought shares they liked that became a bit cheaper, was just fine.)
Now, as Charlie Munger pointed out in a conversation at Harvard-Westlake back in early 2010, there is a real benefit to knowing one can sell, relatively easily, part or all of an investment that they've made; that those risking capital become more apt to invest if they feel certain they'll generally have, when the appropriate times comes along, a straightforward, low cost, way to sell.
As Munger says: "It's not like buying a restaurant in the wrong place."
That doesn't logically mean one must be able to sell their shares every second, minute, and hour of every trading day. The beneficial aspects of this ease of conversion -- from one investment to another -- exists as long as what should be an advantage isn't turned into a disadvantage by doing lots of unnecessary trading.
Actual investment (as opposed to trading price action) just doesn't require all that much buying and selling.*
Certainly not anywhere near the amount that our hyperactive modern market system allows participants to theoretically do.
In fact, in many ways, capital formation and investment is undoubtedly negatively impacted by this hyperactivity and other forms of short-termism.
Closing a market for five years may be extremely unlikely, but it's true that a few hours should matter little to the true investor.
It's what the business does over an investment horizon that matters.
Nasdaq Flash Freeze Called 'Inexcusable'
Nasdaq OMX connectivity disaster highlights stumbling markets
Words like "inexcusable" and "disaster" may apply in some ways but, if anything, the problem seems more that we have too many market participants focused on frenetically trading in and out of marketable stocks (not to mention their derivatives). Adding layers of activity and related costs with mostly no particular enduring value added (and, as we've seen from the financial crisis, some of it plainly destructive).
It's renting price action -- what is a zero-sum game before the frictional costs -- instead of owning pieces of businesses then benefiting from what they produce over the long haul.
Profiting from speculation on near-term price action depends upon cleverly timed trades to get good results.
In contrast, the primary drivers of investment returns come from changes to intrinsic value and the discipline to not overpay in the first place.**
An actual investment is definitely not zero sum; it depends not upon brilliant trading.
Considering the power of long run compounding effects, it seems foolish to no allow those forces to work for the investor. What initially seems like a minor tailwind becomes anything but with the benefit of longer time frames. Well, all this frenetic trading and resultant frictional costs can only, in aggregate, subtract from the magic of compounding returns.
(John Bogle calls this "the tyranny of compounding cost".)
There has certainly been lots of scientific and technological advancements that have enabled all this market hyperactivity.
James Grant once said that in science and engineering more generally (i.e. not just as it relates to finance and financial systems), progress tends to be cumulative.
Unfortunately, that's not really the case in finance.
"Progress is cumulative in science and engineering, but cyclical in finance." - James Grant in Money of the Mind
Grant put it the following way in his latest letter:
"Plainly, physics has made a different kind of contribution to human society than economics has. Then, again, physics is an easier nut to crack than economics. Electrons don't have feelings, as they say.
Progress in science is cumulative; we stand on the shoulders of giants. But progress in finance is cyclical; in money and banking, especially, we seem to keep making the same mistakes." - From Page 17-18 in Grant's Interest Rate Observer, Volume 31 Summer Break, August 23rd, 2013
Apparently, when scientific and technological progress meets financial progress, it is the latter's inherent cyclicality that wins.
(Cyclical in the sense that the same, or at least similar, mistakes seem to be repeated but the size of the financial sector as a percentage of U.S. GDP has been anything but cyclical -- especially since the 1940s.)
The systems have certainly become more sophisticated and technically complex. Whether, as a result, it's serving us better in most of the important ways seems debatable at best.
A market freeze up certainly matters for someone who has funds exposed to the market that are needed in the near term. Of course, funds needed in the near or even intermediate term shouldn't really be exposed to equities in the first place.
(Investment is ideally measured in decades, not years, but the appropriate time horizon is necessarily imprecise and unique to each situation. 2-3 years may seem long-term to some folks but, in my book, that kind of time horizon is simply not an investment horizon.)
A market disturbance like the one yesterday no doubt can pose real problems for the active trader. Yet Buffett and Munger explained back in May of this year why these sort of events should be of little concern to the long-term investor.
During such similar disturbances, the long-term investor who bought (via a marketable stock) part of a quality business at a reasonable valuation in the first place isn't hurt (again, even if the quoted price is temporarily an unpleasant one).
In fact, if it ended up being more than a short-term event, the reduced price should also not bother the long-term owner.
Why?
Well, it not only allows that owner to buy more shares cheap over time, it also allows the funds being allocated to share buybacks to go further. The highest quality businesses generally will throw off excess cash at a high return on capital. So a long-term investor focused on per share intrinsic business value should logically prefer lower stock prices in the near-term (and, for that matter, even the intermediate-term...the longer the low price persists the more powerful a buyback becomes when consistently executed below per share intrinsic value) while the business itself remains, at least, relatively sound.
Naturally an investor should want the earning power of a business to do well over the long haul but, as Warren Buffett has previously explained, a stock price that temporarily (or longer) lags is hardly a problem for the long-term investor.
Investment is about what the business itself produces over time.
Why Buffett Wants IBM's Shares "To Languish"
The intrinsic value of a productive asset (in this case a business that happens to be partially owned via a publicly traded marketable stock), especially one with durable advantages, just will not generally change nearly as much in underlying value as the daily quoted prices might otherwise suggest. There's inevitably lots of noise and, well, emotion in the short-term "votes" of a publicly traded company. A private business owner has no such noise and emotion to consider. With no daily quoted prices to distract, a long-term oriented private business owner can theoretically just focus on making sure the business is being run in a way that creates enduring value.
(Still, even with this longer term focus many businesses will do poorly or fail, of course.)
It need be no different for owners of a high quality business that happens to be publicly traded.
So these almost-certain-to-occur-from-time-to-time market disturbances matter a whole bunch for traders but not so much for investors. When justifiably confident in per share value, the investor focused on long-term effects is not going to mind if something bought at a discount temporarily gets an even bigger discount.
Highly volatile, unpredictable markets (whether due to self-inflicted instability/uncertainty -- market structure, poor system design -- or an external shock) can impact the real economy if severe enough to damage business and consumer confidence.
This can also keep investors who otherwise might participate in the capital markets from doing so.
That's quite a different but potentially very real problem.
Yesterday seemed pretty mild, but I don't doubt that the more serious versions of these kind of events adversely impacts confidence. Yet a more deeply embedded -- culturally and systemically -- longer term perspective among a greater proportion of participants just might mitigate this. Some education -- the development of an alternative trained response to market fluctuations -- and the right incentives can take us a long way toward material improvement in this regard.
So both a cultural shift and systemic changes will certainly be necessary. Well, I think it's fair to say that this kind of fundamental shift is unlikely to happen fast even in the best of circumstances.
In any case, for those with a longer investment horizon, the markets should be made as welcoming as possible.
For pure near-term speculation on price action, markets should be made a less welcoming place.
That'd make for a better balance than what's currently in place.
In the meantime, a long-term investor can still do just fine if they follow sound investment principles.
Buy only what is well understood.***
Focus on underlying business value.
Always have a margin of safety.
Ignore the near-term noise.
In fact, even better yet, is allowing the inevitable market fluctuations resulting from disturbances both small -- as in what happened yesterday -- and large -- as in the financial crisis -- to work for the investor.
The right temperament goes a long way in investing.
Adam
* Charlie Munger also points out -- using Alan Greenspan as an example but there are many others, of course -- some economists are in a camp that thinks "if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization." He also adds that some "presumably are looking forward to trillions" of shares being traded and then says:
"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously..."
Munger states that Alan Greenspan's view of the world when he was leading the Federal Reserve was the the result of having "overdosed on Ayn Rand." Greenspan's views may have changed since (or, maybe, directly as a result of) the financial crisis but were a real factor at the time. At the very least he has seemingly been willing to modify his world view in light of what happened. Others appear less inclined to do so.
** It's buying shares of well understood businesses, with a margin of safety, and for the most part judging correctly -- within a range -- the core long-term economics. False precision in investing just leads to trouble. Act accordingly. It's recognizing what can't be reliably known or predicted. Margin of safety can be seen as just the humble acceptance of one's own limits; the understanding that an inevitably uncertain world exists. Overconfidence in one's own ability to forecast future outcomes will likely lead to more risks taken for less reward over the long haul. When an investor always strives to pay a price that requires nothing great to happen to get a good result, there should be few complaints if things go better than expected. This requires patience, discipline, and often a fair amount of work, but eventually the market usually offers an attractive price of something that is well understood. When it does decisive action is required. Easier said than done if not impossible. When an investor protects against permanent capital loss by employing sufficient margin of safety, the good news is it then also allows unforeseen (or unforeseeable) upside to remain a possibility.
*** Naturally, whether an investment can be understood well is necessarily unique to each investor. Those who make a particular investment because someone else thinks it has attractive long-term prospects (i.e. without having come to that conclusion via their own analysis) just aren't likely to have the conviction needed to hang in there -- or, well, to not hang in there if a mistake was made -- when the price action goes the wrong way. Stick with what you know.
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
Wednesday, August 21, 2013
Munger: "Cognitive Failure" In Economics
From this conversation with Charlie Munger at Harvard-Westlake:
"Alan Greenspan at the Federal Reserve overdosed on Ayn Rand. Basically he kind of thought anything that happened in the free market, even if it was an axe murder, had to be ok. He's a smart man and [a] good man, but he got it wrong. Generally, an over-belief in any one ideology is going to do you in if you extrapolate it too hard, and that's what happened in economics."
So, according to Munger, what caused this "cognitive failure" in economics?
"They reasoned correctly that a free market would be way more predictive than anything else, and they reasoned correctly that once you had a fairly advanced capitalist system – if the people that were putting up the capital could sell their pieces of ownership in the company to other people, they'd be more inclined to invest because it gave them an option to get out if they wanted to leave. It's not like buying a restaurant in the wrong place. Then they reasoned that if that was true, if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization."
Having a million shares trade in a day was a rare occurrence when Munger attended Harvard Law School. Now billions of shares trade each day. He guesses that those who think along these lines are probably looking forward to when trillions of shares will trade in a day. Munger then adds...
"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously, and of course three or four billion shares is way too many. We have computer programs that are trading with other computer programs. We have many of the bright people who ought to be doing our engineering going to work at hedge funds and investment banks and algorithmic trading places and so on and so on."
Munger goes on to say "at any rate, these people got the idea [that] unlimited trading is a big plus for civilization."
Well, John Maynard Keynes certainly thought otherwise as Munger further explains:
"[Keynes] said a liquid market of securities is one of the most attractive gambling devices ever created. It has all the joy of gambling, plus it's respectable. Furthermore, instead of being a zero-sum game, where you are bound to lose the frictional cost, it's a game where you can pay the frictional cost and actually make a profit. This is one of the most seductive gambling devices ever invented by man, and some nut who took economics thinks that the bigger and better it gets, the better it is for wider civilization."
Now, consider that speaking to Forbes back in 1974, Warren Buffett described the business of investing in the following manner:
"I call investing the greatest business in the world...because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it."
Investing can certainly be a great business but all this hyperactivity is directly at odds with the reasons why.
Compared to all this rapid trading of price action, waiting patiently for something you understand to get cheap enough, then owning it for a very long time, is a completely different game.
Modern capital markets are an incredibly convenient way to buy part of a good business that's priced attractively with minimal frictional costs.
To me, it seems quite the shame to see something so incredibly useful and powerful converted into a casino; see it turned into something less than it otherwise might be.*
So more of something doesn't automatically make it better. There's often optimal amount -- at least within some range -- and, of course, diminishing returns or worse. Some short-term oriented speculative activity is necessary and even desirable. That doesn't logically mean that unlimited amounts of it is a good thing.
The amount of speculation relative to investment matters and the former is currently swamping the latter. What John Bogle describes as The Triumph of Speculation over Investment.
There may not be a precisely knowable correct ratio of speculation to investment, but I think it's safe to say we are far from what makes sense. I've used the petrol engine as a simple -- even if a limited and imperfect one -- example of this.
The petrol engine just doesn't function all that well if the air-fuel ratio strays too far from what's optimal (and, eventually, it won't function at all if there's too much of either substance).
As with most any system, even what is a comparably simple one, the proportion matters rather a lot.
If efficiently and effectively allocating capital and strong long-term business performance are the primary goals then, in their current hyperactive form, the equity markets seem likely to have far from the optimal ratio of speculation relative to investment.
Check out the entire conversation with Charlie Munger at Harvard-Westlake.
Lots of useful thoughts and insights.
That 1974 Forbes article is a pretty worthwhile read too even if not exactly breaking news.
Adam
* Capital markets exist to move funds to where they're needed efficiently, to make sure owners of public companies have some reasonable visibility into how well what they own is being managed for the long haul so they can act accordingly, with frictional costs no higher than necessary. It's not a casino that exists to mostly serve the active participants themselves.
Charlie Munger at Harvard-Westlake
"Alan Greenspan at the Federal Reserve overdosed on Ayn Rand. Basically he kind of thought anything that happened in the free market, even if it was an axe murder, had to be ok. He's a smart man and [a] good man, but he got it wrong. Generally, an over-belief in any one ideology is going to do you in if you extrapolate it too hard, and that's what happened in economics."
So, according to Munger, what caused this "cognitive failure" in economics?
"They reasoned correctly that a free market would be way more predictive than anything else, and they reasoned correctly that once you had a fairly advanced capitalist system – if the people that were putting up the capital could sell their pieces of ownership in the company to other people, they'd be more inclined to invest because it gave them an option to get out if they wanted to leave. It's not like buying a restaurant in the wrong place. Then they reasoned that if that was true, if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization."
Having a million shares trade in a day was a rare occurrence when Munger attended Harvard Law School. Now billions of shares trade each day. He guesses that those who think along these lines are probably looking forward to when trillions of shares will trade in a day. Munger then adds...
"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously, and of course three or four billion shares is way too many. We have computer programs that are trading with other computer programs. We have many of the bright people who ought to be doing our engineering going to work at hedge funds and investment banks and algorithmic trading places and so on and so on."
Munger goes on to say "at any rate, these people got the idea [that] unlimited trading is a big plus for civilization."
Well, John Maynard Keynes certainly thought otherwise as Munger further explains:
"[Keynes] said a liquid market of securities is one of the most attractive gambling devices ever created. It has all the joy of gambling, plus it's respectable. Furthermore, instead of being a zero-sum game, where you are bound to lose the frictional cost, it's a game where you can pay the frictional cost and actually make a profit. This is one of the most seductive gambling devices ever invented by man, and some nut who took economics thinks that the bigger and better it gets, the better it is for wider civilization."
Now, consider that speaking to Forbes back in 1974, Warren Buffett described the business of investing in the following manner:
"I call investing the greatest business in the world...because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it."
Investing can certainly be a great business but all this hyperactivity is directly at odds with the reasons why.
Compared to all this rapid trading of price action, waiting patiently for something you understand to get cheap enough, then owning it for a very long time, is a completely different game.
Modern capital markets are an incredibly convenient way to buy part of a good business that's priced attractively with minimal frictional costs.
To me, it seems quite the shame to see something so incredibly useful and powerful converted into a casino; see it turned into something less than it otherwise might be.*
So more of something doesn't automatically make it better. There's often optimal amount -- at least within some range -- and, of course, diminishing returns or worse. Some short-term oriented speculative activity is necessary and even desirable. That doesn't logically mean that unlimited amounts of it is a good thing.
The amount of speculation relative to investment matters and the former is currently swamping the latter. What John Bogle describes as The Triumph of Speculation over Investment.
There may not be a precisely knowable correct ratio of speculation to investment, but I think it's safe to say we are far from what makes sense. I've used the petrol engine as a simple -- even if a limited and imperfect one -- example of this.
The petrol engine just doesn't function all that well if the air-fuel ratio strays too far from what's optimal (and, eventually, it won't function at all if there's too much of either substance).
As with most any system, even what is a comparably simple one, the proportion matters rather a lot.
If efficiently and effectively allocating capital and strong long-term business performance are the primary goals then, in their current hyperactive form, the equity markets seem likely to have far from the optimal ratio of speculation relative to investment.
Check out the entire conversation with Charlie Munger at Harvard-Westlake.
Lots of useful thoughts and insights.
That 1974 Forbes article is a pretty worthwhile read too even if not exactly breaking news.
Adam
* Capital markets exist to move funds to where they're needed efficiently, to make sure owners of public companies have some reasonable visibility into how well what they own is being managed for the long haul so they can act accordingly, with frictional costs no higher than necessary. It's not a casino that exists to mostly serve the active participants themselves.
Charlie Munger at Harvard-Westlake
Friday, July 19, 2013
John Kay on Equity Markets: Exit, Voice, and Short-termism
A year ago, John Kay produced what can only be described as a rather long review focused on the reduction in long-term oriented behavior among UK equity market participants and corporate decision-makers.
The review more than implies that the fault lies both with shareholders and company decision-makers alike. Naturally, the behavior of owners (and, too often, what amounts to "renters" of stock) influence how the board and senior management behaves and vice versa.
The Kay Review of UK Equity Markets and Long-Term Decision Making
Short-termism
Increasingly, business executives, for a variety of reasons, too often end up focused on shorter term outcomes and quick fixes.
From the review:
"Short-termism, or myopic behaviour, is the natural human tendency to make decisions in search of immediate gratification at the expense of future returns..."
Longer tenure among competent senior executives and the right kind of compensation systems would certainly help. The CEO with a short tenure and lots of pressure to perform quarter-to-quarter is less likely think and act longer term. Few would seem likely to focus on long-term effects if the prevailing pay systems, in combination with shorter in duration tenure, frequently reward the next person who gets the job.
A system that tends to reward the next CEO for the long-term decision-making of the current CEO is a system destined to fail.
As far as short-termism goes it's not just executives, of course.
Corporate boards, regulators, and market participants all play a role.
John Kay makes it rather clear nothing short of a major cultural shift is required. That's unlikely to happen quickly under the best of circumstances.
Market participants have shorter time horizons by almost any standard these days; and it is not just the high frequency trading types.
It's an increased number fund managers and other participants who increasingly emphasize shorter term price action and outcomes in markets (w/holding periods maybe not measured in seconds or less but still hardly investing with long-term effects mostly in mind).
Also, the layers of middle men -- investment consultants and financial advisors among others -- not only tend to add frictional costs, but also increasingly create a buffer between those who've invested the capital at some risk and the companies they partially own.
This reduces shareholder engagement.
"Short-termism can also manifest itself in hyperactivity."
Well, as the review points out, individuals that are hyperactive generally "fail to give sustained attention to tasks" but what does this hyperactivity mean for the corporate sector?
"In the corporate sector, hyperactivity can be seen in frequent internal reorganisation, corporate strategies designed around extensive mergers and acquisitions, and financial re-engineering which may preoccupy senior management but have little relevance to the capabilities of the underlying business."
The review points out that the civilized world has for a very long time attempted "to construct devices and institutions to combat our instinctive short-termism. The central question for this Review is whether capital markets in Britain today dissuade or stimulate the search for instant gratification in the corporate sector."
In fact, as Kay notes, attempts to combat this instinct can even be found in the epic story of Ulysses.
"The outcome, not the process, is what matters, and that perspective has been central to this Review. From the outset, we have emphasised that the goals of equity markets are to operate and sustain high performing companies and to earn good returns..."
It's important to note that the review is focused on the more established relatively large public companies that are traded in London (see bottom of page 15 in the review). Of course, smaller, less mature, and not quite as established businesses will require very different things from the capital markets. Many will need efficient access to capital to build their businesses and generally have had more difficulty accessing funding since the financial crisis. Yet, much like the more established businesses, they'd still benefit from a reduced culture of short-termism.
Larger and smaller businesses have that in common even if their needs are otherwise rather different.
Business investment has declined in the past decade in the UK, but it's not because the larger companies are lacking funds.
"Quoted companies, both taken as a whole and in most individual cases, generate more cash from operations than they use for investment. They are not short of cash; they are awash with it. The value of the cash holdings of British business today is larger than the value of its plant and machinery."
And it's not necessarily just about encouraging more shareholder engagement...
"Shareholder engagement is neither good nor bad in itself: it is the character and quality of that engagement that matters."
Exit and Voice
The review also refers to "economist Albert Hirschman's famous distinction between the courses of action available to buyers when the quality of a relationship is inadequate: 'voice' – attempting to improve outcomes within the context of the market relationship; and 'exit' – withdrawal from the market relationship*. These alternatives apply just as much to a shareholder concerned with corporate governance or company performance as to a customer dissatisfied with the produce at the local supermarket. The unhappy shopper can complain to the management, or go elsewhere. And so can the contemporary shareholder."
The problem is that structure and regulation have the emphasis wrong.
"...the structure and regulation of equity markets today overwhelmingly emphasise exit over voice and this has often led to shareholder engagement of superficial character and low quality. We believe equity markets will function more effectively if there are more trust relationships which are based on voice and fewer trading relationships emphasising exit.
The focus of the review is on the UK equity markets but the problems, as well as potential solutions, seem likely to be more similar than different for the United States.
Kay rightly criticizes the hyperactive behavior of senior management and market participants who pursue "immediate gratification". Well, behavior that is longer term oriented is more likely to follow if the right incentives are put in place and enough conflicts of interest can be eliminated.
Considering this apparent attention deficit for anything but what can deliver the quickest rewards, it seems unlikely that this not at all short review will even reach enough of its target audience in the first place (never mind get the focused attention it deserves).
\
This review -- and the subject more generally -- certainly requires that the reader not have such a deficit.
So, in contrast to short-termism, no quick payback or reward will be found in reading Kay's review. It's certainly a worthwhile read for those who'd like to see long run systemic improvements; it's a worthwhile read for those less conflicted (or, at least those who can mostly set conflicts of interest aside for the bigger picture), less susceptible to short-termism, and willing to invest some time to seriously consider what really needs to be changed.
(Though, of course, it's not as if Kay's review could possibly provide all the answers.)
Changes that might make equity markets better serve their purpose for existing in the first place. In reality, nothing appears likely to be fixed anytime soon. The conflicts of interest, wrong incentives, and embedded industry cultural forces are just too powerful.
It's still worth better understanding how the status quo is failing us.
More in a follow up.
Adam
* Hirschman, A. (1970), Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, Harvard University Press
The review more than implies that the fault lies both with shareholders and company decision-makers alike. Naturally, the behavior of owners (and, too often, what amounts to "renters" of stock) influence how the board and senior management behaves and vice versa.
The Kay Review of UK Equity Markets and Long-Term Decision Making
Short-termism
Increasingly, business executives, for a variety of reasons, too often end up focused on shorter term outcomes and quick fixes.
From the review:
"Short-termism, or myopic behaviour, is the natural human tendency to make decisions in search of immediate gratification at the expense of future returns..."
Longer tenure among competent senior executives and the right kind of compensation systems would certainly help. The CEO with a short tenure and lots of pressure to perform quarter-to-quarter is less likely think and act longer term. Few would seem likely to focus on long-term effects if the prevailing pay systems, in combination with shorter in duration tenure, frequently reward the next person who gets the job.
A system that tends to reward the next CEO for the long-term decision-making of the current CEO is a system destined to fail.
As far as short-termism goes it's not just executives, of course.
Corporate boards, regulators, and market participants all play a role.
John Kay makes it rather clear nothing short of a major cultural shift is required. That's unlikely to happen quickly under the best of circumstances.
Market participants have shorter time horizons by almost any standard these days; and it is not just the high frequency trading types.
It's an increased number fund managers and other participants who increasingly emphasize shorter term price action and outcomes in markets (w/holding periods maybe not measured in seconds or less but still hardly investing with long-term effects mostly in mind).
Also, the layers of middle men -- investment consultants and financial advisors among others -- not only tend to add frictional costs, but also increasingly create a buffer between those who've invested the capital at some risk and the companies they partially own.
This reduces shareholder engagement.
"Short-termism can also manifest itself in hyperactivity."
Well, as the review points out, individuals that are hyperactive generally "fail to give sustained attention to tasks" but what does this hyperactivity mean for the corporate sector?
"In the corporate sector, hyperactivity can be seen in frequent internal reorganisation, corporate strategies designed around extensive mergers and acquisitions, and financial re-engineering which may preoccupy senior management but have little relevance to the capabilities of the underlying business."
The review points out that the civilized world has for a very long time attempted "to construct devices and institutions to combat our instinctive short-termism. The central question for this Review is whether capital markets in Britain today dissuade or stimulate the search for instant gratification in the corporate sector."
In fact, as Kay notes, attempts to combat this instinct can even be found in the epic story of Ulysses.
"The outcome, not the process, is what matters, and that perspective has been central to this Review. From the outset, we have emphasised that the goals of equity markets are to operate and sustain high performing companies and to earn good returns..."
It's important to note that the review is focused on the more established relatively large public companies that are traded in London (see bottom of page 15 in the review). Of course, smaller, less mature, and not quite as established businesses will require very different things from the capital markets. Many will need efficient access to capital to build their businesses and generally have had more difficulty accessing funding since the financial crisis. Yet, much like the more established businesses, they'd still benefit from a reduced culture of short-termism.
Larger and smaller businesses have that in common even if their needs are otherwise rather different.
Business investment has declined in the past decade in the UK, but it's not because the larger companies are lacking funds.
"Quoted companies, both taken as a whole and in most individual cases, generate more cash from operations than they use for investment. They are not short of cash; they are awash with it. The value of the cash holdings of British business today is larger than the value of its plant and machinery."
And it's not necessarily just about encouraging more shareholder engagement...
"Shareholder engagement is neither good nor bad in itself: it is the character and quality of that engagement that matters."
Exit and Voice
The review also refers to "economist Albert Hirschman's famous distinction between the courses of action available to buyers when the quality of a relationship is inadequate: 'voice' – attempting to improve outcomes within the context of the market relationship; and 'exit' – withdrawal from the market relationship*. These alternatives apply just as much to a shareholder concerned with corporate governance or company performance as to a customer dissatisfied with the produce at the local supermarket. The unhappy shopper can complain to the management, or go elsewhere. And so can the contemporary shareholder."
The problem is that structure and regulation have the emphasis wrong.
"...the structure and regulation of equity markets today overwhelmingly emphasise exit over voice and this has often led to shareholder engagement of superficial character and low quality. We believe equity markets will function more effectively if there are more trust relationships which are based on voice and fewer trading relationships emphasising exit.
The focus of the review is on the UK equity markets but the problems, as well as potential solutions, seem likely to be more similar than different for the United States.
Kay rightly criticizes the hyperactive behavior of senior management and market participants who pursue "immediate gratification". Well, behavior that is longer term oriented is more likely to follow if the right incentives are put in place and enough conflicts of interest can be eliminated.
Considering this apparent attention deficit for anything but what can deliver the quickest rewards, it seems unlikely that this not at all short review will even reach enough of its target audience in the first place (never mind get the focused attention it deserves).
\
This review -- and the subject more generally -- certainly requires that the reader not have such a deficit.
So, in contrast to short-termism, no quick payback or reward will be found in reading Kay's review. It's certainly a worthwhile read for those who'd like to see long run systemic improvements; it's a worthwhile read for those less conflicted (or, at least those who can mostly set conflicts of interest aside for the bigger picture), less susceptible to short-termism, and willing to invest some time to seriously consider what really needs to be changed.
(Though, of course, it's not as if Kay's review could possibly provide all the answers.)
Changes that might make equity markets better serve their purpose for existing in the first place. In reality, nothing appears likely to be fixed anytime soon. The conflicts of interest, wrong incentives, and embedded industry cultural forces are just too powerful.
It's still worth better understanding how the status quo is failing us.
More in a follow up.
Adam
* Hirschman, A. (1970), Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, Harvard University Press
Tuesday, November 27, 2012
Jeremy Grantham's 3Q 2012 Letter: The Decline in U.S. Net Capital Formation
From Jeremy Grantham's latest letter:
"Typically I see less significance than others in debt and monetary factors and more in real factors. When someone says that China is building its trains and houses on debt I think, "No, they are built by real people with real bricks, cement, and steel and whatever happens to the debt, these assets will still be there." (They may fall down but that's a separate story; you can build a bad high rise with or without debt). So I take the quality and quantity of capital and people very seriously: they are the keys to growth and a healthy economy. A badly trained, badly educated workforce is a problem...but reduced, abnormally low capital investment, particularly in the U.S., is the current topic."
Grantham sees the emergence of the "Bonus Culture" as a contributor to the problem (check out the letter for Grantham's explanation) of reduced capital investment. He later added:
"When I was a young analyst, companies like International Paper and International Harvester would drive us all crazy, for just as the supply/demand situation was getting tight and fat profits seemed around the corner, they and their competitors would all build new plants and everyone would drown in excess capacity. The CEOs were all obsessed with market share and would throw capital spending at everything. It might not have been the way to maximize an individual company's profit but it was great for jobs and growth. Now, in the bonus culture, new capacity is regarded with great suspicion. It tends to lower profitability in the near term and, occasionally these days, exposes the investing company to a raider. It is far safer to hold tight to the money and, when the stock needs a little push, buy some of your own stock back. This is going on today as I write, and on a big scale (approximately $500 billion this year). Do this enough, though, and we will begin to see disappointing top-line revenues and a slower growing general economy, such as we may be seeing right now."
In my view, the buybacks themselves aren't a problem, they're a symptom. As a shareholder of a good business, I'm enthusiastic about buybacks when the stock is cheap. When done the right way for the right reasons, buybacks are an important part of disciplined capital allocation.
(Unfortunately, they're frequently executed with too little discipline.)
Still, Grantham is very right that buybacks require capital that could be put to work elsewhere. For increased economic activity to occur, healthy capital investment is needed to fund good ideas and build useful things. Why, in the current environment, are buybacks the more attractive alternative for so many companies? It's worth understanding the real reasons. Maybe the "Bonus Culture" is a contributor to the problem, but I doubt it comes down to just one thing.* I'm guessing there are many reasons companies are choosing buybacks over other capital investments that might lead to economic expansion.
Understanding the root cause(s) of this might not be an easy thing to do, but incredibly important. Even if a business is not buying back stock, it may just hunker down, remain conservative with its capital expenditures, and avoid other forms of risk until there's more certainty.
Compared to historical norms, we are no where near a healthy level of capital formation. Exhibit 5 in Grantham's letter (see page 8) shows this. Check it out. The chart in that exhibit reveals capital formation as a percent of GDP at levels compared to U.S. historical norms that should make no one comfortable.**
Of course, it's not just how much but how smart the investments end up being. It's, as Grantham says, both "the quality and quantity of capital" that matters, but going from where capital formation was a bit more than 50 years ago to where it's at now can hardly be seen as a good thing.
You'll have a hard time convincing me this can't be fixed once it's more fully understood with some smart policy moves and changes to the system. I'm guessing that increased certainty and confidence will eventually lead to more healthy levels of capital formation and investment.
One can only hope that the best ideas will be considered carefully and turned into action.
There's plenty of capital sitting on the sidelines that eventually can be put to good use.
Adam
* Though increased certainty/confidence for businesses and consumers might be cheapest form of economic stimulus.
** Though no measure is perfect, Fixed Private Investment (FPI) as a percent of GDP, points to a similar dynamic. The following chart shows how FPI as a percent of GDP has looked in the U.S. since 1947:
Based upon that chart, it sure looks as if FPI/GDP was closer to the historic average, it would materially improve recent U.S. GDP growth.
"Typically I see less significance than others in debt and monetary factors and more in real factors. When someone says that China is building its trains and houses on debt I think, "No, they are built by real people with real bricks, cement, and steel and whatever happens to the debt, these assets will still be there." (They may fall down but that's a separate story; you can build a bad high rise with or without debt). So I take the quality and quantity of capital and people very seriously: they are the keys to growth and a healthy economy. A badly trained, badly educated workforce is a problem...but reduced, abnormally low capital investment, particularly in the U.S., is the current topic."
Grantham sees the emergence of the "Bonus Culture" as a contributor to the problem (check out the letter for Grantham's explanation) of reduced capital investment. He later added:
"When I was a young analyst, companies like International Paper and International Harvester would drive us all crazy, for just as the supply/demand situation was getting tight and fat profits seemed around the corner, they and their competitors would all build new plants and everyone would drown in excess capacity. The CEOs were all obsessed with market share and would throw capital spending at everything. It might not have been the way to maximize an individual company's profit but it was great for jobs and growth. Now, in the bonus culture, new capacity is regarded with great suspicion. It tends to lower profitability in the near term and, occasionally these days, exposes the investing company to a raider. It is far safer to hold tight to the money and, when the stock needs a little push, buy some of your own stock back. This is going on today as I write, and on a big scale (approximately $500 billion this year). Do this enough, though, and we will begin to see disappointing top-line revenues and a slower growing general economy, such as we may be seeing right now."
In my view, the buybacks themselves aren't a problem, they're a symptom. As a shareholder of a good business, I'm enthusiastic about buybacks when the stock is cheap. When done the right way for the right reasons, buybacks are an important part of disciplined capital allocation.
(Unfortunately, they're frequently executed with too little discipline.)
Still, Grantham is very right that buybacks require capital that could be put to work elsewhere. For increased economic activity to occur, healthy capital investment is needed to fund good ideas and build useful things. Why, in the current environment, are buybacks the more attractive alternative for so many companies? It's worth understanding the real reasons. Maybe the "Bonus Culture" is a contributor to the problem, but I doubt it comes down to just one thing.* I'm guessing there are many reasons companies are choosing buybacks over other capital investments that might lead to economic expansion.
Understanding the root cause(s) of this might not be an easy thing to do, but incredibly important. Even if a business is not buying back stock, it may just hunker down, remain conservative with its capital expenditures, and avoid other forms of risk until there's more certainty.
Compared to historical norms, we are no where near a healthy level of capital formation. Exhibit 5 in Grantham's letter (see page 8) shows this. Check it out. The chart in that exhibit reveals capital formation as a percent of GDP at levels compared to U.S. historical norms that should make no one comfortable.**
Of course, it's not just how much but how smart the investments end up being. It's, as Grantham says, both "the quality and quantity of capital" that matters, but going from where capital formation was a bit more than 50 years ago to where it's at now can hardly be seen as a good thing.
You'll have a hard time convincing me this can't be fixed once it's more fully understood with some smart policy moves and changes to the system. I'm guessing that increased certainty and confidence will eventually lead to more healthy levels of capital formation and investment.
One can only hope that the best ideas will be considered carefully and turned into action.
There's plenty of capital sitting on the sidelines that eventually can be put to good use.
Adam
* Though increased certainty/confidence for businesses and consumers might be cheapest form of economic stimulus.
** Though no measure is perfect, Fixed Private Investment (FPI) as a percent of GDP, points to a similar dynamic. The following chart shows how FPI as a percent of GDP has looked in the U.S. since 1947:
Based upon that chart, it sure looks as if FPI/GDP was closer to the historic average, it would materially improve recent U.S. GDP growth.
Monday, May 14, 2012
Montier: The Flaws of Finance
On May 6th, 2012, James Montier gave this speech with the title: The Flaws of Finance.
Video: The Flaws of Finance - James Montier
Also, here's a post by Thomas J. Brakke on Montier's speech.
So what are the flaws?
According to Montier, the flaws fall into four categories:
- Bad Models
- Bad Policies
- Bad Incentives
- Bad Behavior
First of all, finance isn't physics but damaging models exist that seem to assume otherwise.
Finance is a social science yet that's somehow misunderstood and/or ignored by some industry participants and their regulators. Popular models like capital asset pricing model (CAPM) and value-at-risk (VaR) mostly fail in reality even if interesting in another, more academic, context.
Once tested under real world conditions they've proved to be flawed and dangerous.
Things that seem to work until they don't.
Policy makers, at least in the past, have tended to buy into some the flawed models (created by the banks themselves no less) leading to what is a great example of regulatory capture.
There are too many poorly constructed incentives in the investment business and throughout the financial system. These incentives often reinforce the wrong behavior and play right into the cognitive biases and other errors in judgment that adversely impact investor decision-making.
Check out Montier's full speech.
Adam
Video: The Flaws of Finance - James Montier
Also, here's a post by Thomas J. Brakke on Montier's speech.
So what are the flaws?
According to Montier, the flaws fall into four categories:
- Bad Models
- Bad Policies
- Bad Incentives
- Bad Behavior
First of all, finance isn't physics but damaging models exist that seem to assume otherwise.
Finance is a social science yet that's somehow misunderstood and/or ignored by some industry participants and their regulators. Popular models like capital asset pricing model (CAPM) and value-at-risk (VaR) mostly fail in reality even if interesting in another, more academic, context.
Once tested under real world conditions they've proved to be flawed and dangerous.
Things that seem to work until they don't.
Policy makers, at least in the past, have tended to buy into some the flawed models (created by the banks themselves no less) leading to what is a great example of regulatory capture.
There are too many poorly constructed incentives in the investment business and throughout the financial system. These incentives often reinforce the wrong behavior and play right into the cognitive biases and other errors in judgment that adversely impact investor decision-making.
Check out Montier's full speech.
Adam
Thursday, April 19, 2012
Market Madness
MF Global is the new poster child for why thoughtful financial regulation is needed more than ever. - Bart Chilton
Some excerpts from this speech given by CFTC Commissioner Bart Chilton last month (in the midst of "March Madness"):
FCIC
The Financial Crisis Inquiry Commission (FCIC) was established to look at what happened. It concluded the Troubled Asset Relief Program or TARP was needed due to two culprits to the calamity.
One culprit: regulators and regulation. You see, in 1999, Congress and the president deregulated banks. Banks were no longer bound by that pesky Depression-era Glass-Steagall Act that cramped their style and limited what they could do with the money in their institutions. With the repeal of Glass-Steagall, regulators got the message to let the free markets roll. And, roll they did—right over the American people.
The second culprit: The captains of Wall Street. FCIC concluded that since they were allowed to do so much more without those annoying rules and regulations, they devised all sorts of creative, exotic and complex financial products. Some of these things were so multifaceted hardly anyone knew what was going on or how to place a value upon them.
Credit Default Swaps (CDS)
CDSs were a significant component of creating this ginormously humongous dark market with no oversight by regulators. When I say ginormously humongous, that's a technical term. You see, we at the CFTC currently oversee roughly $5 trillion in annualized trading on regulated exchanges, but the global over-the-counter (OTC) market is roughly—here it comes—$708 trillion. If you Google ginormously humongous, it should say, "See OTC markets."
In the speech, Chilton goes through what he views as four of the most critical rule changes needed but have yet to be approved or implemented. Speculative position limits is one of the four. He argues that position limits have been needed for years and are now needed more than ever.
The Commission passed a final position limits rule in October but, according to Chilton, implementation has been delayed by a lawsuit and some other unfinished business with the SEC. More excerpts from the speech:
Speculation and "Massive Passives"
I know we need speculators. I know I know I know—there are no markets without them. Speculators are good. But like a lot of good things, too much can be problematic. Therefore, it is the excessive speculation that can cause problems, contort markets, and result in consumers and businesses paying unfair prices and negatively impacting our economy.
Chilton then describes what he calls "Massive Passives":
Between 2005 and 2008 we saw over $200 billion come into futures markets from non-traditional investors. I call them "Massive Passives." They are the likes of pension funds, index funds, hedge funds and mutual funds. These funds are very large—massive—and have a fairly price-insensitive, passive trading strategy.
Then went on to say...
I'm not suggesting that the Massive Passives, or speculators in general, are actually driving prices. Let me be clear. I’m not proposing they were all in cahoots and decided to raise oil prices. What I am saying is that they contribute to price swings, and have a proportional impact in markets based upon their size as a whole, and certainly individual traders can push prices around if they have a large enough concentration. When prices are on the rise, like now, and the Massive Passives and others get into markets, they can push prices to levels that may be uneconomic—certainly not tied directly to supply and demand—and the prices may stay higher longer than they normally would.
The Speculative Premium
...you don't have to take it from me, from Senators or U.S. Representatives, or from the President of the United States. In fact, you don’t have to take it at all. I know that many of you in this crowd won't. Nonetheless, let me lay one more piece of research on you with regard to speculation. This one doesn’t come from some lefty activist group. It comes from one of the big Wall Street banks. Its researchers said that each million barrels of net speculative length adds as much as 10 cents to the price of a barrel of crude oil. The speculative length is a known quantity. With a little math, you can determine that the "speculative premium" on oil these days is around $23 a barrel—and that translates into about an extra 56 cents for a gallon of gas.
Considering the interests involved and the dollars at stake, I'm not surprised it has taken this long to address these kind of things. Still, we'd be smart to not wait too long. The most critical changes ought to be thoughtfully implemented well before the next financial crisis is upon us.
Not doing so is just asking for largely unnecessary self-inflicted economic pain at some unknowable point in the future.
Adam
Some excerpts from this speech given by CFTC Commissioner Bart Chilton last month (in the midst of "March Madness"):
FCIC
The Financial Crisis Inquiry Commission (FCIC) was established to look at what happened. It concluded the Troubled Asset Relief Program or TARP was needed due to two culprits to the calamity.
One culprit: regulators and regulation. You see, in 1999, Congress and the president deregulated banks. Banks were no longer bound by that pesky Depression-era Glass-Steagall Act that cramped their style and limited what they could do with the money in their institutions. With the repeal of Glass-Steagall, regulators got the message to let the free markets roll. And, roll they did—right over the American people.
The second culprit: The captains of Wall Street. FCIC concluded that since they were allowed to do so much more without those annoying rules and regulations, they devised all sorts of creative, exotic and complex financial products. Some of these things were so multifaceted hardly anyone knew what was going on or how to place a value upon them.
Credit Default Swaps (CDS)
CDSs were a significant component of creating this ginormously humongous dark market with no oversight by regulators. When I say ginormously humongous, that's a technical term. You see, we at the CFTC currently oversee roughly $5 trillion in annualized trading on regulated exchanges, but the global over-the-counter (OTC) market is roughly—here it comes—$708 trillion. If you Google ginormously humongous, it should say, "See OTC markets."
In the speech, Chilton goes through what he views as four of the most critical rule changes needed but have yet to be approved or implemented. Speculative position limits is one of the four. He argues that position limits have been needed for years and are now needed more than ever.
The Commission passed a final position limits rule in October but, according to Chilton, implementation has been delayed by a lawsuit and some other unfinished business with the SEC. More excerpts from the speech:
Speculation and "Massive Passives"
I know we need speculators. I know I know I know—there are no markets without them. Speculators are good. But like a lot of good things, too much can be problematic. Therefore, it is the excessive speculation that can cause problems, contort markets, and result in consumers and businesses paying unfair prices and negatively impacting our economy.
Chilton then describes what he calls "Massive Passives":
Between 2005 and 2008 we saw over $200 billion come into futures markets from non-traditional investors. I call them "Massive Passives." They are the likes of pension funds, index funds, hedge funds and mutual funds. These funds are very large—massive—and have a fairly price-insensitive, passive trading strategy.
Then went on to say...
I'm not suggesting that the Massive Passives, or speculators in general, are actually driving prices. Let me be clear. I’m not proposing they were all in cahoots and decided to raise oil prices. What I am saying is that they contribute to price swings, and have a proportional impact in markets based upon their size as a whole, and certainly individual traders can push prices around if they have a large enough concentration. When prices are on the rise, like now, and the Massive Passives and others get into markets, they can push prices to levels that may be uneconomic—certainly not tied directly to supply and demand—and the prices may stay higher longer than they normally would.
The Speculative Premium
...you don't have to take it from me, from Senators or U.S. Representatives, or from the President of the United States. In fact, you don’t have to take it at all. I know that many of you in this crowd won't. Nonetheless, let me lay one more piece of research on you with regard to speculation. This one doesn’t come from some lefty activist group. It comes from one of the big Wall Street banks. Its researchers said that each million barrels of net speculative length adds as much as 10 cents to the price of a barrel of crude oil. The speculative length is a known quantity. With a little math, you can determine that the "speculative premium" on oil these days is around $23 a barrel—and that translates into about an extra 56 cents for a gallon of gas.
Considering the interests involved and the dollars at stake, I'm not surprised it has taken this long to address these kind of things. Still, we'd be smart to not wait too long. The most critical changes ought to be thoughtfully implemented well before the next financial crisis is upon us.
Not doing so is just asking for largely unnecessary self-inflicted economic pain at some unknowable point in the future.
Adam
Monday, April 9, 2012
The Illusion of Skill
This article is adapted from the book "Thinking, Fast and Slow" by Professor Daniel Kahneman that was published last year. The Princeton professor is known for research on how quirks in human behavior lead to illogical decision-making and outcomes.
In the 2nd half of the article, Professor Kahneman focuses on results from studies of active traders, professional fund managers, and wealth advisers.
Active Traders, Take a Nap
According to the article, an analysis of trading records by Professor Terrance Odean* revealed that individual investors lose consistently by actively trading:
On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year...
This doesn't include the not insignificant costs of trading. The article later added:
...the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas.
I've covered this "illusion of control" in a prior post:
The Illusion of Control
Later in the article, Professor Kahneman examines a somewhat different illusion but, before looking at that, here's some more evidence from the article that less activity produces superior results.**
Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns.
The Illusion of Skill
While professional investors and traders may have (or at least would be expected to have) the skill needed to outperform the market compared to amateurs, the evidence from 50 plus years of research suggests:
...for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.
Now, what about wealth advisors? Kahneman looked at data for some anonymous wealth advisers to figure out whether the same advisers consistently achieved better returns for clients and display more skill than others. Once again...
The results resembled what you would expect from a dice-rolling contest, not a game of skill.
So what was the response from the directors when they heard of the findings? Kahneman says he and Richard Thaler told the directors the following:
What we told the directors of the firm was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign that they disbelieved us. How could they? After all, we had analyzed their own results, and they were certainly sophisticated enough to appreciate their implications, which we politely refrained from spelling out.
Then later Kahneman added:
...I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions — and thereby threaten people's livelihood and self-esteem — are simply not absorbed.
Not surprisingly, when they reported the finding to the wealth advisers themselves the response was similar. Kahneman closed with the following:
...overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.
In the 1970s, the work of Kahneman (in collaboration with Amos Tversky) challenged the flawed but once prevailing wisdom in social science that people generally acted rationally and selfishly (in some ways still alive and well even if to a lesser extent). First, they showed that mental shortcuts (heuristics) are useful but "lead to severe and systematic errors." Experiments they did revealed "cognitive biases" or unconscious errors of reasoning. Later, their prospect theory exposed flaws in the dominant models in economics at the time. The basic assumption that people will always act rationally and in their own interests was wrong.
For Kahneman and Tversky, it was obvious that people are not fully rational nor selfish.
In 2002, Kahneman won the Nobel in economic science. What's at least notable about winning such an award is that Kahneman is a psychologist.
I am currently reading Kahneman's "Thinking, Fast and Slow". The book looks at the many forms of cognitive bias and at the flawed manner that traditional economic models assume people behave (among many other things). I've found it insightful and useful for investing and beyond. It is a comprehensive (and, though accessible, I mean comprehensive!) look at the sources of human irrationality.
To me, Kahneman seems most interested in allowing the implications of the better ideas in his field to speak for themselves, while recognizing their limitations, and noting some of the key disagreements among colleagues, where applicable.
To me, it's a refreshingly humble approach.
The book has been well worth reading so far.
Adam
Related posts:
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again
* Terrance Odean is the Professor of Finance at the University of California, Berkeley.
** Based upon Terrance Odean's and Brad Barber's paper: "Trading Is Hazardous To Your Wealth".
In the 2nd half of the article, Professor Kahneman focuses on results from studies of active traders, professional fund managers, and wealth advisers.
Active Traders, Take a Nap
According to the article, an analysis of trading records by Professor Terrance Odean* revealed that individual investors lose consistently by actively trading:
On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year...
This doesn't include the not insignificant costs of trading. The article later added:
...the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas.
I've covered this "illusion of control" in a prior post:
The Illusion of Control
Later in the article, Professor Kahneman examines a somewhat different illusion but, before looking at that, here's some more evidence from the article that less activity produces superior results.**
Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns.
The Illusion of Skill
While professional investors and traders may have (or at least would be expected to have) the skill needed to outperform the market compared to amateurs, the evidence from 50 plus years of research suggests:
...for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.
Now, what about wealth advisors? Kahneman looked at data for some anonymous wealth advisers to figure out whether the same advisers consistently achieved better returns for clients and display more skill than others. Once again...
The results resembled what you would expect from a dice-rolling contest, not a game of skill.
So what was the response from the directors when they heard of the findings? Kahneman says he and Richard Thaler told the directors the following:
What we told the directors of the firm was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign that they disbelieved us. How could they? After all, we had analyzed their own results, and they were certainly sophisticated enough to appreciate their implications, which we politely refrained from spelling out.
Then later Kahneman added:
...I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions — and thereby threaten people's livelihood and self-esteem — are simply not absorbed.
Not surprisingly, when they reported the finding to the wealth advisers themselves the response was similar. Kahneman closed with the following:
...overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.
In the 1970s, the work of Kahneman (in collaboration with Amos Tversky) challenged the flawed but once prevailing wisdom in social science that people generally acted rationally and selfishly (in some ways still alive and well even if to a lesser extent). First, they showed that mental shortcuts (heuristics) are useful but "lead to severe and systematic errors." Experiments they did revealed "cognitive biases" or unconscious errors of reasoning. Later, their prospect theory exposed flaws in the dominant models in economics at the time. The basic assumption that people will always act rationally and in their own interests was wrong.
For Kahneman and Tversky, it was obvious that people are not fully rational nor selfish.
In 2002, Kahneman won the Nobel in economic science. What's at least notable about winning such an award is that Kahneman is a psychologist.
I am currently reading Kahneman's "Thinking, Fast and Slow". The book looks at the many forms of cognitive bias and at the flawed manner that traditional economic models assume people behave (among many other things). I've found it insightful and useful for investing and beyond. It is a comprehensive (and, though accessible, I mean comprehensive!) look at the sources of human irrationality.
To me, Kahneman seems most interested in allowing the implications of the better ideas in his field to speak for themselves, while recognizing their limitations, and noting some of the key disagreements among colleagues, where applicable.
To me, it's a refreshingly humble approach.
The book has been well worth reading so far.
Adam
Related posts:
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again
* Terrance Odean is the Professor of Finance at the University of California, Berkeley.
** Based upon Terrance Odean's and Brad Barber's paper: "Trading Is Hazardous To Your Wealth".
Monday, March 26, 2012
Bats IPO: A Gift to Critics of Modern Market Structure
From this Bloomberg article on the errors that forced Bats to withdraw its IPO and some of the implications of the failure:
The malfunctions will refocus scrutiny on market structure in the U.S., where two decades of government regulation have broken the grip of the biggest exchanges and left trading fragmented over as many as 50 venues. Bats, whose name stands for Better Alternative Trading System, expanded in tandem with the automated firms that now dominate the buying and selling of American equities.
The withdrawal also raises questions about the reliability of venues formed as competitors to the New York Stock Exchange and Nasdaq Stock Market since the 1990s.
Themis Trading LLC has been shedding light for some time on some of the things that led to changes in market structure. I've included excerpts from some of their prior posts and one of their white paper's:
Regulations That Contributed to Existing U.S. Market Structure
Beginning with REG ATS in the late 90′s, the SEC has had the stated goal of transparency, and equal access to pricing by all market participants. Unfortunately, with decimalization and Reg NMS, the velocity of trading has skyrocketed. While this spawned some innovative products, nevertheless it has fragmented the market place and hurt the price discovery process in an unintended way. - From Themis Trading Comments on SEC Dark Pool Proposal
Unintended Negative Consequences
To regain public trust and confidence in our equity market, the SEC must undertake major reform. Such change faces two major challenges, however. It means admitting that the past decade of regulations have had serious unintended negative consequences. And it means going up against the HFT community, which is likely to do everything in its power to slow or water down the reform process.
The HFT community will claim that if any serious reform is implemented, they will be driven out of the market, spreads will increase and liquidity will dry up. We agree that spreads will widen, but liquidity will not vanish; only HFT volume will. And if a slightly wider spread is the cost of getting our market back into the hands of the owners who are responsible for price discovery, then that is a cost that most investors will gladly pay, we believe. While explicit costs will go up, the implicit costs of reduced market confidence will plummet. - From a White Paper by Sal Arnuk and Joseph Saluzzi
Those implicit costs may be hard to measure but that doesn't make the costs of reduced market confidence any less real.
Threat to Market Stability?
The first step in fixing a problem is admitting that you have one and that is exactly what this committee did last week. The unintended consequences of Reg ATS, the Order Handling Rules, Decimalization and Reg NMS have emerged into a serious threat to the stability of our market and they need to be addressed immediately. - From Great Expectations and the Frankenstein Market
Beneficial to Capital Formation?
Were these regulations beneficial to the markets? Were they beneficial to capital formation? Which is larger today: the cash equity business (ownership in real economic corporations), or more profitable market for derivative instruments of those equities? Is today’s Frankenstein market a result of “unintended consequences”, or is this market exactly the intended plan of the insiders, given that the current market participants had literally years to tool up to prepare (and take advantage of) for that very Frankenstein market? - From The Revolving Door
What's at stake seems straightforward enough but the fix won't be easy.
Does the market structure that exists today facilitate anything near the most effective capital raising and formation capability possible?
Are participants who invest primarily with longer term economic effects in mind being pushed aside in favor of more short-term oriented insiders?
I'm pretty sure that answers aren't likely to come from those with entrenched interest in the status quo. Pressure from places with fewer conflicts obviously have the better chance of getting us closer to more a desirable outcome.
Adam
The malfunctions will refocus scrutiny on market structure in the U.S., where two decades of government regulation have broken the grip of the biggest exchanges and left trading fragmented over as many as 50 venues. Bats, whose name stands for Better Alternative Trading System, expanded in tandem with the automated firms that now dominate the buying and selling of American equities.
The withdrawal also raises questions about the reliability of venues formed as competitors to the New York Stock Exchange and Nasdaq Stock Market since the 1990s.
Themis Trading LLC has been shedding light for some time on some of the things that led to changes in market structure. I've included excerpts from some of their prior posts and one of their white paper's:
Regulations That Contributed to Existing U.S. Market Structure
Beginning with REG ATS in the late 90′s, the SEC has had the stated goal of transparency, and equal access to pricing by all market participants. Unfortunately, with decimalization and Reg NMS, the velocity of trading has skyrocketed. While this spawned some innovative products, nevertheless it has fragmented the market place and hurt the price discovery process in an unintended way. - From Themis Trading Comments on SEC Dark Pool Proposal
Unintended Negative Consequences
To regain public trust and confidence in our equity market, the SEC must undertake major reform. Such change faces two major challenges, however. It means admitting that the past decade of regulations have had serious unintended negative consequences. And it means going up against the HFT community, which is likely to do everything in its power to slow or water down the reform process.
The HFT community will claim that if any serious reform is implemented, they will be driven out of the market, spreads will increase and liquidity will dry up. We agree that spreads will widen, but liquidity will not vanish; only HFT volume will. And if a slightly wider spread is the cost of getting our market back into the hands of the owners who are responsible for price discovery, then that is a cost that most investors will gladly pay, we believe. While explicit costs will go up, the implicit costs of reduced market confidence will plummet. - From a White Paper by Sal Arnuk and Joseph Saluzzi
Those implicit costs may be hard to measure but that doesn't make the costs of reduced market confidence any less real.
Threat to Market Stability?
The first step in fixing a problem is admitting that you have one and that is exactly what this committee did last week. The unintended consequences of Reg ATS, the Order Handling Rules, Decimalization and Reg NMS have emerged into a serious threat to the stability of our market and they need to be addressed immediately. - From Great Expectations and the Frankenstein Market
Beneficial to Capital Formation?
Were these regulations beneficial to the markets? Were they beneficial to capital formation? Which is larger today: the cash equity business (ownership in real economic corporations), or more profitable market for derivative instruments of those equities? Is today’s Frankenstein market a result of “unintended consequences”, or is this market exactly the intended plan of the insiders, given that the current market participants had literally years to tool up to prepare (and take advantage of) for that very Frankenstein market? - From The Revolving Door
What's at stake seems straightforward enough but the fix won't be easy.
Does the market structure that exists today facilitate anything near the most effective capital raising and formation capability possible?
Are participants who invest primarily with longer term economic effects in mind being pushed aside in favor of more short-term oriented insiders?
I'm pretty sure that answers aren't likely to come from those with entrenched interest in the status quo. Pressure from places with fewer conflicts obviously have the better chance of getting us closer to more a desirable outcome.
Adam
Friday, March 23, 2012
North American Oil and Gas Revolution
From this CNBC article:
Increased production of energy from a number of sources including deepwater drilling, natural gas exploration and Canada's oil sands could make North America the next Middle East, according to a new report from Citigroup.
According to the report, supply will go up substantially a result of the substantial strides in natural resource extraction. In addition, demand for oil in the U.S. is down 2 million barrels per day (since the peak in 2005) and is expected to continue declining over the next decade. Some of this is the result of the 2008 recession but it is also partly a structural decline.
The article quotes Ed Morse, head of global commodities research at Citigroup. Mr. Morse says this supply and demand revolution has "potentially extraordinary" economic consequences.
The report also predicts that the U.S. could overtake both Russia and Saudi Arabia in oil production by 2020. Check out the chart in this article.
According to the article, Citigroup's analysts assert that some of the consequences for the U.S. in a "good case" scenario include:
- An increase in GDP of 2.0 to 3.3 percent
- Roughly 3.6 million new jobs by 2020
- Decreased geopolitical risks
- A decline in oil prices
In 2011, the U.S. became an exporter of refined oil for the first time since 1949 but will likely continue to be a net importer of crude oil for a very long time. The U.S. currently imports roughly 9 million barrels of crude oil per day so there's a long way to go.
There's still a ways to go but the Citigroup report suggests the U.S. could put a material dent in those 9 million barrels of daily imported crude oil in less than ten years.
From this article in The New York Times:
Across the country, the oil and gas industry is vastly increasing production, reversing two decades of decline. Using new technology and spurred by rising oil prices since the mid-2000s, the industry is extracting millions of barrels more a week, from the deepest waters of the Gulf of Mexico to the prairies of North Dakota.
We are also using significantly less gasoline. In part due to the recession and high prices but also from driving less with more fuel-efficient machines. While our reliance on imports continues to be substantial, I doubt many would have predicted that anything like this would happen in the U.S. as recently as five or so years ago.
The question is whether there's a smart way to invest in this.
That I haven't figured out yet.
Adam
Increased production of energy from a number of sources including deepwater drilling, natural gas exploration and Canada's oil sands could make North America the next Middle East, according to a new report from Citigroup.
According to the report, supply will go up substantially a result of the substantial strides in natural resource extraction. In addition, demand for oil in the U.S. is down 2 million barrels per day (since the peak in 2005) and is expected to continue declining over the next decade. Some of this is the result of the 2008 recession but it is also partly a structural decline.
The article quotes Ed Morse, head of global commodities research at Citigroup. Mr. Morse says this supply and demand revolution has "potentially extraordinary" economic consequences.
The report also predicts that the U.S. could overtake both Russia and Saudi Arabia in oil production by 2020. Check out the chart in this article.
- An increase in GDP of 2.0 to 3.3 percent
- Roughly 3.6 million new jobs by 2020
- Decreased geopolitical risks
- A decline in oil prices
In 2011, the U.S. became an exporter of refined oil for the first time since 1949 but will likely continue to be a net importer of crude oil for a very long time. The U.S. currently imports roughly 9 million barrels of crude oil per day so there's a long way to go.
There's still a ways to go but the Citigroup report suggests the U.S. could put a material dent in those 9 million barrels of daily imported crude oil in less than ten years.
From this article in The New York Times:
Across the country, the oil and gas industry is vastly increasing production, reversing two decades of decline. Using new technology and spurred by rising oil prices since the mid-2000s, the industry is extracting millions of barrels more a week, from the deepest waters of the Gulf of Mexico to the prairies of North Dakota.
We are also using significantly less gasoline. In part due to the recession and high prices but also from driving less with more fuel-efficient machines. While our reliance on imports continues to be substantial, I doubt many would have predicted that anything like this would happen in the U.S. as recently as five or so years ago.
The question is whether there's a smart way to invest in this.
That I haven't figured out yet.
Adam
Monday, March 12, 2012
Credit Default Swaps: Insurance Masquerading As A Financial Product
Yesterday's Washington Post article by Barry Ritholtz provided some useful history and background on credit-default swaps (CDS).
Washington Post: Credit default swaps are insurance products. It's time we regulated them as such.
It's well worth reading and makes a strong case for regulating CDS the same way as other insurance products.
In the article, Ritholtz makes the following points:
- CDS obtained their favored status as unregulated insurance policies thanks to the Commodity Futures Modernization Act of 2000 (CFMA). They continue to be, effectively, unregulated insurance policies.
- The act was built on the assumption that markets could self-regulate (I think it is fair to say we've learned otherwise) and, as a result, basically eliminated all relevant regulations.
- Commodity Exchange Act of 1936 was modified so derivative transactions were exempted from regulations as "futures" and "securities" (via fed securities laws).
- CFMA exempted credit-defaults swaps and other derivatives from regulation by state insurance regulators.
So that means...
- CDS can be traded like any financial products but is not considered a security.
- CDS can be used to hedge future prices but is not considered a futures contract.
- CDS pays in the event of a specific loss but is not considered an insurance policy.
Makes sense, right?
Well, not surprisingly this "innovation" changed behavior in the industry. The article also points out insurance companies have to typically set aside reserves to cover losses. With swaps there is no such requirement.
Ritholtz goes on to write that "they are still exempt from all insurance regulatory oversight," even though they are "thinly disguised insurance products" with the added bonus that they lack reserve requirements.
Why does this matter? Ultimately, the problem is reserves (or the lack thereof).*
If treated like the insurance products that they are, insurance regulators would impose appropriate reserve requirements. This, of course, would reassure participants that the institutions on the hook are actually capable of paying down the road. It seems fairly obvious that this would increase the health, stability, and effectiveness of the financial system.
First and foremost, the increasingly complex and vital financial system is built upon trust and confidence. If system-wide robustness is in doubt it can't function optimally. As it stands now, knowing whether there is a systemically crucial institution liable for something it's incapable of absorbing isn't easy for anyone to judge. It opens the door for rumors and raw emotion to set the agenda in lieu of facts and rationality.
We should know from recent experience that, at least during chaotic markets, this matters a whole bunch.
The mere fact that it's so difficult to figure out who's potentially liable for what creates damaging uncertainty.
That uncertainty, during times of economic stress, potentially amplifies the size of the problem.
We've already learned that during times of financial crisis what starts as a seemingly manageable problem takes on an unpredictable life of its own.
Check out the full article.
Adam
* Lack of reserves certainly aren't the only problem with CDS. It's an established principle for an insurance company to not let someone insure something they don't own because they do not have an insurable interest. England figured out centuries ago it's a good idea to remove the ability to profit from another's loss and the possibility of misconduct associated with it. Human nature hasn't changed. Warren Buffett made this point in an interview last year on CNBC: "...you can't go out and insure my house against fire because you do not have an insurable interest, as they call it in the trade. Because once you insure my house against fire and you may decide that, you know, that maybe dropping a few matches around my lawn might be a good idea." Yet, with credit default swaps, one can take out insurance on a bond without actually owning that bond. So someone that doesn't own an underlying corporate or sovereign bond have been able to place a bet against it via the purchase of a credit default swap then directly benefit if a default occurs. It's rather similar to being able to insure someone else's home and directly benefiting from something bad happening to it. These side bets, it seems, have the potential to be massively destabilizing though there is far from universal agreement on this. Some argue that wise limits to reign this sort of thing in is plainly needed (if not an outright ban); others argue for quite the opposite. I'll take the recently adopted outright ban on sovereign debt sooner than later. It may not be sufficient but it's a start.
Related prior posts include:
Sinking Seaworthy Ships
The Bond Market Rules
Buffett: Credit Default Swaps Potentially "Very Anti-social" Instruments
Washington Post: Credit default swaps are insurance products. It's time we regulated them as such.
It's well worth reading and makes a strong case for regulating CDS the same way as other insurance products.
In the article, Ritholtz makes the following points:
- CDS obtained their favored status as unregulated insurance policies thanks to the Commodity Futures Modernization Act of 2000 (CFMA). They continue to be, effectively, unregulated insurance policies.
- The act was built on the assumption that markets could self-regulate (I think it is fair to say we've learned otherwise) and, as a result, basically eliminated all relevant regulations.
- Commodity Exchange Act of 1936 was modified so derivative transactions were exempted from regulations as "futures" and "securities" (via fed securities laws).
- CFMA exempted credit-defaults swaps and other derivatives from regulation by state insurance regulators.
So that means...
- CDS can be traded like any financial products but is not considered a security.
- CDS can be used to hedge future prices but is not considered a futures contract.
- CDS pays in the event of a specific loss but is not considered an insurance policy.
Makes sense, right?
Well, not surprisingly this "innovation" changed behavior in the industry. The article also points out insurance companies have to typically set aside reserves to cover losses. With swaps there is no such requirement.
Ritholtz goes on to write that "they are still exempt from all insurance regulatory oversight," even though they are "thinly disguised insurance products" with the added bonus that they lack reserve requirements.
Why does this matter? Ultimately, the problem is reserves (or the lack thereof).*
If treated like the insurance products that they are, insurance regulators would impose appropriate reserve requirements. This, of course, would reassure participants that the institutions on the hook are actually capable of paying down the road. It seems fairly obvious that this would increase the health, stability, and effectiveness of the financial system.
First and foremost, the increasingly complex and vital financial system is built upon trust and confidence. If system-wide robustness is in doubt it can't function optimally. As it stands now, knowing whether there is a systemically crucial institution liable for something it's incapable of absorbing isn't easy for anyone to judge. It opens the door for rumors and raw emotion to set the agenda in lieu of facts and rationality.
We should know from recent experience that, at least during chaotic markets, this matters a whole bunch.
The mere fact that it's so difficult to figure out who's potentially liable for what creates damaging uncertainty.
That uncertainty, during times of economic stress, potentially amplifies the size of the problem.
We've already learned that during times of financial crisis what starts as a seemingly manageable problem takes on an unpredictable life of its own.
Check out the full article.
Adam
* Lack of reserves certainly aren't the only problem with CDS. It's an established principle for an insurance company to not let someone insure something they don't own because they do not have an insurable interest. England figured out centuries ago it's a good idea to remove the ability to profit from another's loss and the possibility of misconduct associated with it. Human nature hasn't changed. Warren Buffett made this point in an interview last year on CNBC: "...you can't go out and insure my house against fire because you do not have an insurable interest, as they call it in the trade. Because once you insure my house against fire and you may decide that, you know, that maybe dropping a few matches around my lawn might be a good idea." Yet, with credit default swaps, one can take out insurance on a bond without actually owning that bond. So someone that doesn't own an underlying corporate or sovereign bond have been able to place a bet against it via the purchase of a credit default swap then directly benefit if a default occurs. It's rather similar to being able to insure someone else's home and directly benefiting from something bad happening to it. These side bets, it seems, have the potential to be massively destabilizing though there is far from universal agreement on this. Some argue that wise limits to reign this sort of thing in is plainly needed (if not an outright ban); others argue for quite the opposite. I'll take the recently adopted outright ban on sovereign debt sooner than later. It may not be sufficient but it's a start.
Related prior posts include:
Sinking Seaworthy Ships
The Bond Market Rules
Buffett: Credit Default Swaps Potentially "Very Anti-social" Instruments
Thursday, February 23, 2012
SEC May Ticket High Speed Traders
Apparently, the Securities and Exchange Commission (SEC) may start charging fees to curb high frequency trading. In this Wall Street Journal article, Mary Schapiro said the following:
...a large portion of equities trading has little to do with "the fundamentals of the company that's being traded." She said it had more to do with "the minuscule aberrational price move" that computer-assisted traders with direct connections to the exchange can "jump on" in fractions of a second.
In addition to forcing traders to pay for cancelled trades (it turns out cancelled trades make up something like 95 to 98% of orders by high-frequency traders), the SEC may impose a requirement on high-speed participants to maintain competitive buy and sell orders throughout most of the trading day.
According to this article, Schapiro's concerns were sparked by the "flash crash" back in May of 2010.
That article points out that the SEC's mission is to "maintain fair, orderly and efficient markets" and to "facilitate capital formation." It seems to me that most high-frequency trading activity adds little value to the capital formation process and, if anything, might be one of the reasons we've seen record volatility.
In it's current form, whether high-frequency trading somehow helps "maintain fair, orderly and efficient markets" seems at least debatable.
The article points out the crash is a challenge to the SEC's stated mission.
...to "maintain fair, orderly and efficient markets" and to "facilitate capital formation." If investors are afraid of a market crash, in other words, they won't provide the capital that public companies need to expand their businesses.
According to Schapiro, the SEC has implemented some fixes since the flash crash including:
-Circuit breakers for stocks that have large moves in a short period of time.
-A ban on stub quotes (offering to buy/sell far from what most investors are willing to pay...a contributor the the flash crash).
Some questions come to mind:
Will the fees on cancelled trades be substantial enough to actually change high-speed trading behavior?
Will the requirement to maintain competitive buy and sell orders for a certain percentage of the trading day change behavior?
In what time frame will the changes be implemented?
Are other solutions being considering to curb the influence of high frequency trading?
Just a guess but those involved in high frequency trading will likely not think these fees and other changes under consideration are such great ideas since, of course, they'll have adverse effects on "liquidity".
Well, I think we can stand for a bit less liquidity and a bit more actual investing. Charlie Munger said it best. He doesn't see much benefit to the massive amount of trading between computers that goes on. He also doesn't seem to think the energy expended and talent utilized writing algorithms (that ultimately the rest of us pay for) provides much social contribution.
"...why should we want to encourage our brightest minds to do what amounts to code-breaking and electronic trading? No I think the whole system is stark-raving mad. Why should we want 25% of our graduating engineers going into finance?" - Charlie Munger
Munger: Cut Banking Sector 80%
The economics of high frequency trading will have to be fundamentally changed for this to work in the long run. It's not like this is static. Adjustments by high-speed traders will naturally be made to try and thrive under whatever the new rules end up being.
Adam
...a large portion of equities trading has little to do with "the fundamentals of the company that's being traded." She said it had more to do with "the minuscule aberrational price move" that computer-assisted traders with direct connections to the exchange can "jump on" in fractions of a second.
In addition to forcing traders to pay for cancelled trades (it turns out cancelled trades make up something like 95 to 98% of orders by high-frequency traders), the SEC may impose a requirement on high-speed participants to maintain competitive buy and sell orders throughout most of the trading day.
According to this article, Schapiro's concerns were sparked by the "flash crash" back in May of 2010.
That article points out that the SEC's mission is to "maintain fair, orderly and efficient markets" and to "facilitate capital formation." It seems to me that most high-frequency trading activity adds little value to the capital formation process and, if anything, might be one of the reasons we've seen record volatility.
In it's current form, whether high-frequency trading somehow helps "maintain fair, orderly and efficient markets" seems at least debatable.
The article points out the crash is a challenge to the SEC's stated mission.
...to "maintain fair, orderly and efficient markets" and to "facilitate capital formation." If investors are afraid of a market crash, in other words, they won't provide the capital that public companies need to expand their businesses.
According to Schapiro, the SEC has implemented some fixes since the flash crash including:
-Circuit breakers for stocks that have large moves in a short period of time.
-A ban on stub quotes (offering to buy/sell far from what most investors are willing to pay...a contributor the the flash crash).
Some questions come to mind:
Will the fees on cancelled trades be substantial enough to actually change high-speed trading behavior?
Will the requirement to maintain competitive buy and sell orders for a certain percentage of the trading day change behavior?
In what time frame will the changes be implemented?
Are other solutions being considering to curb the influence of high frequency trading?
Just a guess but those involved in high frequency trading will likely not think these fees and other changes under consideration are such great ideas since, of course, they'll have adverse effects on "liquidity".
Well, I think we can stand for a bit less liquidity and a bit more actual investing. Charlie Munger said it best. He doesn't see much benefit to the massive amount of trading between computers that goes on. He also doesn't seem to think the energy expended and talent utilized writing algorithms (that ultimately the rest of us pay for) provides much social contribution.
"...why should we want to encourage our brightest minds to do what amounts to code-breaking and electronic trading? No I think the whole system is stark-raving mad. Why should we want 25% of our graduating engineers going into finance?" - Charlie Munger
Munger: Cut Banking Sector 80%
The economics of high frequency trading will have to be fundamentally changed for this to work in the long run. It's not like this is static. Adjustments by high-speed traders will naturally be made to try and thrive under whatever the new rules end up being.
Adam
Wednesday, February 1, 2012
The Fracking Revolution: End of the Peak-Oil Hypothesis?
Fracking* is a method of extracting natural gas (and increasingly oil) that seems to be transforming the energy industry.
This Bloomberg article says that the U.S. oil market may be about to have a fracking revolution not unlike what has happened with natural gas.
Fracking Boom Could Finally Cap Myth of Peak Oil
In the U.S., the primary controversy when it comes to fracking has been and continues to be concerns over the adverse environmental effects.
Still, what seems amazing, no matter how the environmental issues play out, is how quickly these advances have changed the oil and gas landscape.
In the article, CEO Jim Mulva of ConocoPhillips said the following:
"The revolution has spread to domestic oil production. And it may track the path it followed with natural gas."
Experts refer to oil that comes from shale formations as "tight oil".
The federal Energy Information Administration estimates that production of crude oil in the U.S. will rise to 6.7 million barrels per day by 2020 (much coming from tight oil and development of offshore resources), a level not achieved since 1994.
As a comparison, domestic crude oil in the U.S. was produced at a rate of 5.5 million barrels per day in 2010.
Some think the future estimates are still conservative since projections of "tight oil" continue to be revised higher. Energy analyst Seth Kleinman added this in the Bloomberg article:
The year ahead, he [Kleinman] says, "could really see the death of the peak-oil hypothesis..."
This Reuters article from late last year also explains some of the implications of horizontal drilling and fracking. Some excerpts from the article:
Transformed in Less Than Half a Decade
The combination of horizontal drilling and hydraulic fracturing has already transformed North America's natural gas market in less than half a decade. It is now starting to do the same for U.S. oil production...
Worldwide Transformation & Major Constraints
Fracking and horizontal drilling have the potential to transform the industry worldwide.
Inside North America and Western Europe, the major constraint on the roll-out of the technology is political and environmental opposition. Outside the United States, the main constraints are lack of specialised equipment, know-how and skilled personnel.
The lack of specialised equipment and skills outside the U.S. would seem to sort itself out over time. Knowing how some of the environmental controversies end up impacting the potential of all this seems harder to gauge.
Adam
* The term fracking (or hydrofracking) is short for hydraulic fracturing.
This Bloomberg article says that the U.S. oil market may be about to have a fracking revolution not unlike what has happened with natural gas.
Fracking Boom Could Finally Cap Myth of Peak Oil
In the U.S., the primary controversy when it comes to fracking has been and continues to be concerns over the adverse environmental effects.
Still, what seems amazing, no matter how the environmental issues play out, is how quickly these advances have changed the oil and gas landscape.
In the article, CEO Jim Mulva of ConocoPhillips said the following:
"The revolution has spread to domestic oil production. And it may track the path it followed with natural gas."
Experts refer to oil that comes from shale formations as "tight oil".
The federal Energy Information Administration estimates that production of crude oil in the U.S. will rise to 6.7 million barrels per day by 2020 (much coming from tight oil and development of offshore resources), a level not achieved since 1994.
As a comparison, domestic crude oil in the U.S. was produced at a rate of 5.5 million barrels per day in 2010.
Some think the future estimates are still conservative since projections of "tight oil" continue to be revised higher. Energy analyst Seth Kleinman added this in the Bloomberg article:
The year ahead, he [Kleinman] says, "could really see the death of the peak-oil hypothesis..."
This Reuters article from late last year also explains some of the implications of horizontal drilling and fracking. Some excerpts from the article:
Transformed in Less Than Half a Decade
The combination of horizontal drilling and hydraulic fracturing has already transformed North America's natural gas market in less than half a decade. It is now starting to do the same for U.S. oil production...
Worldwide Transformation & Major Constraints
Fracking and horizontal drilling have the potential to transform the industry worldwide.
Inside North America and Western Europe, the major constraint on the roll-out of the technology is political and environmental opposition. Outside the United States, the main constraints are lack of specialised equipment, know-how and skilled personnel.
The lack of specialised equipment and skills outside the U.S. would seem to sort itself out over time. Knowing how some of the environmental controversies end up impacting the potential of all this seems harder to gauge.
Adam
* The term fracking (or hydrofracking) is short for hydraulic fracturing.
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