Good Reading -- October 2009
Shorter list, but more editorial commentary (sorry). Hope everyone is doing well. - Phil
"Liquor Before Beer, in the Clear" -- David Einhorn's speech at the Value Investing Congress. I don't agree with 100% of the content, but as usual there is some thoughtful analysis of important issues. (I do have to say that I still roundly reject the notion of gold as an "investment" or a de facto inflation hedge.)
"Fear and Loathing in Las Vegas" -- an academic study finding evidence that gamblers act irrationally to minimize regret rather than to maximize their utility/bankroll. This obviously goes against much of ecnomic theory, which relies heavily on the purely rational man, and supports the Kahneman/Taversky view of the world, to which I subscribe. Anyone who's played blackjack, or poker, or followed the behavior of many stock market "investors," will likely appreciate this one.
"Just Desserts and Markets Being Silly Again" -- Jeremy Grantham's quarterly letter. Ignore, or read at your own peril, the macro-, forward-looking commentary sprinkled in beginning on page 4, but the first few pages have some exceptionally biting but worthwhile commentary.
"The Investor's Manifesto" -- I don't know much about the author (although I get the feeling we'd have our differences), but based on the table of contents and this excerpt, this book seems interesting. The author seems to be switching from "You can do it!" to "Let's stop and think this through," which, combined with the Ben Graham homage and emphasis on history, encourages me. The five points in the foreword are worthwhile, as is the conclusion that the four required characteristics to be a successful investor (strong interest in the subject, ability in math, knowledge of history, and emotional discipline) means the vast majority of people will not have the full skill set and thus should not actively invest their own money (i.e., they should buy a low-cost index). I also agree whole-heartedly that the average investor's biggest enemy is himself, and that "two of the most virulent behavioral organisms are overconfidence and an overemphasis on recent history."
"Warren Buffett and His 9% Discount Rate" -- I'm not sure when or where this was published, but it does a good job of debunking the myth of beta and CAPM (namely, that past stock price movements relate to future price movements, and that price volatility = risk; the Warren Buffett view of the world is that the past price performance of anything is almost devoid of meaning, especially as it pertains to value, and that risk equals the permanent loss of capital, not volatility). Other thoughts:
I believe (but can't substantiate) that Buffett uses 10% rather than 9%, as a general rule of thumb...
...but the point remains the same. The important thing is that his concept of appropriate return is fairlyconstant -- again, it is not irrespective of risk as the article claims (risk is a mostly function of the price paid), but it is irrespective of inflation, interest rates, etc.
Note the important caveat at the end about staying in one's circle of competence
The point about the absurdity of five-year cash flow forecasts of speculative VC start-ups is great, but note that the "exit multiple" or "terminal value" compounds the inaccuracy, and is often an even bigger probculprit
While it's true that "Buffett does not use discount rates as a proxy for risk," it is misleading to say that he then "adjusts for risk by projecting more accurate free cash flows" -- it may well be true that his cash flows are more accurate, but he doesn't necessarily model them out to a better/more accurate degree. Instead, he seeks a margin of safety, whether through asset values, a competitive moat, a clearer or contrarian view of cash flows, whatever.
Copied and Linked To
"Wall Street Smarts" -- quite a bit of truth here.
Paul Volcker and Breaking Up Wall Street -- Austan Goolsbee is a dangerous idiot, but he's right that the Obama administration should respect and listen to Paul Volcker. Volcker is that rare human being in Washington with the courage and integrity to look beyond his own self interest and the next news or election cycle. Volcker is on the side of reason and the country's long-term best interests; the politicians are on the opposing of short-termism, special interests and getting reelected. But despite Goolsbee's claim, Volcker is being roundly ignored by the current administration. One of Volcker's most important points -- regarding the need to break up the megabanks or otherwise reinstate Glass-Steagall so as to separate trading and investment/merchant banking from commercial banking, is especially important right now.
Opposing views on the end of the world (links only) -- this guy, citing Marc Faber among others, says the collapse of America and capitalism is at hand, with dubious figures, non sequitors and spurious correlation galore. Warren Buffett points to history and says things are very rough but the system works; we've been through worse and we'll come through this too. I know which side I'm on...
"Why Minksy was Right: The Next Bubble is Already Underway" -- I would ignore most of the commentary in the first few paragraphs about valuing the market (valid as it may be) and get to the part about the endgame for central banks and the implication for asset prices and inflation. The results are not pretty.
October 14, 2009
Wall Street Smarts
By CALVIN TRILLIN
“IF you really want to know why the financial system nearly collapsed in the fall of 2008, I can tell you in one simple sentence.”
The statement came from a man sitting three or four stools away from me in a sparsely populated Midtown bar, where I was waiting for a friend. “But I have to buy you a drink to hear it?” I asked.
“Absolutely not,” he said. “I can buy my own drinks. My 401(k) is intact. I got out of the market 8 or 10 years ago, when I saw what was happening.”
He did indeed look capable of buying his own drinks — one of which, a dry martini, straight up, was on the bar in front of him. He was a well-preserved, gray-haired man of about retirement age, dressed in the same sort of clothes he must have worn on some Ivy League campus in the late ’50s or early ’60s — a tweed jacket, gray pants, a blue button-down shirt and a club tie that, seen from a distance, seemed adorned with tiny brussels sprouts.
“O.K.,” I said. “Let’s hear it.”
“The financial system nearly collapsed,” he said, “because smart guys had started working on Wall Street.” He took a sip of his martini, and stared straight at the row of bottles behind the bar, as if the conversation was now over.
“But weren’t there smart guys on Wall Street in the first place?” I asked.
He looked at me the way a mathematics teacher might look at a child who, despite heroic efforts by the teacher, seemed incapable of learning the most rudimentary principles of long division. “You are either a lot younger than you look or you don’t have much of a memory,” he said. “One of the speakers at my 25th reunion said that, according to a survey he had done of those attending, income was now precisely in inverse proportion to academic standing in the class, and that was partly because everyone in the lower third of the class had become a Wall Street millionaire.”
I reflected on my own college class, of roughly the same era. The top student had been appointed a federal appeals court judge — earning, by Wall Street standards, tip money. A lot of the people with similarly impressive academic records became professors. I could picture the future titans of Wall Street dozing in the back rows of some gut course like Geology 101, popularly known as Rocks for Jocks.
“That actually sounds more or less accurate,” I said.
“Of course it’s accurate,” he said. “Don’t get me wrong: the guys from the lower third of the class who went to Wall Street had a lot of nice qualities. Most of them were pleasant enough. They made a good impression. And now we realize that by the standards that came later, they weren’t really greedy. They just wanted a nice house in Greenwich and maybe a sailboat. A lot of them were from families that had always been on Wall Street, so they were accustomed to nice houses in Greenwich. They didn’t feel the need to leverage the entire business so they could make the sort of money that easily supports the second oceangoing yacht.”
“So what happened?”
“I told you what happened. Smart guys started going to Wall Street.”
“I thought you’d never ask,” he said, making a practiced gesture with his eyebrows that caused the bartender to get started mixing another martini.
“Two things happened. One is that the amount of money that could be made on Wall Street with hedge fund and private equity operations became just mind-blowing. At the same time, college was getting so expensive that people from reasonably prosperous families were graduating with huge debts. So even the smart guys went to Wall Street, maybe telling themselves that in a few years they’d have so much money they could then become professors or legal-services lawyers or whatever they’d wanted to be in the first place. That’s when you started reading stories about the percentage of the graduating class of Harvard College who planned to go into the financial industry or go to business school so they could then go into the financial industry. That’s when you started reading about these geniuses from M.I.T. and Caltech who instead of going to graduate school in physics went to Wall Street to calculate arbitrage odds.”
“But you still haven’t told me how that brought on the financial crisis.”
“Did you ever hear the word ‘derivatives’?” he said. “Do you think our guys could have invented, say, credit default swaps? Give me a break! They couldn’t have done the math.”
“Why do I get the feeling that there’s one more step in this scenario?” I said.
“Because there is,” he said. “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that. All of that easy money had eaten away at their sense of enoughness.”
“So having smart guys there almost caused Wall Street to collapse.”
“You got it,” he said. “It took you awhile, but you got it.”
The theory sounded too simple to be true, but right offhand I couldn’t find any flaws in it. I found myself contemplating the sort of havoc a horde of smart guys could wreak in other industries. I saw those industries falling one by one, done in by superior intelligence. “I think I need a drink,” I said.
He nodded at my glass and made another one of those eyebrow gestures to the bartender. “Please,” he said. “Allow me.”
Calvin Trillin is the author, most recently, of “Deciding the Next Decider: The 2008 Presidential Race in Rhyme.”
Volcker Fails to Sell a Bank Strategy
By LOUIS UCHITELLE
Listen to a top economist in the Obama administration describe Paul A. Volcker, the former Federal Reserve chairman who endorsed Mr. Obama early in his election campaign and who stood by his side during the financial crisis.
“The guy’s a giant, he’s a genius, he is a great human being,” said Austan D. Goolsbee, counselor to Mr. Obama since their Chicago days. “Whenever he has advice, the administration is very interested.”
Well, not lately. The aging Mr. Volcker (he is 82) has some advice, deeply felt. He has been offering it in speeches and Congressional testimony, and repeating it to those around the president, most of them young enough to be his children.
He wants the nation’s banks to be prohibited from owning and trading risky securities, the very practice that got the biggest ones into deep trouble in 2008. And the administration is saying no, it will not separate commercial banking from investment operations.
“I am not pounding the desk all the time, but I am making my point,” Mr. Volcker said in one of his infrequent on-the-record interviews. “I have talked to some senators who asked me to talk to them, and if people want to talk to me, I talk to them. But I am not going around knocking on doors.”
Still, he does head the president’s Economic Recovery Advisory Board, which makes him the administration’s most prominent outside economic adviser. As Fed chairman from 1979 to 1987, he helped the country weather more than one crisis. And in the campaign last year, he appeared occasionally with Mr. Obama, including a town hall meeting in Florida last fall. His towering presence (he is 6-foot-8) offered reassurance that the candidate’s economic policies, in the midst of a crisis, were trustworthy.
More subtly, Mr. Obama has in Mr. Volcker an adviser perceived as standing apart from Wall Street, and critical of its ways, some administration officials say, while Timothy F. Geithner, the Treasury secretary, and Lawrence H. Summers, chief of the National Economic Council, are seen, rightly or wrongly, as more sympathetic to the concerns of investment bankers.
For all these reasons, Mr. Volcker’s approach to financial regulation cannot be just brushed off — and Mr. Goolsbee, speaking for the administration, is careful not to do so. “We have discussed these issues with Paul Volcker extensively,” he said.
Mr. Volcker’s proposal would roll back the nation’s commercial banks to an earlier era, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities.
The Obama team, in contrast, would let the giants survive, but would regulate them extensively, so they could not get themselves and the nation into trouble again. While the administration’s proposal languishes, giants like Goldman Sachs have re-engaged in old trading practices, once again earning big profits and planning big bonuses.
Mr. Volcker argues that regulation by itself will not work. Sooner or later, the giants, in pursuit of profits, will get into trouble. The administration should accept this and shield commercial banking from Wall Street’s wild ways.
“The banks are there to serve the public,” Mr. Volcker said, “and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties” and ultimately fails.
The only viable solution, in the Volcker view, is to break up the giants. JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. Goldman Sachs could no longer be a bank holding company. It’s a tall order, and to achieve it Congress would have to enact a modern-day version of the 1933 Glass-Steagall Act, which mandated separation.
Glass-Steagall was watered down over the years and finally revoked in 1999. In the Volcker resurrection, commercial banks would take deposits, manage the nation’s payments system, make standard loans and even trade securities for their customers — just not for themselves. The government, in return, would rescue banks that fail.
On the other side of the wall, investment houses would be free to buy and sell securities for their own accounts, borrowing to leverage these trades and thus multiplying the profits, and the risks.
Being separated from banks, the investment houses would no longer have access to federally insured deposits to finance this trading. If one failed, the government would supervise an orderly liquidation. None would be too big to fail — a designation that could arise for a handful of institutions under the administration’s proposal.
“People say I’m old-fashioned and banks can no longer be separated from nonbank activity,” Mr. Volcker said, acknowledging criticism that he is nostalgic for an earlier era. “That argument,” he added ruefully, “brought us to where we are today.”
He may not be alone in his proposal, but he is nearly so. Most economists and policy makers argue that a global economy requires that America have big financial institutions to compete against others in Europe and Asia. An administration spokesman says the Obama proposal for reform would result in financial institutions that could fail without damaging the system.
Still, a handful side with Mr. Volcker, among them Joseph E. Stiglitz, a Nobel laureate in economics at Columbia and a former official in the Clinton administration. “We would have a cleaner, safer banking system,” Mr. Stiglitz said, adding that while he endorses Mr. Volcker’s proposal, the former Fed chairman is nevertheless embarked on a quixotic journey.
Alan Greenspan, the only other former Fed chairman still living, favored the repeal of Glass-Steagall a decade ago and, unlike Mr. Volcker, would not bring it back now. He declined to be interviewed for this article, but in response to e-mailed questions he cited two recent public statements in which he suggested that the nation’s largest financial institutions become smaller, so that none would be too big to fail, requiring a federal rescue.
Taking issue implicitly with the Volcker proposal to split commercial and investment banking, he has said: “No form of economic organization can fully contain bouts of destructive speculative euphoria.”
For his part, Mr. Volcker is careful to explain that he supports 80 percent of the administration’s detailed plan for financial regulation, including much higher capital requirements and “guidelines” on pay. Wall Street compensation, he said in a recent television interview, “has gotten grotesquely large.”
Before the credit crisis, the big institutions earned most of their profits from proprietary trading, and those profits led to giant bonuses. Mr. Volcker argues that splitting commercial and investment banking would put a damper on both pay and risky trading practices.
His disagreement with the Obama people on whether to restore some version of Glass-Steagall appears to have contributed to published reports that his influence in the administration is fading and that he is rarely if ever in the small Washington office assigned to him.
He operates from his own offices in New York, communicating with administration officials and other members of the advisory board mainly by telephone. (He does not use e-mail, although his support staff does.) He travels infrequently to Washington, he says, and when he does, the visits are too short to bother with the office. The advisory board has been asked to study, amid other issues, the tax law on corporate profits earned overseas, hardly a headline concern.
So Mr. Volcker scoffs at the reports that he is losing clout. “I did not have influence to start with,” he said.
Why Minsky was right: The next bubble is already under way
By: Wolfgang Münchau
We did not need to wait until the Dow Jones Industrial Average hit 10,000. It has been clear for some time that global equity markets are bubbling again. On the surface, this looks like 2003 and 2004 when the previous housing, credit, commodity and equity bubbles started to inflate, helped by low nominal interest rates and a lack of inflation. There is one big difference, though. This bubble will burst sooner.
So how do we know this is a bubble? My two favourite metrics of stock market valuation are Cape, which stands for the cyclically adjusted price/earnings ratio, and Q. Cape was invented by Robert Shiller, professor of economics and finance at Yale University. It measures the 10-year moving average of the inflation-adjusted p/e ratio. Q is a metric of market capitalisation divided by net worth. Andrew Smithers* has collected the data on Q, a concept invented by the economist James Tobin.
Cape and Q measure different things. Yet they both tend to agree on relative market mispricing most of the time. In mid-September both measures concluded that the US stock market was overvalued by some 35 to 40 per cent. The markets have since gone up a lot more than the moving average of earnings. You can do the maths.
The single reason for this renewed bubble is the extremely low level of nominal interest rates, which has induced people to move into all kinds of risky assets. Even house prices are rising again. They never fell to the levels consistent with long-term price-to-rent and price-to-income ratios, which are reliable metrics of the property markets’ relative under- or over-valuation.
But unlike five years ago, central banks now have the dual role of targeting monetary and financial stability. As has been pointed out time and again, those two objectives can easily come into conflict. In Europe, for example, the European Central Bank would under normal circumstances already have started to raise interest rates. The reason it sits tight is to prevent damage to Europe’s chronically under-capitalised banking system, which still depends on the ECB for life support. The same is true, more or less, elsewhere.
Now, I agree there is no prospect of a significant rise in inflation over the next 12 months, but the chances rise significantly after 2010.
Once perceptions of rising inflation return, central banks might be forced to switch towards a much more aggressive monetary policy relatively quickly – much quicker than during the previous cycle. A short inflationary boom could be followed by another recession, another banking crisis, and perhaps deflation. We should not see inflation and deflation as opposite scenarios, but as sequential ones. We could be in for a period of extreme price instability, in both directions, as central banks lose control.
This is exactly what the economist Hyman Minsky predicted in his financial instability hypothesis.** He postulated that a world with a large financial sector and an excessive emphasis on the production of investment goods creates instability both in terms of output and prices.
While, according to Minsky, these are the deep causes of instability, the mechanism through which instability comes about is the way governments and central banks respond to crises. The state has potent means to end a recession, but the policies it uses give rise to the next phase of instability. Minsky made that observation on the basis of data mostly from the 1970s and early 1980s, but his theory describes very well what has been happening to the global economy ever since, especially in the past decade. The world has witnessed a proliferation of financial bubbles and extreme economic instability that cannot be explained by any of the established macroeconomic models. Minsky is about all we have.
His policy conclusions are disturbing, especially if contrasted with what is actually happening. In their crisis response, world leaders have focused on bonuses and other irrelevant side-issues. But they have failed to address the financial sector’s overall size. So if Minsky is right, instability should continue and get worse.
Our present situation can give rise to two scenarios – or some combination of the two. The first is that central banks start exiting at some point in 2010, triggering another fall in the prices of risky assets. In the UK, for example, any return to a normal monetary policy will almost inevitably imply another fall in the housing market, which is currently propped up by ultra-cheap mortgages.
Alternatively, central banks might prioritise financial stability over price stability and keep the monetary floodgates open for as long as possible. This, I believe, would cause the mother of all financial market crises – a bond market crash – to be followed by depression and deflation.
In other words, there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability.
For all we know, there may not be a safe way down.
*Wall Street Revalued: Imperfect Markets and Inept Central Bankers, Wiley 2009; ** Stabilising an Unstable Economy, McGraw-Hill, 2008