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Gaurav Khanna
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Manager of the Fifth Quarter Fund, a long/short equity hedge fund based in San Jose, CA. Multiple years of investing in stocks and options, with a recent focus on trading volatility ETFs and options.
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  • The 2012 US Election And Market Impact

    Now that everyone has had some time to digest the results of the recent US election, the discussion turns to the short-term and long-term impact on the US markets. Prior to November 6th, there seemed to be consensus that the "market" favored a Romney victory and that a second Obama Administration would be "bad" for the stocks long-term. The reaction in the US stock market the day after the election seemed to support this view. Indeed the DJIA (^DJI) was down over 700 points (5%) at its post-election low; the S&P 500 (SPY) was also down by 75 points (approximately 5% as well).

    However, on closer inspection this election revealed a great deal of information that, based on historical trends, may actually be good news for stocks and bonds in the long-term. In order to understand what this impact may be, it's worth reviewing some of the salient points from the election results and see what they tell us about the future political landscape.

    First, the popular vote for President is still very close. Obama's margin of victory here was approximately 2.5%. However, in the Electoral College (which Obama won handily 332 to 206), the Democrats seem to have a substantial advantage that is solidifying. This is because the voting patterns revealed what demographers have known for some time: minority groups -- Latinos, Asians, and African-Americans -- are becoming a larger part of the US population and hence the electorate. The figure below from CNN summarizes the voting breakdown by ethnic group and compares it to 2008 election.

    As we can see, a comfortable majority of Latinos and Asian-Americans vote Democratic and those percentages have increased since the 2008. The African-American support for Democrats dropped slightly from 2008, but is still comfortably over 90%.

    The growing population and influence of minorities in this country is not news. Demographers and the recent census have been telling us that the United States will eventually become more "non-white" than "white".

    The Pew Research Center published a widely-quoted report on population trends and projections up till 2050. According to their analysis, the past 40 years has seen 40 million new immigrants to the US, making this the largest immigration wave in US history (based on absolute numbers, not percent increase). As we know, earlier immigrant waves, such as in the early 20th century, were almost entirely European. However this more recent wave has had a substantial number of Asian and Hispanic immigrants.

    (click to enlarge)

    One of the Pew report's authors also wrote an interesting analysis of the recent election, with some of the conclusions summarized in the figure shown above. The Latino population is currently the nation's largest minority group. It will triple in size and account for most of the United States' population growth through 2050, when they will account for 29% of the total population. Whites will become a minority by 2050, dropping to 47% of the population. The non-white ethnic groups comprise 37% of the population today and cast 28% of the total votes (according to exit polls) in the 2012 election. Not only was this a record, it is expected to increase in future elections. These minority groups taken together gave 80% of their votes to President Obama.

    Key takeaway #1: the minority groups of today will be the majority in two generations. Their voting preference to date has been leaning strongly Democratic.

    This shift in the electorate at the national and state level brings about a whole new political calculus for both political parties. White working-class voters, older voters, and those in rural areas can be counted on to vote for the GOP. In contrast, Democrats are winning handily in the major cities and suburbs that are growing and have a mix of whites and upwardly mobile minorities.

    The "electorally critical" swing states, such as Iowa, Pennsylvania, Colorado, and Nevada, have been Democratic-leaning in the past two elections and all went to Obama in 2012. This shift, while only giving Democrats a slight advantage for now, may grow if the Hispanic and Asian-American population continues to grow and voting patterns stay the same.

    Ohio and Florida was the focus on much attention in the days leading up to the election. As it turns out, Obama didn't even need those states -- and their combined 44 electoral votes -- to win. By winning the other swing states, Obama gave himself enough of a margin. He ended up winning Ohio anyways and eventually Florida when they were done counting.

    Nate Silver, author of the FiveThirtyEight blog in the New York Times, makes a key point: the Republicans are winning some states such as Tennessee, Kentucky, Arkansas, and West Virginia by very large margins; so large in fact that neither presidential candidate bothers to campaign there much. However, this large margin of victory is not reflected in similar Electoral College gains, since the system doesn't allocate "extra" electrical college votes to account for their blowout margins. So the Republican's victory in these states is "inefficient" from an Electoral College point of view.

    The narrative of all the elections in the past decade is that if any party can win its "base states" and a handful of the swing states, they can get enough electoral college votes to win the Presidential election. The problem for the current Republican Party is that this wave of minority voters will start to have more of an influence in some of their "base states", especially in the Southwest.

    This can be seen in a great series of interactive graphics published in the Wall Street Journal. The most interesting result shows the counties that have become more blue since 2004. This shows a clear trend of counties in the Southeastern states trending Democratic. There are states where the Republicans have counted on solid support for decades. If any of these sure-fire red states in the South "flips" to blue in the coming years, it will spell trouble for the Republicans in the Presidential race. Most of the counties and states getting redder are already solidly Republican -- which doesn't buy them much in the way of Electoral College advantage.

    Key takeaway #2: Due to the distribution of Electoral College votes and change in voting patterns of key states, the Democrats may be solidifying their advantage in the race for President despite a close popular vote.

    While the Democrats may hold the advantage for Presidential races, the calculus of state and local elections can be very different. Very often (and certainly in many places this election), voters are comfortable casting their ballot for leaders of one party at the local level and the opposing party at the state and national level. Ostensibly, this is because one particular issue, support for a ballot measure, etc. may dominate voters' political party preference at the local level.

    In fact, Republican's still enjoy historically high levels of representation in state legislatures and governorships. Even with the tectonic demographic changes discussed above, we still have a split in governance with the Democrats holding the Presidency and the Senate, the Republicans holding the House (albeit the numbers from each party in Congress did favor the Democrats).

    Key takeaway #3: Neither political party is expected to dominate both houses of Congress and the Presidency simultaneously. Split governance is likely here to stay.

    So - what does all this mean for the markets? There are a few trends and predictions we can make based on historical data and what we have seen in the past few weeks:

    • Having a Democrat as president and a split Congress has historically been *good* for the markets. As the figure below from a JP Morgan report shows, the Democrats have controlled at least one of the chambers of Congress for 69 out of the 74 years from 1937 - 2011. With this specific split party scenario we currently have in Washington, the annual returns historically have been over 15%.

    (click to enlarge)

    • The stock market has been and will continue to react primarily to news about the "Fiscal Cliff" and whether a divided Congress can work with the President to resolve it. Investors woke up the day after the election to find the same leaders in place that failed to reach a meaningful accord last summer over the debt ceiling. In the three weeks since the election, the second and third key takeaway points discussed above are starting to sink in: The President may have the advantage and momentum post-election, but his party does not control Congress. More importantly, this situation is likely to persist. The question then becomes whether both parties heed the long-term trends and start working to a compromise - or ignore these lessons and dig-in even more hoping to get an advantage in the next election. We should expect news about progress on this front to drive market performance through the end of the year. Market participants may not love every detail of legislation that emerges from Washington. But what they dislike the most - and what impacts the market the most -- is uncertainty and pulling the country to the edge of fiscal brinkmanship. A compromise or even a long-term solution to the deficit may signal to investors that politicians of both parties recognize the new political landscape that has been revealed in this election and will tilt towards compromise over deadlock.
    • There is likely to be another US debt downgrade if the "Fiscal Cliff" is not resolved in a meaningful way this time. The gridlock last summer resulted in the first downgrade of the United States' credit rating by Standard & Poors. The Dow fell 635 points the first trading day after the downgrade last summer, and fell over 700 at the low since the election. While the markets has regained some ground since, the DJIA and S&P 500 are still down 2% and 2.5% respectively since Nov 6th.
    • Bonds will continue to perform well, irrespective of a debt downgrade. Despite all the talk about a bubble in the bond market, there are several reasons to expect this. First, this election and the current political status quo will mean far less impetus for drastic cuts to government spending and entitlements. The United States will continue to run high deficits and this will continue to be an issue that will divide the parties. The best we can hope for is that the deficits start to decrease, and fall as a fraction of GDP. But unless a miracle occurs and entitlement spending is brought under control, the US government will have to sell close to a $1 trillion in bonds each year to finance the deficit. Interestingly enough, even after last summer's debt downgrade, bonds continued to rally and rates on long-term treasuries continued to decline. The Barclays 20-year+ Treasury Bond ETF (TLT) has been one of the best ways to play the bond rally in the past two years. During that period, the TLT is up almost 30%, handily outperforming the S&P 500. This was partially due to quantitative easing by the Fed and their active participation in the market. Another major reason is the flight to quality away from European sovereign debt. While the TLT may not return the same performance as it has, as long as investors continue to believe that holding US bonds is far safer than anything in Europe it should perform well.

     

    • Expect a new Fed Chairman to be appointed who is dovish and will continue some form of quantitative easing - which is a long-term positive for the stock market. It's been reported that Ben Bernanke has told close associates that he will not run for a third term when his current tenure expires in January 2014. So Obama will have an opportunity to appoint a new Fed Chairman half-way through his second term - and this new Chairman will outlast his Presidency. Since the current Fed has gone "all in" to keep rates low and QE in full swing, expect Obama to nominate a candidate that will stay the course.

     

    • Financial sector stocks have been under pressure and will continue to be. The performance of these stocks is driven as much by their performance as the perception that they will be hampered by onerous rules and regulations.

      It will now be impossible to stop all the rules from the landmark Dodd-Frank legislation to be written. Irrespective of what the Volcker Rule looks like, it has already had a dampening effect on proprietary trading. In fact, financial stocks have been some of the worst performing since the election. For example, the Financial Select SPDR ETF (XLF) is down 3% since election day, performing worse that the overall S&P 500.

      Had Mitt Romney won, he would not have had the authority to simply overturn Dodd-Frank as was mistakenly assumed. However, any President does have the power to suspend or significantly delay writing the specific regulations that result from a bill. This will not happen now with Obama's re-election - and within the next 4 years we can expect most (if not all) the regulations to be put in place.

    • Expect volatility, as measured by the VIX (VIX) index, to stay relatively low (barring any major outbreak of violence somewhere in the world).

      Clearly, all the Eurozone and "Fiscal Cliff" fears have not been enough to send the VIX above 20. Perhaps that is a sign that investors believe these issues will be resolved in some manner, even if means kicking the can down the road some more.

    Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: I have a position in SPY by selling near-term out-of-the-money puts in the ETF.

    Nov 28 6:52 AM | Link | Comment!
  • All Too Human - Why The Rajat Gupta Case Reminds Us Of Ourselves

    The question that remains on a lot of people's minds is, "Why did he do it"?

    By now the story of Rajat Gupta is a familiar one. He was man who came from humble beginnings in India and rose to the pinnacle of power and prestige in the United States. In the Indian-American community especially, he was revered. Yet he risked everything by passing along confidential corporate information to Raj Rajaratnam, his friend and business partner who ran the Galleon hedge fund. What makes it all the more puzzling is that Gupta did not benefit directly from this information nor any of the trades. Last Friday, a jury found him guilty of several counts of security fraud and conspiracy.

    Why did he do it?

    Unfortunately, a definitive answer about his motive did not emerge from his trial. Although it's debatable, the prosecution technically did not have to demonstrate any motive at all. In its 1997 decision in United States vs. O' Hagan, the Supreme Court validated the "misappropriation theory" of insider trading. Under this theory, person commits fraud anytime he misappropriates confidential information for security trading purposes, because it is considered a breach of duty owed to the source of the information. So you don't have to necessarily profit from the insider trading - the mere act of passing along confidential information will get you in trouble.

    But in Gupta's case, the prosecution was in a bind. Unlike the trial against Rajaratnam, there were no wiretaps of Gupta's phone as he was tipping off his friend. So the prosecution tried to establish motive by detailing their business dealings. It's true that Gupta could have possibly benefited from closer business ties with Rajaratnam. By giving his friend this confidential information, perhaps Gupta was counting on some quid-pro-quo and getting a slice of the huge profits at Galleon. But those were speculative arguments, which the defense rightfully pounced on.

    The dialogue in the press offered up the familiar reasons for "motive" and why the rich and powerful get into trouble: they are cloistered in their own world, consider themselves above the law, feel they can get away with it, and get a rush from "living on the edge."

    As usual, I'm not completely happy with any of these explanations. Not that they are wrong, but mainly because they are inconsistent with who Gupta was outside of his dealings with Rajaratnam. From what we can tell, he conducted all his other affairs with competence and integrity. The prosecution didn't (and couldn't) bring up any other dealings from Gupta's life which would indicate he was predisposed to this kind of illicit behavior.

    So the question remains: why did he do it?

    This had been nagging me ever since the whole Galleon case became public. The beginnings of an answer came last week when I was reminded of a conversation I had in the early 1990s with a physics graduate student at the University of Chicago. I was an intern at Argonne National Lab (just south of Chicago) and was at the university with my mentor to discuss some research results. The University is famous for the extraordinary number of Nobel laureates associated with it - on the faculty, retired, or otherwise. Apparently there were so many laureates that, within that elite group, a pecking order had developed. Amongst all the science departments for example, Subrahmanyan Chandrasekhar was unquestionably at the top of the laureate heap. He was an astrophysicist who won the 1983 Nobel Prize for a calculation he did almost 50 years earlier on the back of an envelope while traveling to England on a ship. I didn't much care for finance back then, but I'm confident the pecking order in the Economics department would have culminated with Milton Friedman.

    According to our host, it was almost comical to watch these laureates at seminars trying to outdo each other in the way they talked and asked questions. Winning the Nobel Prize is the pinnacle of a career in science - you have nothing to prove after that (so we think). Yet here were these men jostling with each other, sizing each other up while berating the poor guest speaker.

    This act of sizing up and evaluating of others is discussed in a remarkable book, Envy Up, Scorn Down, published recently by Princeton psychology professor Susan Fiske. As she explains, human beings are constantly comparing themselves to each other as individuals and as groups. We are "comparison machines" by our DNA and evolution. Her research into the neuroscience behind this illustrates how these comparisons form the basis of self-knowledge. After all, knowing how we rank amongst each other informs us of our own strengths and weaknesses. These social comparisons evoke the two emotions of envy and scorn mentioned in the title. Fiske provides a model and explains in great detail how these emotions can account for a wide range of interactions, motives, and emotions we feel towards one another. Why do we resent a rich neighbor? Why do elites sometimes "dumb down" who they are? Why do we feel the need to put certain people or groups in their place? Our actions can range from the harmless, benign neglect of certain groups to grotesque violence.

    I cannot possibly do justice to the enormous amount of research, including her own work, which is presented. But Fiske's work suffices as a framework for understanding interactions in our own lives and what happened in the Gupta case. The key point is that we are all wired to compare. We are social beings -- whether we'll admit to it or not, sizing up others is part of the game.

    For example, how many times have we played up the importance of the work we do when talking with peers or competitors? I'll share one story with you. In the late 1990s, during my time a graduate student at Stanford, I saw Palo Alto get overrun by people who moved out here to work at dot-com start-ups. Striking up conversations with them at local bars downtown had many of the elements discussed in Fiske's work. These "dot-commers" weren't my rivals in any direct way, but they had chosen a path that I could have chosen and some were rewarded handsomely for it. I was envious and maybe even a little resentful. Even if they weren't rich yet, the perception was that they would soon be loaded. Plus they were doing something that was now considered sexy and cool and had captured everyone's imagination. And here I was stuck in a lab day and night. So in those conversations, I had to exaggerate the importance of my research. 'I am solving big, important scientific problems … you are just a Java developer.' I'm sure the conversation in their mind was similar: "That dude goes to Stanford but he has no money!" Thankfully the dot-com bust took a lot of this excess away so I could feel better about myself and not have to fight for a seat at the bars anymore.

    A lonely graduate student playing up his research was as pathetic as it was emotionally necessary. A bunch of Nobel-prize winning physicists thumping their chest probably just added comic relief to an otherwise boring seminar - predictable given the competitive setting of UChicago, but ultimately harmless. However, when two powerful men were brought together in a complex, competitive relationship, things become more interesting … and more toxic.

    Through the reporting, wiretaps, and other evidence presented in the case, we get an interesting picture of how these men interacted in private and their sometimes convoluted relationship.

    Rajat Gupta was the ultimate corporate insider who had worked his way up the ladder at McKinsey & Co. In 1994 he was elected managing director, becoming the first Indian-born CEO of a major multinational company. He is widely credited with McKinsey's successful expansion and cementing its reputation as the top consulting firm in the world. The list of companies, non-profits, business schools, and other institutions he was affiliated with is simply staggering. He was very active in philanthropy, focusing on global health and education issues. Combined with his position at McKinsey, he was in the orbit of anyone who was important in the business world.

    In contrast, Raj Rajaratnam was a trader at a long/short equity hedge fund. As a manager of a similar (but much, much smaller) fund myself, it was quite gratifying to learn that Rajaratnam's trading wasn't overly sophisticated (I'm sure Susan Fiske could appreciate that sentiment!). He traded stocks and options actively around several core positions and proclaimed to his investors that it was all based on rigorous fundamental analysis. His trading was no big deal - every long/short fund does this one way or another.

    If there was any "sophistication" in Rajaratnam's operation, it was his "expert network" of agents on Wall Street and Silicon Valley, which he had assiduously cultivated over the years. We now know that much of that " rigorous analysis" was confidential information gained illegally and used to make significant profits.

    I'm not denying that money could have been some motive for Gupta to pass on secrets - but perhaps not in the way we've been led to believe. Indeed, both were keenly aware of each other's income and net worth. The reported sums that Gupta could have gotten from his actions (but didn't) aren't anywhere close to what Rajaratnam or the top Wall Street leaders make. Let me illustrate a quick back-of-the-envelope calculation: Rajaratnam wanted to grow Galleon from a $7 billion to a $10 billion hedge fund (making it one of the largest on Wall Street). At $10B, if the fund's returns were 10% in a year, the profits would be $1 billion. Assuming standard fees, Rajaratnam would earn 20% of those profits, or $200 million a year. He already had a net worth of over $1 billion. By comparison, Gupta's entire net worth was estimated at $100 million. The point is that Rajaratnam's single-year profits were on track to rival Gupta's entire lifetime's net worth.

    Gupta had nothing on the horizon - no job, no partnership - that would have put him in that same league. The prosecution's case made it sound like there was a symbiotic business relationship between these two men. The fact is that there was nothing really concrete that would have earned Gupta the type of money his friend was making. Gupta had spent decades around Wall Street - these people were embedded in his social life. He was keenly aware of his place on the money ladder and that he had nothing which would catapult him significantly ahead.

    When we question why Gupta, such an accomplished and revered man, would risk it all for seemingly little gain, we are asking the question from the wrong frame of reference. Gupta was not looking in the rear view mirror, content with a lifetime's worth of achievement. He was comparing himself to what was in front of him, and was becoming increasingly insecure about where he stood in the competitive landscape.

    What Gupta saw in Rajaratnam was a friend as well as a rival. They were business partners who were congenial and talked regularly. Under the surface, there was a level of fierce comparison and competition that belied their public persona. Gupta was a pioneer in consulting - he was instrumental in building a business that helped others create great things. Rajaratnam didn't create anything except more money -- to Gupta he was just like everyone else on Wall Street. I would hear Raj Gupta's name often in Indian social circles while growing up in New York in the 1980s. The first I heard of Rajaratnam was when he was in handcuffs. Gupta was as connected as anyone could be with the who's who of the world. Rajaratnam was a bottom feeder for confidential information from friends in low places. Yet it was Rajaratnam's whose wealth that was growing by leaps and bounds, not Gupta's.

    However, Gupta had one key thing that Rajaratnam didn't: a seat at the table. In fact, Gupta had a seat at many tables, and his rival didn't. And Gupta was going to let Rajaratnam know it. We can only guess whether Gupta felt envy or scorn towards Rajaratnam. Given the complexity of their relationship, it was likely a mixture of both. But as Professor Fiske describes, the actions that result as a consequence of both emotions can often be detrimental. By passing along the nuggets of confidential information, Gupta was subtly reminding his rival about where he stood in the pecking order.

    This is why the "money as the motive" argument doesn't really work. The fact that they had both achieved wealth and success beyond their wildest dreams was irrelevant. They were not comparing themselves to us but to each other. What drove Gupta was a toxic combination of emotions that form the core of who we are as social beings. Gupta's actions were as pathetic as they were emotionally necessary. And this ultimately led to his downfall.

    There was a very interesting wiretapped conversation that was part of this case. While this particular piece of evidence wasn't central to the case against Gupta, to me it said quite a lot. It was a conversation between Rajaratnam and Anil Kumar, a former McKinsey executive and a friend of both men. They were discussing Gupta's interest in joining KKR, a top private equity firm known for its generous compensation. Interestingly, it was Rajaratnam who points out Gupta's financial insecurity. "I think he [Gupta] wants to be in that circle", Rajaratnam gossips to Kumar, "That's a billionaire circle, right? … Goldman (GS) is like the hundreds of millions circle, right?" It was not the only time Rajaratnam would speak disparagingly of his business partner.

    To understand why Raj Gupta did what he did, we have to look no further than ourselves. He was a superstar who will likely spend most of his remaining years in prison. He was found guilty on three counts of securities fraud and one count of conspiracy. In the end, what he is really guilty of is being all too human.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: GS, economy
    Jun 19 10:39 AM | Link | 1 Comment
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