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Keith McCullough
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Research Edge, LLC (http://www.researchedgellc.com/) is the leading real-time research firm. Focused exclusively on generating and delivering actionable investment ideas, the firm combines quantitative, bottoms-up and macro analysis with an emphasis on timing. The Research Edge team features... More
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Research Edge LLC
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Diaries of a Hedge Fund Manager
  • GM In Bankruptcy – The Lamb’s Share 1 comment
    Jul 22, 2009 8:28 AM

    Nails In The Coffin

    How are the mighty fall’n!
    -    2 Samuel, 1:19
       
    Just like in the Bible, there are no coincidences in real life.  The past weeks saw the Icarus-like plummeting of two high-flying financial Daedaluses.  Far apart as their stories may seem, we find far more similarities than differences in these twin cautionary tales.

    News media can be misleading.  Thus, one might be forgiven if, upon reading the Financial Times headline (10 July) – “The Storms That Swept Away Meriwether’s Flagship Fund” – one formed the impression that John Meriwether was the victim of an irrational market. 

    We ask that you refrain from pointing out the unerring acuity of hindsight.  Hindsight was staring us in the face in the avatar of Long Term Capital Management.

    Among our favorite financial media moments is the excellent segment of Public TV’s “Nova”, dedicated to the rise and demise of LCTM (PBS airdate: February 8, 2000).  LCTM, staffed by the rocketingest of rocket scientists, and supported not by one, but two Nobel prizewinning economists – Robert C. Merton and Myron  Scholes – managed to create one of the greatest pools of risk in the history of finance.  We keep being reminded of the fundamental truths we learned from the successful old-time stockbrokers.  Those who strive belly-to-belly in the trench warfare of money are most sensitive to the true driver of economic forces: emotion.

    Andrew Racz, he of the Eraserhead hairdo and staccato Hungarian accent, told us years ago, “Smart people never buy.  They only sell.”  Meriwether & Co sold risk.  The banks, the brokers, the investors – even the regulators all bought it.

    The denouement of the Nova segment includes clips of a Who’s Who of the “Models Model” of market economics – Paul Samuelson, Myron Scholes, Alan Greenspan and others – musing on the humbling of the “model” model of market economics.

    Here is Merton Miller: “Models that they were using, not just Black-Scholes models, but other kinds of models, were based on normal behavior in the markets and when the behavior got wild, no models were able to put up with it.”

    Peter Fisher, Executive VP at the New York Fed during the LTCM crisis, says “I don’t yet know the balance between whether this was a random event or whether this was negligence on theirs and their creditors’ parts. If a random bolt of lightning hits you when you're standing in the middle of the field, that feels like a random event. But if your business is to stand in random fields during lightning storms, then you should anticipate, perhaps a little more robustly, the risks you're taking on.”
    Fade to the past couple of weeks, where another icon was toppled as unceremoniously as the statue of Saddam Hussein.  Former baseball star Len Dykstra – whom Jim Cramer described in glowing terms as a stock picking Wunderkind – filed for bankruptcy, leaving in his wake a Hall Of Fame list of lawsuits.


    In rebutting allegations that Dykstra was a beard for a scrum of no-name stockpickers who used Dykstra’s name recognition for marketing purposes, Wall Street pro Richard Suttmeier wrote (quoted in Silicon Alley Insider, 16 June 2008, “Lenny Dykstra makes His Own Stock Picks, Says Pro Who Helps Him”) “Lenny makes his own picks after reading tons of research notes from the most respected independent minds. He has become one of the best stock pickers after doing several years of homework. I can’t even explain how he uses his deep in the money call strategies.”


    We especially like that last sentence.  Suttmeier devotes half his piece to bristling at being characterized as “a little-known strategist”, detailing his own professional resume, and his many television appearances.  He finishes with a flourish: “It was after one of these CNN ‘Talking Stock’ shows when Lenny Dykstra called me and said, ‘Hey Dude, can you teach me how to read a stock chart?’”
    As our CEO, Keith McCullough, points out, running a P&L is not the same as running a business.  And – in his former capacity as Captain of the Yale hockey team – we are sure he would agree that even a .310 season batting average does not qualify one to handle investments.  Not one’s own, and not someone else’s.
    The fault, to paraphrase Shakespeare, lies not in our markets, but in ourselves.  Markets, like computers, give us back what we provide: Garbage In, Garbage Out.
    The traditional Wall Street management model consistently promotes excess over good sense.  In many firms the most successful salesmen are routinely turned into managers.  The apotheosis of this process is perhaps the elevation of Jimmy Cayne to head of Bear Stearns – accounts of the demise of that once-great firm - but it has deep and untouchable roots.  The finance business is, after all, about getting other people’s money – not about making money for other people. 
    Superstar traders like Meriwether are able to generate outlandish profits for their firms for a number of reasons.  Not the least among those reasons, to be sure, is their own unique market acumen.  But running a profitable trading desk uses one skill set, while running a successful financial company uses a different one.

    Meriwether was an all-star at Salomon Brothers, where he was Head of Fixed Income Arbitrage.   Traders who worked under him there credited Meriwether with applying a “yield-to-worst” analysis to their positions, trying to gauge the effect on their positions of, as one trader put, “the world going down.”

    Here’s the rub: this is the right process for a trading desk manager to apply to protect his P&L.  In the meantime, he needs pay no attention to the cost of his office rent, light fixtures, telephone lines, or the expensive lunches he caters to feed the traders on his desk.  One would think that a well-run firm would charge these items back to the profit center.  But on Wall Street, the profit centers, to paraphrase the old management saw, walk out the door at the close of business every day.  Come year end, the same conversation takes place in every boardroom, when the heads of the profitable desks sit down with senior management.  We can just see Meriwether sitting across from Gutfreund.  Gutfreund is holding a gigantic cigar and gazing with his impassive basilisk stare as Meriwether, red pencil in hand, cuts expense items from his desk’s P&L.

    In good times, firms end up eating the lion’s share of the expenses of their profitable departments.  The most profitable department – and Meriwether was a super-duper-star – gets first crack at ramming expenses back down the throat of the shareholders.  By the time this exercise is done and bonuses paid, the company ends up with a winnowed-down profit number, and the traders get new Porsches.

    Who shoulders the burden of business decision-making at these hedge funds?  Managers who run world-class desks at major financial institutions find themselves paralyzed by having to face personnel decisions, by having to make decisions on compliance procedures, by having to negotiate with portfolio managers who insist on hiring staff.  Never mind the year-end bonus discussions.  High-profile traders at major firms are insulated from serious business decisions, and frequently falter when they must take them on in running their own firms.

    Just like Lenny Dykstra.  “One of the great ones in this business,” according to Jim Cramer.  Dykstra’s options newsletter on TheStreet.com reportedly netted him $1 million a year until being discontinued earlier this year.  In a sad denouement reminiscent of “Requiem For A Heavyweight”, the public is ghoulishly watching as Dykstra’s former sports glory, his second career, his personal life, and the respect he once enjoyed from colleagues, friends and teammates all go down in flames.  Clearly, Dykstra was “one of the great ones”… until he wasn’t.

    Both Meriwether and Dykstra represent what’s wrong with this system.  Both men were outstanding at their chosen vocations – and both appeared untouchable in their first careers.  In their second careers, they have fallen victim to the ultimate Wall Street sin: they believed their own hype.

    Worse yet, the rest of the world believed it too.
     

    Themes: Compliance
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  • Smoking Alpha
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    "As our CEO, Keith McCullough, points out, running a P&L is not the same as running a business. And – in his former capacity as Captain of the Yale hockey team – we are sure he would agree that even a .310 season batting average does not qualify one to handle investments. Not one’s own, and not someone else’s."

     

    Since when do Hockey player's have batting averages?
    22 Jul 2009, 09:14 AM Reply Like
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