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Co-founded Rational Investing LLC and built its first models starting in 1999. We value 2500+ public companies worldwide using an automated DCF process. Designed and developed the FX trading platform of now supporting 40,000 retail and 400 institutional clients. FXCM is the world’s... More
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  • The Gods Vs. The Federal Reserve


    Yesterday, Today, and Tomorrow, are the three eras my three-year-old is aware of. He was in mom's tummy Yesterday, he fell at school and got a boo-boo Today; he will attend the big K-5 school next door Tomorrow. I have come to realize, in irritation with the time it takes stock prices to absorb changes in valuation, the equity market thinks exactly the same way. Lehman Brothers collapsed Yesterday, an all but unforeseeable Chinese bank run will bother us Tomorrow, but the Fed is providing easy money Today. Why worry?

    Yesterday…. The Gods vs. the Federal Reserve

    Ours is a new generation dedicated more than the last to the fear of indexing and the worship of monetary policy; grown up to find all Gods of value dead, all crashes over, all faiths in free markets shaken. . . . Apologies to F. Scott Fitzgerald.

    I would not have dreamt, sitting in Finance 432, Chicago's flagship class on capital asset pricing taught by now Nobel Laureate Eugene Fama, that I would one day think of multi-factor return analysis as a moral problem. In our faithless generation, there proved very short lived any fear of final judgment, vanished if not vanquished within months after 2008, fear of a situation where Saints Graham and Dodd put you in purgatory for paying 42X Revenues for Twitter, or for having bought Greek bonds at 10 bps over the curve instead of donating the principal to the poor of Bangladesh, where it might have done some actual good. In the meantime, monetary policy as the sole driving factor of returns has made for a world where $25+ trillion of QE has propped up asset markets as stores of wealth, but has done little to move new capital stock into productive activity, which requires an attractive point of entry. In plain English, condos and secondary tech offerings have been used to store the wealth of Indian, Chinese and Russian oligarchs at negative expected returns (since the money is laundered, or worse, default is fully intended on the borrowed capital, who cares?) In the meantime, to legitimate managers, financing the purchase of productive assets makes no sense. Our models, with a somewhat shorter horizon than most DCF valuations, suggest the market is overpriced by 20+%.

    Until now, I used to assume the market became more efficient every year, hence it took better models and a larger team to remain competitive. Recently, it seems, the opposite has happened - the global securities market has been assaulted by the US government and its agencies; first by Congress in demanding mortgage lending to the point where money was given away to those willing to lie the most, then by the Fed in printing so much it was given away to those willing to speculate the most. Of course, those capable of doing both well show up on CNBC telling us they worry they are not long enough….

    We will look back on the Alan Greenspan - Barney Frank - Ben Bernanke era as one in which the march of rationality came to a grinding halt, albeit hopefully a temporary one. Nobel Laureates now go on national TV to discuss books by French Marxists. Tomorrow (as defined earlier, whether in 2014 or 2018,) we will pick up the pieces, those of us actually attempting to measure risks best as they can, and rebuild faith in markets one tick at a time. Valuations now harken back to the dot com era: supports our conclusions.

    Today…. The Ninth Gate (of the Kingdom of Shadows)

    In the movie, the character of Boris Balkan thought he had a deal with the Devil, or at least a clean shot at one, but finds out the Devil is a slippery counterparty, in search of a smarter, if not more attractive alternative to him as protégé. Central bankers are finding themselves in the same position. They think they have struck their bargain of QE to allow the G7 to de-lever at the expense of the risk averse savers of the world, but may find out the devil, just for the fun of it, decided to let the market clear after all. The fine print of the Faustian contract is now become apparent. Some salient side effects:

    The same left'ish elite which sanctioned this expropriation also continues to regulate growth out of the G7. Hollande now sell Mistrals to Putin, to be aimed at Syria and Georgia, just to make ends meet, but finds it impossible to cut social charges for corporations or government spending.

    Valuations, have climbed to levels not sustained by profit or cost of capital trends, yet trading volumes are at a fraction of peaks. The Treasury market volume is a fifth of normal. The 'whale' was perhaps a stunning absence of liquidity in principal funding markets rather than a miscalculation of value.

    China's economy increased leverage during this time by 2x its private production. So did western private equity, and options laden corporate managers.

    This leverage flowed into real estate markets in financial centers. New York, London, Miami, Singapore, et al. condos have peaked in real terms for the remainder of our natural lives.

    While industrial activity stalled, continued investment in fixed assets in emerging markets, driven by said leverage and rising wages, meant that energy prices rebounded sufficiently to hurt G7 growth. The oil market has slipped into backwardation. For those busy in the peanut gallery in futures class, this means forward prices are lower than spot, more likely a prediction of recession rather than additional supply.

    In the middle of all this, the hot war between Shiites and Sunnis and the cold war between China and the US continue to gather steam, with Japan and Russia as the side stories. The Chinese have been drinking a bit of Kool-Aid; what they plan to win by bickering with their largest customer is beyond me.

    The Silent Depression

    Chairman Bernanke, a keen student of the Depression, managed with Secretaries Paulson and Geithner to fight the 2008 meltdown, but, by continuing to print money helped legislatures worldwide abdicate responsibility for the underlying problem of generating productive growth. We have instead the opposite challenge from the Depression: we have reached the limits of government's ability to tax and interfere in the economy, as various debt crisis from Illinois to Italy and growth crises from India to New Jersey demonstrate. The one lesson unlearned from the Depression is that policy must not hinder private growth, which even social programs revered today managed to do in the thirties.

    In the recession of the early nineties, companies were forced to restructure by competition as well as the newly energized market for corporate control, when merger defense lawyers had not yet invented 'poison pills'. By the same token growth sucked up the supply of labor rapidly into new semiconductor technology driven industries. Today, large firms have been regulated into oligopolies, and the government is fighting hydraulic fracturing, the new high tech boom of the US, ignoring an outdated education and training system that leads to 15+% underemployment, and further corrupting the healthcare market, where we already waste more than 5% of our entire industrial and service capacity….

    In the Depression, Britain's ability to spend colonial taxes and profits on US goods collapsed as India spun out of control, as the Salt March of 1930 triggered the Civil Disobedience Movement. (Upon cursory examination, 25% of GDP was being extracted out of India as cash crops, including the opium export into China and onwards to the US, while the loss of food production created some side effects….) In the Great Recession, the economic model of spending of money from refinanced mortgages on Asian imports hit a wall. To boot, the US supply chain's profitability is being wrecked by an increase in wages at both ends; note the gap between recent producer and consumer price inflation. The economies that work - Germany, Singapore, Poland - are unique situations which will get copied in part. But the generalized solution of throwing money at the problem is way past its expiration date; money perversely stolen from the real economy to feed financial institutions. Citibank gets away with charging 18% on credit cards while paying zero on deposits. James Bond wishes he had that license.

    The Intellectual Bankruptcy of the FOMC

    One mid-September Tuesday in 2013, King Willem-Alexander of the Netherlands gave the most important speech of the 21st century. He outlined the notion that the compact between the state and the individual has to change. While he talked about an obscure corner of the west best known today for tulips, tourism and cheese, this was a truth that most elites outside a few US states and Germany cannot yet muster the courage to speak up, if they do indeed understand it. To a greater or lesser degree, the existing level of command and control in all societies was a relativistic outcome of the Soviet age. Yes, the welfare state is almost 150 years old, and yes, the US was more free than, say, India, but every government benchmarked off Moscow in setting targets for welfare spending and political control. Twenty years after the fall of the Berlin Wall, the bankruptcy filing of Lehman triggered the real end of this era, by demonstrating the impossibility of the US mortgage subsidy. There is now an institutional panic in the government-academic complex on how to keep the size of government and the depth of its oversight of the political economy intact, including, amazingly, the subsidy that triggered the crisis.

    The Democrats ditched Larry Summers, by far their best candidate to run the Federal Reserve, because he was, like the government of the Netherlands, wont to speak the truth and test the boundaries of ideology. The Federal Reserve, for a while, declined to begin tapering. Let's be clear: they were going to reduce purchases from $85bn to $75bn a month, still printing $900bn a year on a balance sheet of 4+ trillion. This crew makes Arthur Burns (the Fed Chair responsible for double digit consumer inflation in the seventies) look good. This was the FOMC's Lehman moment - no I do not refer to September 15, 2008 filing, but the September 18, 2007 earnings call, when CFO Chris O'Mara declared that a circa $1bn write-down and closure of an obscure mortgage processing unit was all the damage done. That was the moment when management could have said, 'There is a real problem, we need to shrink the mortgage book 40% and hit our equity, but this too, shall pass.' Jeremy Irons made confronting the truth look easy in Margin Call. No one in the movie suggests making risk numbers up. Lehman Brothers chose to be dishonest, 'beat' estimates, then a year later lamented the government did not save them.

    The Fed has done the same thing. Printing a trillion dollars a year, more than 10% of private production, for six years, can only buy 2% growth while creating another global asset bubble? What if the Fed had bought no assets? Consider the drastic poverty of this payoff. Would we really have been in a 5-year recession? Sure government would have shrunk faster, like many a conglomerate in 1992. One wonders if we might have beaten 2% handily like other recoveries by allowing managers who had not levered up pre-crash to purchase assets at attractive values rather than expropriating their savings at 0%. Yes, tapering is finally on. In the meantime, the S&P was squeezed up another 30%. Now we are at the question of 1999: How high is too high? Where will the momentum stop on the way down?

    The Chinese are still hallucinating 7.5% GDP growth, while making commercial research a crime on par with espionage. If their industrial production is growing at 10% as their M2 grows at 50% a year, exactly what is the marginal profitability and whom are they selling to anyway, if their customers are printing $1trillion a year just to reach 2% growth? The press continues to print this rubbish verbatim. After the dot-com bust, many in the fourth estate swore up and down they would not be as incredulous ever again. Well, then there was the housing bubble, which was supposedly contained, and now it Chinese inflation and ISM numbers, which must be legitimate if they insist on repeating them ad nauseam. No wonder Rupert Murdoch shut down News of the World and bought the Wall Street Journal - the real scandal Today is at the Chinese Ministry of Commerce, not at parties of Manchester United WAG's.

    The South China Morning Post (which Mr. Murdoch's News Corp. seems to have a residual stake in) recently printed an MBA student's paper describing how Chinese inflation is rigged. Sometime in the near future, Skynet will become sentient, markets will realize there is chaos at the top of the global bureaucratariat; someone more credible than a graduate student will dare sign a document describing how housing costs are undercounted in Beijing's inflation statistics. This loss of ability to control the truth is leading to a fracturing of governments unlike anything since Gorbachev gave up control of the Soviet Empire. But in a twist to the Hollywood tale, at the nodes of the network are human citizens beginning to push back at governments, who are looking around for Terminators. They have found Janet Yellen.

    Tomorrow…. The End of History

    So we need to grow shale drilling in Europe, banking in rural India, women's employment in Japan, etc. etc. How quickly can all this really happen? In India, the right man is on the job at the Reserve Bank. Occasionally history chooses someone to take a crack at improving the lives of a billion people. I, for one, have high hopes in Raghuram Rajan. The election of Mr. Modi gives him room to reform banking. The White House, meanwhile, is being ripped apart by the repeated scandal of management by political hacks from Chicago, the city, (determinedly) not the University. As for France, a generation of elites is proving clueless, their policies making the Maginot line look good. Someone is needed at the top who is up to a street fight with the unions and can finally put the ghost of the guillotine to rest. The Japanese are enjoying the relief of a devaluation which, if unreciprocated, catches up with their competitors, while the Germans are beginning to face the reality of over-reliance on China. Russia and the Middle East will find growth hard given those forward oil prices and strife along their geopolitical fault lines. History somehow refuses to end in the liberal democratic nirvana Francis Fukuyama envisioned in 1989.

    One way or the other, a movement of capital from financial to real markets is desperately required. Prices proved highly elastic to the supply of cheap money as a proxy for future economic growth. But markets will not hold up as expected returns turn negative, especially as the marginal lender, the People's Bank of China has decided to improve returns of its own depositors. That change of tack combined with slowing demand is the definition of a hard landing. For the outcome, one need look no further than the Nikkei since 1989. As the research paper by Fama and Miller (1978) stated, the marginal bidder in a market sets the price. In US equities, that marginal bidder is one Jeremy Grantham, of GMO in Boston. When he publishes a statement saying 'the market could go on for another 20%, but I'm taking the other side of the trade', do what he does, not what he says.

    Disclosure: The author is long TLT.

    Additional disclosure: I am often long or short SPY based on a volatility model, more often short than long, and have hundreds of long and short recommendations for clients in individual tickers in a market neutral model portfolio.

    Jun 16 6:52 AM | Link | Comment!
  • Equity Commits Hara Kiri, The End Of The Beginning Of Europe, The Beginning Of The End Of Global Macro, And ‘Active' Money Management

    Guillotines are so 18th century. In order to 'spread the wealth around', to coin a phrase, Japan's mandarins, who are now theoretically responsible to elected officials, though in practice have been a power all their own for several centuries, allowed Japanese equity markets to commit hara kiri. By some recent measures, public company book values did not rise for two decades. The practice was intended for the nobility who launched unsuccessful wars to absorb the blame of the bloodshed, sparing society from broader fratricide. As a moral parallel, equity holders and managements might be expected to absorb the shock of economic disappointment and restructuring rather than laying off the working stiffs, but as a practical outcome measured by GDP growth, the desired result may have fallen a tad short. Japan is a very wealthy society, and there were no committees of le sans culottes selecting which ticker got whacked. But over time, the terminal systematic risk premium in our DCF's rose to 10%. The structural bias for larger tickers is even higher, as both management and technology of industrial conglomerates age along with customer saturation. So the average index stock trades at 6x normalized cash flow, which our Standard Value system now deems fair, leaning towards expensive.

    This is our second letter in a row which brings up Japan. When we began coverage, it modeled cheap across the board. Such a systematic outcome would usually have been merely irritating to a process focused on market neutral outcomes, since what matters is consistency rather than median accuracy, but the fact that the rest of the G7 faces similar macroeconomic troubles made the problem more urgent. We think of Japan as a template for what is the likely path of equities elsewhere, while societies debate their safety nets in a time of economic trouble. The Japanese decided to 'invest' their way out of the malaise, with the government spending twice its income, but the money has to come from somewhere, and the usual suspect is equity. Assuming our Harvard wonks do only half as much damage as the Waseda law graduates in the Ministry of Finance, the US should plan for a lost decade or so.

    For those who think about such things, the terminal value[1] of a firm depends on two factors: 1) how the macro economy is doing 2) how the company is doing. In DCF modeling, both have to be extrapolated off current conditions. In Japan, the market assumes the macro economy will be repaired 2/3 back to 'normal' equity spread of 5.5-6% over 10 years, and so will specific companies, forced to restructure comparably, likely by competition. One could argue a democracy is capable of faster adjustment than that, but without a market for corporate control, i.e. hostile M&A, these assumptions are not pessimistic. In addition, a yield curve of 0.1% for the 1-year and 0.75% for the 10-year government bond makes the definition of democracy a little suspect. Maybe someone who went to the University of Tokyo or, say MIT, to make a wild guess, has the power to decide the price of your currency. If they could only decide its value….

    The biggest counterargument is the performance of the Dow over the last four years i.e. if cheap money is so bad, why is the market up? The answer lies in the initial impact vs. long term effect. As rates are falling, the market reacts positively. The implicit assumption is that when rates have to be raised, it would be in reaction to a rapidly strengthening economy. However, when the market realizes that rates have stabilized at low levels permanently, then the softness of the economy and the absence of final goods inflation finally sinks in. At that point, there is no floor to the outcome, as Japan has found out.[2]

    Onto Europe:

    As the Nazis tore up the Molotov-Ribbentrop pact of 'non-aggression', Hitler reputedly said that treaties were just pieces of paper, and ordered tanks onto Russian oilfields. As the Europeans are finding out, currency unions are just like treaties. Eventually, to avoid becoming just pieces of paper, they have to be defended. A population with sufficient critical mass and industry has to be taxed, or worse, drafted to war, to support the geopolitical weakness or outright political error of another signatory, entering into a contract with whom seemed like a good idea at the time. Ironically, a time has arrived when it might be convenient for another German leader to tear up another piece of paper called the Euro, but she seems to be resisting the temptation. Angela Merkel may well prove to be the most significant politician to shape Europe since Churchill rose to the occasion when Norway was invaded in 1940.

    Mrs. Merkel has decided there is no choice but to defend the Euro. While reigning Greek politicians (many now voted out) acted like junkies whose favorite dealer had just been shot - panic, melodrama, withdrawal - she convinced the German electorate to backstop the gradual political restructuring of southern Europe. Since no one is getting drafted, Germans voters are reacting to the series of bailouts the same way as my usually generous two-year-old does when asked to share ice cream: he would have you know he really likes you, but if you chose to get your own scoop, he really wouldn't mind. The German population's grudging assent to having its wealth spread around has the potential to help European equity markets outperform the rest of the world while southern Europe restructures.

    No one is being drafted yet because, with the help of the German taxpayer, this argument is still about the pace of restructuring of government rather than scarcity of resources. But continued mis-allocation might yet lead to such scarcity. Given the growth in Asia, the price of food and energy is not about to go down. 'They gotta eat, and they wanna drive' is the best refrain I have heard. 600mm people in India do not eat enough, so the price of food is where 6% growth in GDP is likely to go. I have seen 3-wheelers stuffed with a dozen kids in school uniform in the morning along the Delhi-Agra road. For those who have experience a ride from the Taj Hotel in Delhi to the Taj Mahal in Agra, memory of that traffic should be sending a shiver down your spine. If those kids were all seat-belted to western standards over the next 10 years, Indian fuel consumption will double, giving western central bankers the kind of inflation they are not looking for.

    If inflation does not start wars, I am not sure what does. If it spikes and the Treasury market hits the wall, debilitating our ability to spend money to police Asian waters, an outright war between China vs. India + Japan would go from being a ludicrous idea to merely unlikely. Germany started two World Wars because it was always threatened by the potential, and occasionally real, stranglehold of Russia and France on the natural resources required to feed its industrial complex. In the twenties, France was occupying the Ruhr and Russia thought of Poland as its own scoop of ice cream. German strategy did not work out, but today China is in the same place, and its decisions will impact every country touching the Pacific and Indian Oceans. Thanks to the demand for raw materials, southern Europeans and northern Africans are going to find their service prices for tourism and textiles hacked by competition even as wheat / corn and oil remain in uptrend. The US, thanks to the Mississippi and Missouri, and a technology called fracking, finds itself immune for now, but the troubles of the world are rarely escaped for long.

    Meanwhile, in Greenwich, Connecticut….

    All this geopolitical volatility has had the effect of wrecking all the assumptions behind statistical global macro models. There was a time when, once you got into Chicago, the only thing standing between you and half a million a year doing God's Work on Broad Street was Eugene Fama's signature on your favorite statistical equation in Finance 432, the class used to weed out the mere stockbrokers from the true believers. In hindsight, it was quite obvious from presentations of investment banks that government interest rate and currency policy was the equivalent of The March of the Light Brigade; and one simply had to implement a basic statistical relationship between yields and exchange rates and hang on tight through the volatility as they allowed their coffers to be robbed.

    That volatility eventually led all the brokers to go public, so that the partners enjoyed a cheap put from the public shareholders. The good old days were when inflation was trending in a single direction, and emerging countries were sufficiently mercantilist and inexperienced to 'manage' exchange rates and your last name did not even have to be Soros to make 30% a year - and then the bank levered you 30x.

    Today, as assumptions change after every Fiscal Cliff meeting or Euro Summit or Middle East revolution, models have to be recalibrated in real time. Volatility has to be managed, and the technology to do so is rare, and so the work becomes labor intensive. This is leading the prior generation of the most successful fund managers to return outside capital and form 'family offices'. The next generation is still in a fight to ensure its models can outrun the new volatility and transaction costs.

    These troubles will now show up in company operating margins, an event delayed by Comrade Bernanke for four solid years; no minor miracle, that. I remain a skeptic of so shortsighted a monetary policy, but while America is still a functional addict, it is quite hard to hang on to one's convictions. Maybe we are the few who, like Gianni Versace, can wake up without a hangover at 5 am after partying on South Beach, morning after morning, and get to work. Otherwise, even as the Treasury curve is flattened, the credit curve is likely to reverse course and become impossibly steep[3]. The present peak in junk prices may well be comparable to the 1984 peak in gold.

    Input inflation also puts the well-established global supply chains of the S&P500 at risk. The rents will be squeezed out of their franchises for the multinational elite to avoid the guillotine, i.e. final prices might not keep up with costs. Witness India's resistance to $80k a year for cancer medicines, which is more money than made by 99% of Indians, vs. merely the bottom 47% in America. The likes of Roche's management need a lobotomy if they cannot come up with a pricing equilibrium for a new market of 1.2bn. The masses will demand that monopoly rents be constrained for the added volume of business. As history has taught, they are rarely content to eat cake.

    To summarize, rising inputs and declining service prices cannot be positive for margins and company valuation or volatility.

    Active Human Managers[4]

    This brings us to an interesting phenomenon we recently observed in the distribution of our own model's quarterly market neutral returns[5]. Per calendar quarter, average price returns are distributed as follows:

    Month 1 Month 2 Month 3


    This is counterintuitive, because earnings season in the US starts in earnest in the middle of Month 1, so Month 2's strength is understandable, but Month 3's relative softness followed by next quarter Month 1's strength is a mystery given the value of information must fade steadily over time to some degree, even if we believe our technology takes several months to get fully reflected in the market.

    This is until one thinks of window dressing and tax loss selling. While one's personal finances might be genuinely helped by selling in December, the idea that professional managers would go into a mild panic late every quarter and start dumping decliners and buying momentum in sufficient size to create a noticeable swing in returns over the course of a quarter says something about the state of 'active' money management. With the application of stops to get out of the way of this herd, and getting back in at the close of the month, the difference in actual returns between the two months amounts to at least 1% a year in a very diverse portfolio of 1000 tickers. Too small for the individual investor to notice, perhaps, in times of high inflation or market returns. But since intuition suggests Month 3 returns should be meaningfully higher than Month 1, the real difference might be closer to 2% a year. These days, that is more than what some government bonds pay, even if you lend for 10+ years. And the phenomenon does not seem to be restricted to the United States. The global value of this exercise, whatever its cause, might be in the hundreds of billions of dollars a year. Enough to solve some budget crises.

    [1] The projected final value of the firm at the end of the investment horizon of a Discounted Cash Flow model, typically 10 years, when the cash flows of the firm are treated as a (hopefully) growing perpetuity.

    [2] . For those statistically inclined, a test of equity returns vs. real Treasury yield levels and rate of change of those yields might offer some insights. I did a little work on rates vs. gold, and the results went along with my hypothesis. Please email for more details or if you are able to help me develop this idea a little further.

    [3]Treasury Curve is market lingo for difference between the cost of short term and long term borrowing by the government, typically the difference between interest rates for 1 year and 10 year government bonds. Credit curve is the difference in interest paid between low risk AAA and high risk B or C rated borrowers.

    [4] Thanks to Steven Zheng of SAC for suggesting an analysis that should have been done years ago.

    [5] Based on a monthly ticker by ticker stop loss and reallocation at month-end closing prices.

    Feb 01 5:07 AM | Link | Comment!
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