The price of everything

Power failure on Wall Street

“Doubt is not a pleasant condition, but certainty is absurd.” – Voltaire.

 

Have there ever been bigger dislocations between the behaviour of financial markets and the likely fortunes of western economies ? Has the reputation of Wall Street and the City ever stood at a deeper discount to the actualité ? Does current market behaviour really tell us anything about the market’s longer term prospects ?

 

There used to be a quotation above my father’s desk; it may still be there:

 

“Finding the right answers is easy. It’s asking the right questions that’s difficult.”

 

(This is only a variation on a theme: “Judge of a man by his questions rather than by his answers” (Voltaire); “Good questions outrank easy answers” (Paul Samuelson)). I used to find this quote trite but the longer I spend in the markets, the more pertinent it becomes. Which is itself a little like a particular Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished by how much he’d learned..”

 

One of the innumerable problems with Wall Street and the City is that they never do seem to learn from their mistakes. Property market bubbles; whichever hedge fund John Meriwether is associated with this week; the venality of quasi-monopolistic agencies associated with credit, housing or debt ratings.. Each generation seems obligated to re-experience the errors of its predecessors. There is little or no ‘race memory’ that might at least mean that this year’s crisis is brand new rather than a tired retread of past embarrassments.

 

And while Wall Street typically shies away from overly intrusive questions, it certainly seems to have all the answers. Where is the oil price headed ? $141 a barrel during the second half of 2008, according to Arjun Murti of Goldman Sachs. (Could Goldman Sachs possibly have any material interest in oil trading ?) Because Mr. Murti was also behind a prediction for higher oil prices in 2005, his apparent ability to foresee the future has led to his universal resource market canonization in the financial press. Actually, the target is $150, says T. Boone Pickens, another presumably disinterested oil trader. The last time we saw this kind of easy momentum-chasing and price target leapfrogging was during the dotcom boom (Amazon.com – essentially impossible to value during its early hyper-growth phase, so easily justifying Henry Blodget’s $400 share price target even when it was overpricedly trading at $242), and it did not end well. As the analysts at McCall, Aitken, McKenzie have suggested, welcome to “dot.oil”.

 

The difficulty with commodities prices, as Bloomberg’s Caroline Baum recently pointed out, is that unlike more traditional financial instruments such as stocks or bonds, there is no fundamental yardstick of value:

 

“..metrics that allow us to quantify the degree to which prices have strayed from their fundamental moorings. Stock prices have an historical relationship with underlying earnings. House prices don’t stray too far from their “earnings” stream, or rental value.. With commodities, no such quantifiable ratio exists.”

 

So in assessing the valuation of commodities and natural resource prices, we are all left orienteering in the fog. Patrick Perret-Green of Citigroup has at least tried to square this circle using behavioural finance techniques. In his occasional ‘Chart of Shame’ he archly compares markets that have experienced classic booms and busts with contenders for the Emperor’s new clothes. Back in January he cheekily overlaid a chart of the Nikkei (grotesque peak in 1989), Nasdaq (grotesque peak in 2000), the Saudi Tadawul All Share Index (grotesque peak in 2006) and the Shanghai Composite (grotesque-looking peak in, erm, late 2007). Chinese stocks have obediently collapsed since then. One swallow, of course, doesn’t make a Murti. Last week, Patrick somewhat ominously updated the ‘Chart of Shame’ but with the FTSE 350 Mining Index as the ‘bubble’ candidate.

 

As anyone who holds mining stocks will confirm, the sector dutifully collapsed, albeit in the short run. One can argue, as always, that “this time it’s different”, and that mining stocks trading on “just” approaching 20x p/e ratios and 1% dividend yields are hugely better value than internet stocks were in 2000 with p/e ratios approaching the infinite and no dividend yields, but the charts have a fairly compelling power, and anyone sitting on gains of the order of 200-300% or more is wholly justified in a spot of profit-taking.

 

What makes markets so intriguing today is that equities seem largely immune to a combination of $120+ oil, softening housing markets and a likely collapse in western consumer spending. Arguing that several trillion currently either sheltering in money market funds or rapidly accumulating thanks to petrodollar wealth in sovereign wealth funds will ride in to support stock markets (a.k.a. greater fool theory) only logically goes so far in the face of such sizeable challenges. But some confusing short-term resilience on the part of stock markets does not invalidate the need for caution, it rather reinforces the need for patience. On a separate note, James Ferguson of Pali asks whether it might be time to commit heresy and talk, not of $200 oil (or $1000 oil, has anyone on Wall Street tried that yet ?), but merely $100 oil ? “The last three times, in the 7-year bull run that West Texas Intermediate (crude) has enjoyed, that the oil price got more than two standard deviations above trend, it precipitated an almost immediate profit-taking that resulted in an average -28% drop.” Wall Street’s venal salesmanship and management of subprime goes some way to underpinning its credibility in other markets, so its bandwagon-chasing on oil can be largely discounted on fundamental trustworthiness. The bigger question is how long equity markets can hold their poise in the face of the world’s mounting unbalances, and that question touches on government bond valuations too in the face of the smoke of the battle around inflation.

 

Sir Francis Bacon once wrote:

“If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts he shall end in certainties.”

 

In the face of almost insurmountable doubts (over likely economic slowdown, the impact on consumer confidence of softening residential property prices, the robustness of Asian fundamentals in the face of the ongoing commodity rally, the impact of $130+ oil, and the health of government bond markets given growing doubts over the under-reporting of inflationary pressures) it makes absolute sense to assume ongoing and substantial macro uncertainties. That argues, in turn, for nuanced and highly selective exposure to equity market risk, to capital preservation strategies in bond market terms, and to a healthy degree of ‘absolute return’ (quality hedge fund) as opposed to long-only market positioning, not to mention further asset diversification. Markets may not yet be flashing red, but there seem to be more than usually strong headwinds about. Unfortunately, an especially discredited Wall Street establishment now has peculiarly weak authority in either recommending appropriate strategies or taking advantage of the resultant dislocations in markets. Happily, evolutions in financial products and the rapid democratisation of more sophisticated investment vehicles make it easier for independent asset managers and private individuals to try and resolve these questions for themselves, rather than simply overpaying to engage with a mountain of conflicted interests.


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Sacrificing some sacred cows

“Absurdity, n.: A statement or belief manifestly inconsistent with one’s own opinion.”

- Ambrose Bierce, ‘The Devil’s Dictionary’.

 

Certain combinations of words can be virtually guaranteed to lower the spirits. One thinks of constructions like “Michael Winner”; “diplomatic solution”; “Ricky Martin”; “Big Brother” (the Endemol incarnation, as opposed to George Orwell’s). To which grim list we can now add “academic studies” and “the wisdom of pension funds”. In a letter to the Financial Times, investment manager Evan Salway alludes to the futility of academic studies when contemplating the benefits of active versus passive management. He goes further and cites the debatable wisdom of those pension funds who, having largely ignored the biggest equity bull market in history (1982-2000), finally took the plunge – at the start of 2000 – and cheerfully switched out of bonds and into stocks just in time to a) get hosed by a catastrophic bear market in stocks, and b) miss out on a monster rally in bonds.

 

Mr. Salway points out that while academic studies of active versus passive management may suggest that the average active manager underperforms, such studies can easily be challenged, not least because they tend to focus on long-only investing. But regulators have made it increasingly easy for active managers to sell short as well as trudge along the long-only treadmill. It is difficult (though not, sadly, impossible) to believe that there are investors out there who cling resolutely to the “long-only is best” school of guaranteeing sub-optimal investment returns. He also suggests that with much corporate newsflow pointing to the adoption of passive management by pension funds,

 

“at such an inflection point in capital markets when choosing between active and passive on a historical performance basis, it is [perhaps] just as dangerous as choosing between equities and bonds on that basis in 2000.”

 

To descend to the ‘policy out of the rear-view mirror’ level of pension funds for just one moment, a comparison between the benchmark hedge fund index and the benchmark global equity index makes a striking argument in favour of the former. Between 1994 and 2008, hedge funds – as represented by the CSFB / Tremont hedge index – returned an annualised 10.7%. Stocks – as represented by the MSCI World index – returned an annualised 6.3%. The data haven’t been arbitrarily “fixed”: the Tremont index doesn’t go back beyond 1994. Not only did hedge funds, in aggregate, deliver 68% higher returns per year – after fees – than stocks, but they did so with significantly lower drawdowns. Hedge funds’ worst period historically (July-October 1998) incurred a drawdown of 13.8%. That is shorter in duration and shallower by comparison with the 30-month drawdown of 48.4% suffered by the global stock market between March 2000 and September 2002. In crude terms, with the benefit of hindsight, which market would you rather have owned ?

 

Some caveats may be required. Survivorship bias – which removes failed businesses from the indices – will be present, but in both indices. And it could turn out to be the case that the hedge fund industry, having seen huge capital inflows during the period as it grew toward maturity, has delivered its best returns. But the single biggest caveat is that we are not realistically comparing like with like: equities constitute a discrete asset class; hedge funds comprise an altogether broader school of disparate individuals who putatively represent talent. Whereas the equities asset class is by definition long-only, the hedge fund sector is effectively unrestrained, whether in terms of investible assets (anything), positioning (long or short, or both), or leverage.

 

The fragility of academic study of investment is that, as with economics, it presumes the existence of a closed, scientifically rational system. Not only are there multiple players within the markets with multiple approaches and beliefs and multiple relevant time horizons, not even a majority of that varied crowd can ever realistically be described as entirely rational. And whether or not there is an information gap between the academics who study the markets and the professionals who work within them, there is undoubtedly a wealth gap, the existence of which carries its own conclusions.

 

On the topic of pension funds, Bloomberg’s Caroline Baum (“Pension funds ‘diversify’ into commodity bubble”) quite fairly points out that while other asset classes enjoy metrics that express the degree to which prices have travelled beyond fundamental anchors (earnings, for example, in the case of stocks, and yields in the case of bonds), for commodities “no such quantifiable ratio” (other than the crude measure of the rate of price increases over time) exists. Her implication is that now that pension funds seem to have fully embraced the commodities story, their entry into the market could easily represent a worrisome near-term top. Michael Aronstein of Marketfield Asset Management is cited with the following useful advice:

 

“If you want to be in commodities, buy a process, not a product.. Own a gas company. Or a forest products company. Buy an entity that extracts value. And you get a free option: the product might appreciate.”

 

So although the macro picture darkens daily, there are still pockets of promise within the equities markets, even if those markets in aggregate now seem to be trading on nothing more than the fumes of wishful thinking. And this gets to the heart of the “academic” wrangling over active versus passive investing. Markets and investment products are too complex to be reduced to binary decisions like (higher cost) active versus (lower cost) indexed. Investor expectations, too, are more nuanced than the academics (and consultants ?) might care to admit. In broadly efficient and relatively low-yielding markets like government bonds currently, active managers, with all their attendant costs, will have to perform heroically to outperform low-cost ETFs. In the maelstrom of equity markets, however, investor requirements and objectives are likely to be more varied. While some investors will crave outsized returns, others will have a natural preference for avoidance of loss and the pursuit of absolute returns. Both strategies demand active management. Other investors, particularly with a longer and perhaps more disinterested time horizon, will be largely satisfied with low cost passive management. But passive management comes with its own costs – particularly during a bear market that will doom advocates to tracking that same market lower. No one approach can possibly suit all. To assume otherwise does a grave disservice to those managers expending valuable intellectual capital to preserve and grow client capital in the midst of a treacherous market environment.



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The infantilization of markets

“What are the facts ? Again and again and again – what are the facts ? Shun wishful thinking, ignore divine revelation, forget what “the stars foretell”, avoid opinion, care not what the neighbours think, never mind the unguessable “verdict of history” – what are the facts, and to how many decimal places ? You pilot always into an unknown future; facts are your single clue. Get the facts !”

-  Excerpt from the notebooks of Lazarus Long, from Robert Heinlein’s “Time Enough for Love”.

 

Or instead of “facts”, he could have said “prices”. Clobbered by months of write-offs and profits warnings from distressed banks; nervously peering at the prospect of softer property prices for the foreseeable future; and overshadowed by crude oil trading north of $120 a barrel, stock markets have done the only thing one could reasonably have expected them to do – they have rallied strongly off the lows. No small thanks are due to the interventionist zeal of the US Federal Reserve. Note how US equity markets bottomed this year just before the emergency support lent to ailing (and “too interconnected to fail”) brokerage Bear Stearns.

Are we now being borne up by nothing more substantial than a relief rally ? Quite possibly. Banks and investors now seem exhausted by news of the credit crisis, and understandably want to focus on something new. Be careful what you wish for.. Pretty soon we can all get to worry about the impact of widespread deleveraging on the consumer, on consumer spending, on the services sector that defines most western equity market valuations, and whether rising food and fuel prices will start to dismantle the growth story for Asia. On which note, UBS estimates that China’s foreign currency reserves, which are currently the world’s largest, could be cut in half over coming years if grain prices were to double again from existing levels. Having until recently been a significant grain exporter, the China of 2010 is forecast to be importing the equivalent of 40% of US corn exports. Niels Jensen of Absolute Return Partners mischievously suggests that as the largest wheat exporters today comprise the US, Canada, Russia, the European Union, Kazakhstan and Australia, they might wish to set up between them an OGEC (an Organisation of Grain Exporting Countries) to match the economic clout (and vested self-interest) of OPEC in oil. As Niels indicates,

 

“..investors will increasingly differentiate between the ‘haves’ and ‘have nots’ [in food production]. And the ‘haves’ are those countries which control the world’s resources.. few countries are net exporters of both oil and foods on a large scale. Come to think about it, it is less than a handful. And no Asian country is on the list. (Italics mine.) So who is on it ? In the old world only one – Canada. In the grey zone (emerging economies but not necessarily young and dynamic populations) perhaps two – Russia and Kazakhstan. And amongst full blooded emerging economies ? No-one today, although Brazil has the potential to turn itself into a winner and so does Africa, it if can sort itself out.”

 

There are other reasons to see pockets of opportunity within equity markets. US multi-nationals will have benefited from the weaker dollar even though that trend now seems to be going into reverse; and in the realm of energy services and infrastructure, oil price strength – assuming it continues – may well outweigh the impact of a newly enlivened dollar. The Financial Times reported on Thursday that “senior officials” now have a “united” desire to see a stronger dollar versus the euro. A degree of distress at an uncomfortably high euro is inevitable in the euro zone, given the somewhat baffling monetary policy intransigence (if not liquidity provision) of the ECB. But any supposed feelings from US officials about a stronger dollar should be taken with a pinch of salt. Rhonda Schaffler and John Brinsley for Bloomberg News reported on April 16^th that former Treasury Secretary Paul O’Neill (admittedly perhaps one of the worst in the role in recorded time) had said that the

 

“’strong dollar’ policy that he and every other Treasury chief since 1995 endorsed is a vacuous notion.. It implies in it that somehow we have the ability to manage the relationship between the value of the US dollar and other currencies around the world.. When I was Secretary of the Treasury I was not supposed to say anything but ‘strong dollar, strong dollar’.. The markets actually have control over those relationships. When people say strong dollar, if they don’t mean that ‘we believe intervention can work and we’re prepared to intervene’, then ‘strong dollar’ is ridiculous.”

 

It would be similarly ridiculous to believe anything expressed by unnamed “senior officials”. But even if the sentiments expressed were genuinely felt, as Paul O’Neill points out, it is the markets, and not the central banks, that have the capital to act upon them. And according to the BIS, average daily turnover in the traditional foreign exchange markets runs at roughly $3.2 trillion. No central bank can do anything in that market other than seize onto a change in trend and hang on for grim life. The latest analysis of IMM data points to a reversal in fortunes for both the euro (weaker) and Sterling (weaker) against the dollar. Sterling’s specific exposure to a domestic banking, government finance and property crisis makes it look like a basket case currency against just about anything. Look out below.

The hopeful nature of equity market investors faced with the effects of the credit crisis (largely priced in and behind us) but also with the looming impact of economic slowdown points to the way in which markets have become juvenilized. Few investors have the patience to sit out a slowdown, so the presumption becomes that markets are now looking out to the anticipated recovery perhaps 12 to 18 months down the line. Wishful thinking is no way to manage a portfolio. In some respects, the hedge fund lobby is responsible for this infantilized approach to volatility, peddling the myth that investors can almost without effort secure constant positive monthly returns without incurring risk. But markets aren’t like that. Will the equity rally be sustainable ? The most dangerous presumption would be to presume that you really know. In the absence of such perfect foreknowledge, the argument for asset class diversification – and the avoidance of obvious equity market blackspots – remains as sound as ever.


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