Wednesday, February 25, 2009
The media has recently reported on the trading blow-up of Boaz Weinstein, 36, a prop desk trader formerly at Deutsche Bank, here: Deutsche Bank Fallen Trader Left Behind $1.8 Billion Hole. For background on Mr. Weinstein, see here: "Young traders thrive in stock/bond nexus."
A credit derivative, such as a credit default swap (CDS), is an insurance contract that allows a trader to bet that a bond will rise or fall in value (technically that the default risk of the bond will increase or decrease). Broker-dealers like Deutsche Bank or Morgan Stanley match buyers with sellers, and earn huge fees - often their own prop traders take positions. Mr. Weinstein was an early gambler (uh... trader) in this market, earning Deutsche Bank a few hundred million dollars in profits each year for four or more years, and tens of millions of dollars for himself personally. He then lost it in the crash in Fall 2008, losing Deutsche Bank $1.8bn (this is the WSJ estimate - I've had some CDS traders who were counterparties say this loss was $3bn or more).
So what went wrong? Was the Boy Genius of Deutsche Bank brash and reckless, or did his risk management handlers undercut him?
One could argue that if Mr. Weinstein could have held his positions (reportedly basis trades, that is, bets on the discrepancy between CDX indexes and the cash bonds which they supposedly tracked), he could have made much money. Yet, the handlers of Deutsche Bank's prop desk money, the risk management team, became uncomfortable and pulled the plug, causing Mr. Weinstein to lose large sums of money. So who is at fault? The risk managers doing their job and cutting what seemed like bad positions (and so saving their jobs)? Or Mr. Weinstein, for not getting approval from his handlers to make very volatile trades that could have eventually made much money? That is, is he at fault for not getting staying power through a sign-off or a contractual right by informing his bosses ex ante ("Chief, if a crisis happens, I will lose $X first, but make $2X later, so you need to stick with me)? Or does fault lay with the Deutsche Bank bosses that gave Mr. Weinstein so much money to bet with in the first place, taking the easy hundred million dollar profits in past years and then taking the multi-billion dollar loss in 2008 (what Taleb likened to picking hundred dollar bills up in front of an oncoming bulldozer)?
The more scary thought is that the entire CDS market could have collapsed with all its major broker-dealers and counterparties defaulting. So, even if you bet right and won, you would have really lost because the other side would be bust and couldn't pay you. Many smart hedge fund managers avoided CDS just for this reason (but alas, lost cash or good securities by keeping them in a Lehman Brothers prime broker account that could be re-hypothecated, and so are in receivership after Lehman went bust). Mr. Weinstein, and his former employer Deutsche Bank, were playing with zappo lighters while standing on a wire above jet fuel - the first hard winds coming by blew them over.
Earnings numbers are bunk – with all the various gaps and fudges GAAP allows, a company’s net income and earnings per share is at best a weak indicator of the actual economic value of a firm. More likely, the earnings number is some CFO’s deception. In the bubble, i-bankers and promoters were successful at using these false numbers to get suckers to buy stocks and bonds. But the suckers didn’t even learn after the tech crash in 2001. Today, after the credit crash and our current mini-depression, investors are turning again to what matters: cash. Dividend yields matter - dividends are paid with cash. Stock buybacks matter - buybacks are made with cash. Debt assumed or debt-paid-off matter - debt is cash borrowed or paid back. Asset values matter (but only if the assets produce cash or can be sold for cash!). Shrewd businesspeople - what a rational investor should emulate, per Ben Graham and common sense - look at these numbers, and they are not easily reduced to a single figure or ratio. The closest ratio is something like a price/cash flow ratio, where cash flow is sensibly defined as the sensible “free cash flow” (FCF) calculation (not EBITDA, but cashflow after taxes, interest, and capital expenditures are paid – the sustainable cash that can be distributed out of a company). Generally, FCF can be used to pay dividends, buy back stock, or make acquisitions or capital improvements to improve the company (and generate higher FCFs). So let’s look at what matters.
Dividends: From December 1936 through March 31 2008 the average dividend yield for the S&P 500 was 3.828% vs. 3.833% for December 2007. It peaked at nearly 12% in 1932, and fell to a low about 1.2% in 2000 (the median from 1925 to 2007 was about 3.87%). The current 12-month dividend yield is 2.14% vs. the 1.89% yield for December 2007. The yield is based on the cash dividends paid over the prior four quarters and the closing quarterly price. Does this means companies how gotten worse by paying lower dividends? Not really. While the secular trend has been for a dividend yield under 3%, when you add back non-debt financed stock buybacks, it was probably between 3% to 4%.
Stock Buybacks: When these come from debt or leveraged buyouts, they’re part of the credit bubble. Real buybacks come from FCFs (or selling assets, which isn’t sustainable). For Q3 2008, Standard & Poor's announced S&P 500 stock buybacks of $89.7 billion, representing a 47.8% decline over the record setting $172.0 billion spent during the third quarter of 2007. On a sector basis, Standard & Poor's notes that Energy was the only sector to increase buybacks during the third quarter of '08 versus the third quarter of '07. Information Technology continued to account for a quarter of all buybacks, with Energy now accounting for 18%. That reflects the real value created in these two sectors, unlike the chimerical returns from “Financials” (taking on debt to pay off equity). Since the buyback boom began during the fourth quarter of 2004, S&P 500 issues have spent approximately $1.73 trillion on stock buybacks compared to $1.87 trillion on Capital Expenditures and $907 billion on dividends. If you sum the three, earnings numbers (the “E”) would be near $4.4 trillion, but as a shareholder, you can’t consume capital expenditures.
For investors in stocks, only dividends and buybacks matter, that is, cash paid out (or expectations of future payouts - read up on John Burr Williams and his original dividend discount model). While asset values are important, you can’t consume assets (a car plant has little value to you and me). Companies have been manipulating earnings for too long – I just don’t trust those numbers. While some have started manipulating their cash numbers by taking out debt to do buybacks or pay dividends, that can’t last either. Cash is difficult to manipulate. It is trustworthy, and so a P/FCF number has validity (it must be examined in context of a company’s capital structure). P/E numbers are just marketing ratios that bankers and their credit-agency accomplices put out to fool investors.
Tuesday, February 24, 2009
Here’s a graph of the historical PE (price to earnings) ratio of US equities over the last 100 years. The PE ratio is what investors were willing to pay for a company relative to the previous year’s earnings. A lot of things affect what investors are willing to pay including interest rates, the opportunity cost of their money, expected inflation, and their general tolerance for risk.
Most textbooks teach that rational investors use the “risk-free rate”, basically US treasuries, as their benchmark when deciding whether to invest in equities. The theory goes that investors compare the future returns on equities to treasuries, and will hold equities if the excess returns are high enough to justify the risk. I think this is a silly way of thinking about it. We have only a guess as to what future returns will be, and more importantly, we have no idea how future returns connect to current prices. The academic model suggests that with the S&P 500 index at 1100 I might be unwilling to invest in equities because the equity premium is too small, but with the index at 1000, I would throw my money into equities since my expected returns are now greater. In reality, as the market drops from 1100 to 1000, I have no reason to think that equities are now a better investment. Perhaps the market is being efficient and correctly pricing in new bad information. Moreover, most investors will reasonably grow more risk averse because their real wealth has decreased and volatility (risk) has probably increased.
So what is a fair PE ratio today? Since the wealth of the world (and of most investors) has plummeted, PEs should be low. We are all more risk averse when our nest eggs (or tier 1 capital) has eroded. Low interest rates would normally justify higher PE ratios since the opportunity cost of money would be low, but today’s interest rates are deceiving; while the treasury and interbank rates are low, companies and individuals can’t actually borrow at those rates. Low interest rates also justify higher PEs because they increase the present value of future corporate earnings, but again this is deceiving; a lot of investors (myself included) believe that the low interest rates on government debt are crowding out private borrowing and thus reducing future growth prospects. Using historical data as a rough guide, we can expect PEs in the 10-16 range over the next few years. However, a bad recession frequently sends PEs below 8 for a brief period, so we need to be prepared for that possibility. If inflation expectations become severe, we can expect lower PEs for longer as investors require higher rates of nominal returns to make up for the erosion caused by inflation.
Next time you hear someone say that a stock is cheap relative to its earnings, ask what those earnings are worth. Even if corporate earnings were completely unchanged, a rational drop in the risk appetite of investors or a rise in inflation could justify a 50% drop in share prices.
Tuesday, February 17, 2009
Italy and Greece have quickly growing public debt of about 100% of GDP and shrinking tax revenues. Without independent currencies, Italy and Greece can’t devalue and inflate away their debt. Investors are still willing to finance such high levels of borrowing at single digit interest rates under the assumption that as members of the EU, Italy and Greece are safe from both inflation and default. What happens when investors start questioning the long-term solvency of these governments? What happens if they face a sovereign “bank run” as investors flee to safer sovereign debt?
As this graph (courtesy of John Mauldin) shows, the process has begun. The sovereign debt spreads are widening in a self-fulfilling process that threatens to turn exponential. If credit spreads continue to widen, at some point the costs of remaining in the EU will outweigh the benefits. The source of the problems for Italy, Greece, and the other weaker EU members like Spain, Portugal, and Ireland is primarily that their labor costs are much higher than the stronger EU members. This is causing rising unemployment, already double digit in Spain. Politicians may soon find the pressure from labor to be overwhelming. Their constituencies are demanding jobs and the only way to provide them is to boost export competitiveness by leaving the EU so they can devalue their currencies.
There are some alternatives. While the IMF’s remaining reserves would just be a drop in the bucket, they could issue special drawing rights or insure loans to temporarily sweep the problem under the rug. Germany could start buying the sovereign debt of weaker EU members and establish a symbiotic balance of payments relationship like that between the US and China. None of these are particularly attractive options though as they just put off the adjustment that will eventually have to occur. History has shown that currency imbalances can persist for decades, but they must eventually reverse; the longer they’re put off, the more spectacular the fireworks.
So will the EU exist in its present form in 3 years? Probably. But there is a serious risk that investors will pull capital out of the weaker EU members and create a self-fulfilling crisis in the near future.
Friday, February 6, 2009
George Soros has long expounded on the topic of “reflexivity”, a way of looking at financial markets that is both common sense and academic heresy. Reflexivity includes the idea that market prices don’t just reflect economic reality, they actively shape it. Take the petroleum industry for example, where new investment frequently won’t pay dividends for 4+ years. If crude oil prices are stable at $70, oil companies will invest to maintain adequate production levels so we’re likely to have similar oil prices in 5 and 10 years. However, if oil prices plummet below $40, oil companies curtail investment leading to a production shortage in 5 years and potentially $200+ oil.
When there is a consensus on future market prices, it usually ends up being wrong specifically because the consensus exists. In other words, while consensus is self-fulfilling in the short-term as speculators push market prices in the direction of the consensus, it is self-negating in the long-term. If everyone agrees home prices will keep going up, developers build more homes so there’s plenty of supply and prices can’t rise. If everyone agrees natural gas will be plentiful and cheap for many years, investors don’t spend to expand production, causing shortages and higher prices in a few years.
Today we pretty much have a consensus on inflation. There’s a lot of debate over whether the inflation will start in 3 months or 3 years, but just about everyone agrees it’s in our future. Does this mean we’re unlikely to actually get inflation? Inflation is an exception to the “anti-consensus rule” because inflation expectations are themselves inflationary. When we expect prices to rise we buy goods today, demand raises, sell treasuries, and buy houses and commodities. Our expectations are self-fulfilling in an endless loop with no end in sight. While the talk of inflation encourages central bankers to tighten the money supply, they face fiscal and political obstacles that also feed the inflationary loop. As inflation expectations increase and prices start rising, unions push harder for raises and the government struggles to finance its debt at higher interest rates. Without some very tough political decisions, the only end of the inflationary loop is a complete collapse of the currency and the introduction of a new currency regime. Let’s hope we don’t have to break the loop.
Tuesday, February 3, 2009
4. Current market information - for most asset classes, we can look to the collective wisdom of the market for the short-term risks. For example, the current prices of options reveal the market's consensus on the probability distribution of equities over the next few months. Most of the time the market is very accurate and does a fine job of predicting the day to day volatility of a portfolio.
3. Over a very long time frame, historical data shows us what is likely to happen in similar circumstances and the great extremes that are possible. For example, we should note that in previous recessions, P/E ratios frequently dropped below 12; given current estimates for next year's corporate earnings, a P/E ratio of 12 would entail the S&P 500 dropping another 35% (from 840 to 550). Contrary to current market information, historical data suggests that risks are highest at the peak of booms when implied volatility is lowest.
2. Consider "game changers." Any pricing of risk makes assumptions about how the future will resemble the past. What assumptions could be proven wrong? For example, credit default swap contracts priced in almost no risk of the issuer defaulting, and that changed overnight. Must US treasuries sell off in an inflationary environment or is that just consensus? In investing, consensus frequently ends up being wrong, current market pricing of volatility changes, and historical patterns continue until they don't. We need to consider that the risks themselves may change.
1. Absolute exposure - ultimately the only metric of risk in which we can have full confidence is the total dollar exposure. A leveraged portfolio will always have a greater risk of going to 0 than a portfolio with 20% in cash. As leverage increases, so does the exposure to mistaken risk analysis. A 20x leveraged portfolio can only weather a slight miscalculation by management. No management is perfect, we all make mistakes despite our best efforts. An unleveraged (or only modestly leveraged) portfolio allows for a necessary margin of error.
You'll notice I ommitted recent historical data like "beta." I think focusing on concepts like "beta" and "alpha" are more misleading than helpful. As Alpha noted, big losses usually come from uncertainty not risk. As risk managers, we should focus on constantly seeking out sources of uncertainty. We need to construct a portfolio that can tolerate our inevitable misjudgements and the unpredictable "black swan" events that will test us.