Investors,
60 years ago a wealthy man owned and operated a factory and made 20x what his workers made. Today, the wealthy man got wealthy by lying about the value of derivatives and made 100x the earnings of the workers in the pension fund he fleeced. The Occupy Wall St movement reflects disillusionment and anger; beyond that there are few shared goals. However, it plays a critical role in the 70 year boom-bust cycle we're experiencing now. In this commentary I'll discuss the movement, where we are in the boom-bust cycle, and some political views. First, a very brief rehash of the recent news and market action.
Recent News and Market Action:
Eurozone political leaders announced a new resolution; it's far from a solution to the Euro problem, but a legitimate strong step in the right direction. They've organized an orderly default of Greece (that will not legally be called default to avoid triggering Credit Default Swaps), an increase in the EFSF bailout facility to a trillion euros, a plan to recapitalize banks, and additional austerity measures. It reduces the risk of a catastrophic disorderly default, and so the market rallied strongly on the news. Equities were oversold at the start of the month, so the anticipation and realization of this good news led to a whopping 14% rally. I just sold my long crude oil position for a 13% gain, probably far too early but I am again uncomfortable being long any risk assets. If the market continues to rally I will scale into a larger short equity position. Global economic releases have been generally bad suggesting a global recession is still the base case.
The 70 year boom-bust cycle:
Historically, developed markets experience 70 year credit booms followed by major busts. The basic pattern is that the boom begins with real growth in productivity, this kindles "animal spirits" and encourages entrepreneurship, investment, and easier credit. Over time the general public becomes giddy with the pace of development; politicians reduce regulation which leads to booming profits, especially in the financial sector. Eventually the credit gets too easy and rational greed becomes stupid greed and we get a bubble. When the ponzi scheme of easy credit reaches its pinnacle, the bubble collapses and we go through a painful deleveraging process. Excessive debt can be eliminated in 2 basic ways - you can pay it off with profits (or taxes in the case of national debt) or you can forgive the debt in bankruptcy court or a similar restructuring. When a credit bubble is unwinding, profits and tax revenues are shrinking, so option #1 is impossible. So far, the government has tried to shuffle the debt to parties more able to bear it and to push the debt into the distant future when hopefully tax revenues will be higher. There are also plans for additional debt forgiveness for homeowners and students.
The role of social unrest:
You may recall in mid 2009 that I questioned why we didn't see more social unrest. In my studies of history, every major credit crisis has resulted in significant social upheaval. I wasn't expecting revolution in the USA, but isolated riots could be expected. At the time, this influenced my belief that the "bust" portion of the cycle had much further to go. I continue to believe that until we see major social unrest and the average american swear off equity investing, that the "bust" portion of the cycle is not complete. Right now we're seeing the early stages of a major social movement. The mainstream media continually understates the size of the demonstrations, but they are large and growing. What can we expect in the future? This is a difficult question because early stage social movements are chaotic beasts. I am very curious as to how the social will eventually be converted to the political. President Obama seems to be trying to co-opt the movement, but he has proven he lacks the stomach to confront special interests. The ultimate outcome of the anger will likely be sweeping regulatory reform. Economists and politicians currently believe that the "too big to fail" banks must be kept gigantic; they believe that there are inherent economies of scale in banking and that smaller banks will either be uncompetitive or simply reunite like the Ma Bell telephone companies. If this view holds, the only option is to more thoroughly socialize the banking system. Banks will likely be separated into retail banks with government backing and implicit subsidies that remain huge, and investment banks that will effectively be forced to shrink in size as they lose the implicit government support. The result will likely be that the finance sector in general becomes smaller and much less profitable, both at the corporate and individual level. As investments, the financial sector is likely to underperform the broad market over the next twenty years.
The politics:
A frequent criticism of the Occupy Wall St movement is that it has no cohesive goals. This is a valid criticism - the movement includes both socialists and libertarians - its members call for more government redistribution of wealth and better health care and support for unions - and the exact opposite. The greatest theme that resonates with me, and I believe will eventually resonate with the middle class, is one of fairness. I am a tremendous champion of capitalism. The problem today is that the government is supporting crony capitalism. Small banks recently had their fees and taxes hiked to pay to support a handful of "too big to fail" banks. Incompetent CEOs are receiving $10+ million dollar golden parachutes even as their companies are saved from bankruptcy with taxpayer money. Companies like General Electric have an entire branch devoted to lobbying government for customized tax loopholes; these loopholes make it nearly impossible for smaller companies that can't afford similar lobbying to compete. This isn't a question of wage inequality or liberal vs conservative politics. This is a question of integrity. It appears to many observers (myself included), that government regulation is actually entrenching corrupt business practices. Businesses are then forced to either compete with their own lobbyists and unethical financial schemes or to resign themselves to shrinking profits or even bankruptcy. Citigroup CEO Charles Prince said, "When the music's playing, you've got to dance." In today's oligopolistic industries which include the banking sector, ratings agencies, and even software, our only hope is for the government to turn off the music and stop encouraging the unethical behavior.
Back in 2009 I tried to do my part and voiced support for a "Tobin Tax": http://www.riskoverreward.com/2009/11/in-support-of-tobin-tax-vega.html
Cheers,
Ari
Friday, October 28, 2011
Saturday, October 8, 2011
Why I Do Not Short Markets and Securities - Alpha
After getting 29% returns on my short financials portfolio in 2008 (with no longs!), I eventually decided to stop shorting (I shorted Greece and the big Euro banks early in 2010, losing some money, but recently those trades have done well). In late July 2011 I made a call on the S&P dropping due to Euro bank fragility and a friend sent me this image of the market's return after the call.
A Lucky Call, or Obvious in Hindsight - "S&P500 Will Drop From August On"
My call worked out but I have a few reasons for no longer shorting. It boils down to...
SHORTING IS VERY DIFFERENT THAN GOING LONG. Superficially, the two are similar. You calculate the intrinsic value of an asset and then compare it to the market price. For a long, you buy the asset; for a short, you sell it. The biggest differences are time, risk/return profiles, and psychology. Also shorting is always speculation, but long investing can be speculation or investing (by the classic Graham/Buffett definition).
1) TIME IS YOUR ENEMY WHEN YOU SHORT: In long investing, time is your friend. When an asset's price stays low (or falls), you can keep buying it and "clip the coupons" of interest, dividends, etc. You want it to fall lower and can be patient. At an extreme, you want the price to fall below ST earnings or cash/book value per share. In contrast, when a short goes against you, your lender can crush you by forcing you out of your position or raising the collateral margin or borrow rate. Also, good news comes gradually and in a planned way but bad news comes in random and unpredictable bursts. This makes the timing of shorting very hard. If you're right on the fundamentals and wrong on timing, you lose big bucks and many nights of sleep.
2) THE RISK/REWARD FOR SHORTS SUCKS: For longs, your theoretical return is infinite but your loss is capped. You can lose what you pay but get a 10x-20x return. Shorting is the opposite. At most you can make 100% (2x) if the stock goes bankrupt; but you can lose an infinite amount if the stock rises for a while and the market stays irrational longer than you can stay solvent.
3) PERSONAL AND MARKET PSYCHOLOGY: As numerous bubbles in the last 20 years (Tech bubble, housing bubble, sovereign debt bubble) and last 50 years (emerging markets bubble, S&L bank bubble, commercial paper bubble, etc.) have shown, markets can be irrational for long periods of time. Mr. Market is often right but sometimes a complete doofus. So as a short speculator, you need to have flair for timing and trading, whereas this is less important (not unimportant) for long investing. (NOTE: Two books I suggest you read about bubbles: Kindelberger, "Manias, Panics, and Crashes" and Hunter and Kaufmann's "Asset Price Bubbles.")
My thesis is that most value investors have long-term mentalities and so do not have the trading prowess to be short. This is fundamental. Temperamentally, you need conviction, emotional stability, and contrarian staying power to be a good long investor. These are bad qualities for a short speculator, who needs to be nimble and trade around positions a lot. A short speculator needs a high tolerance for pain and needs to wait through pauses or the market manipulation of management.
In sum, there are brilliant short speculators out there like Andrew Lahde and Jim Chanos (see the article below). However, the number of people that can go long and short smartly over time are rare (Steinhardt and Soros were legends in doing both, and Dr. Michael Burry comes to mind, but even he prefers the asymmetric outcomes of longs). Also, by shorting you can create stress for your own investor LPs (e.g. Burry and Julian Robertson) and even have a public reputation of profiting off of misery (as George Soros, John Paulson, and others saw).
My bottom line: Know your temperament and create a method that respects it. It's very hard to be both long and short. The Tiger Cubs follow the AW Jones model of a hedged 40% net portfolio with a book of longs balancing their shorts - this is one smart way to do it. A better strategy is to be long only and then switch to bonds and cash when timing requires it.
APPENDIX I: Eric Savitz's Notes from Chanos' Appearance at the Stanford Director's Conference on Jue 24, 2008
Chanos, the president of Kynikos Associates, which has $6 billion invested in bearish bets on the stock market, gave a talk at the Stanford Directors’ College, an annual symposium at Stanford Law School for the directors of public companies.
Chanos provided some insights on what he does, areas of the market where he sees opportunity to short stocks, and how directors ought to react when the find short interest in their stocks rising.
Here are a few bullet points from the talk:
** Chanos noted jokingly that he doesn’t often get invited to talk to corporate directors - and that when he does, “there tends to be a battery of lawyers in the room and a stenographer.” More seriously, he said part of his goal was to make it clear that shorts are neither “the evil omnipotent financial geniuses the market thinks we are on down days or the village idiots the market thinks we are on up days.”
** Kynikos has 5 investment partners with a combined 160 years of experience, and 20 investment professionals in all. Chanos notes that the firm has “no opinions on interest rates, or drilling offshore, or the dollar, or the Fed.” Instead, he says, “we are just looking at companies, the only place we feel we can add value.” And he adds that they “delve into companies more than you would ever want to know.”
** Chanos notes that there is a basic asymmetry in the financial markets; he notes that the short side is not simply the mirror image of going long. While he says they evaluate companies much like any securities analyst might, he says there is a distinct difference. Chanos notes that the daily “hum and drum” of Wall Street, where “the constant backdrop is positive.” He says that Wall Stret is “a giant positive reinforcement machine.” Chanos notes that his firm is short about 50 U.S. stocks and another 50 international stocks, and that every morning at least 10-20 of those have had estimates raises, or CNBC appearances by the CEO, or takeover rumors, or some other factor pushing stocks higher. “It’s the Muzak of the investment business,” he says, though “most of it has no informational content long term.”
** Chanos notes that people tend to prefer positive reinforcement; short-sellers, he observes, are constantly told “you are wrong.” The number of people who can take the heat and succeed professionally on the short side, he said to the assembled group of directors, “would fit at a couple of tables.”
** Chanos outlined some of the broad themes he follows in seeking out short candidates. One of those is “booms that go bust,” or more specifically, credit-driven asset bubbles. Examples include the telecom boom of the late 1990s and the commercial real-estate boom and bust that created the S&L crisis in the 1980s. (He says we could see another one in debt from private equity deals.)
** Another theme: technological obsolescence. “This is a very fruitful area,” he says. In recent years, he says, “the digitization of of many businesses has destroyed a lot of companies.” Chanos says he’s been actively looking for companies where the distribution of analog products had been digitized. He cites video rentals, music retailing and newspapers as a few areas where he has had successful short positions in recent years. Chanos says he’s currently short cable and satellite stocks on the theory that video will be the next area to be disintermediated. At times of great technological advancement, he says, there are often more losers than winners.
** Yet another theme: growth by acquisition, and its cousin, questionable accounting. Chanos says that most large acquisitions destroy shareholder value, rather than enhancing it. He also sees the potential for accounting mischief when companies take large charges and reserves related to M&A, allowing things to look better than they are.
** Another red flag, he says is the use of “irregular accounting.” He points to Enron as a prime example of the use of “mark to model” accounting, rather than “mark to market.” Another example, he says, was the use of “gain on sale” accounting at sub-prime lenders like the Money Store in the mid-to-late 90s. One more example he cited involved Tyco’s ADT home security unit. He says ADT at one point was buying up subscribers from other security providers for about $900 each, at a time when others were only willing to pay $600 per sub. He says the sellers turned around and paid ADT $200 in fees which were booked as revenue; the result was a net cost of $700, and at the same time, a magic way to turn capital into earnings. “Make sure your companies are not turning capital into earnings,” he told the directors. “The market will be fooled by that for a while, but then the lawsuits start flowing.”
** Chanos advised the directors to ask management for a concrete explanation when there is a short position building at a company where they sit on the board. “I guarantee you the CEO and CFO know why,” he says.
** Chanos said he’s often asked why financial frauds continue to occur, despite the installation of new rules like Sarbanes-Oxley. He notes two decade-old surveys that found a shocking number of CFOs that had been asked at one time in their careers to falsify financial results. A July 1998 Business Week CFO survey, he says, found 55% had been asked to falsify documents but refused to do; 12% said that had been asked and agreed to. A similar survey in 1999 by CFO magazine found 45% of CFOs had been asked by the CEO to falsify financial results. “There is a lot of hanky-panky going on in corporate America, gang,” he said. “And it continues to this day. There is always incentive to shade the truth, to make things appear rosier than they are.”
APPENDIX II: Dr. Burry explains his CDS short thesis of mortgage securities in two investor letters.
2006 Scion Letter: http://www.scioncapital.com/PDFs/Scion%202006%204Q%20RMBS%20CDS%20Primer%20and%20FAQ.pdf
2008 Scion Letter: http://www.scioncapital.com/PDFs/Scion%202008%201Q.pdf
Michael Lewis on Burry (background): http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004?printable=true
A Lucky Call, or Obvious in Hindsight - "S&P500 Will Drop From August On"
My call worked out but I have a few reasons for no longer shorting. It boils down to...
SHORTING IS VERY DIFFERENT THAN GOING LONG. Superficially, the two are similar. You calculate the intrinsic value of an asset and then compare it to the market price. For a long, you buy the asset; for a short, you sell it. The biggest differences are time, risk/return profiles, and psychology. Also shorting is always speculation, but long investing can be speculation or investing (by the classic Graham/Buffett definition).
1) TIME IS YOUR ENEMY WHEN YOU SHORT: In long investing, time is your friend. When an asset's price stays low (or falls), you can keep buying it and "clip the coupons" of interest, dividends, etc. You want it to fall lower and can be patient. At an extreme, you want the price to fall below ST earnings or cash/book value per share. In contrast, when a short goes against you, your lender can crush you by forcing you out of your position or raising the collateral margin or borrow rate. Also, good news comes gradually and in a planned way but bad news comes in random and unpredictable bursts. This makes the timing of shorting very hard. If you're right on the fundamentals and wrong on timing, you lose big bucks and many nights of sleep.
2) THE RISK/REWARD FOR SHORTS SUCKS: For longs, your theoretical return is infinite but your loss is capped. You can lose what you pay but get a 10x-20x return. Shorting is the opposite. At most you can make 100% (2x) if the stock goes bankrupt; but you can lose an infinite amount if the stock rises for a while and the market stays irrational longer than you can stay solvent.
3) PERSONAL AND MARKET PSYCHOLOGY: As numerous bubbles in the last 20 years (Tech bubble, housing bubble, sovereign debt bubble) and last 50 years (emerging markets bubble, S&L bank bubble, commercial paper bubble, etc.) have shown, markets can be irrational for long periods of time. Mr. Market is often right but sometimes a complete doofus. So as a short speculator, you need to have flair for timing and trading, whereas this is less important (not unimportant) for long investing. (NOTE: Two books I suggest you read about bubbles: Kindelberger, "Manias, Panics, and Crashes" and Hunter and Kaufmann's "Asset Price Bubbles.")
My thesis is that most value investors have long-term mentalities and so do not have the trading prowess to be short. This is fundamental. Temperamentally, you need conviction, emotional stability, and contrarian staying power to be a good long investor. These are bad qualities for a short speculator, who needs to be nimble and trade around positions a lot. A short speculator needs a high tolerance for pain and needs to wait through pauses or the market manipulation of management.
In sum, there are brilliant short speculators out there like Andrew Lahde and Jim Chanos (see the article below). However, the number of people that can go long and short smartly over time are rare (Steinhardt and Soros were legends in doing both, and Dr. Michael Burry comes to mind, but even he prefers the asymmetric outcomes of longs). Also, by shorting you can create stress for your own investor LPs (e.g. Burry and Julian Robertson) and even have a public reputation of profiting off of misery (as George Soros, John Paulson, and others saw).
My bottom line: Know your temperament and create a method that respects it. It's very hard to be both long and short. The Tiger Cubs follow the AW Jones model of a hedged 40% net portfolio with a book of longs balancing their shorts - this is one smart way to do it. A better strategy is to be long only and then switch to bonds and cash when timing requires it.
APPENDIX I: Eric Savitz's Notes from Chanos' Appearance at the Stanford Director's Conference on Jue 24, 2008
Chanos, the president of Kynikos Associates, which has $6 billion invested in bearish bets on the stock market, gave a talk at the Stanford Directors’ College, an annual symposium at Stanford Law School for the directors of public companies.
Chanos provided some insights on what he does, areas of the market where he sees opportunity to short stocks, and how directors ought to react when the find short interest in their stocks rising.
Here are a few bullet points from the talk:
** Chanos noted jokingly that he doesn’t often get invited to talk to corporate directors - and that when he does, “there tends to be a battery of lawyers in the room and a stenographer.” More seriously, he said part of his goal was to make it clear that shorts are neither “the evil omnipotent financial geniuses the market thinks we are on down days or the village idiots the market thinks we are on up days.”
** Kynikos has 5 investment partners with a combined 160 years of experience, and 20 investment professionals in all. Chanos notes that the firm has “no opinions on interest rates, or drilling offshore, or the dollar, or the Fed.” Instead, he says, “we are just looking at companies, the only place we feel we can add value.” And he adds that they “delve into companies more than you would ever want to know.”
** Chanos notes that there is a basic asymmetry in the financial markets; he notes that the short side is not simply the mirror image of going long. While he says they evaluate companies much like any securities analyst might, he says there is a distinct difference. Chanos notes that the daily “hum and drum” of Wall Street, where “the constant backdrop is positive.” He says that Wall Stret is “a giant positive reinforcement machine.” Chanos notes that his firm is short about 50 U.S. stocks and another 50 international stocks, and that every morning at least 10-20 of those have had estimates raises, or CNBC appearances by the CEO, or takeover rumors, or some other factor pushing stocks higher. “It’s the Muzak of the investment business,” he says, though “most of it has no informational content long term.”
** Chanos notes that people tend to prefer positive reinforcement; short-sellers, he observes, are constantly told “you are wrong.” The number of people who can take the heat and succeed professionally on the short side, he said to the assembled group of directors, “would fit at a couple of tables.”
** Chanos outlined some of the broad themes he follows in seeking out short candidates. One of those is “booms that go bust,” or more specifically, credit-driven asset bubbles. Examples include the telecom boom of the late 1990s and the commercial real-estate boom and bust that created the S&L crisis in the 1980s. (He says we could see another one in debt from private equity deals.)
** Another theme: technological obsolescence. “This is a very fruitful area,” he says. In recent years, he says, “the digitization of of many businesses has destroyed a lot of companies.” Chanos says he’s been actively looking for companies where the distribution of analog products had been digitized. He cites video rentals, music retailing and newspapers as a few areas where he has had successful short positions in recent years. Chanos says he’s currently short cable and satellite stocks on the theory that video will be the next area to be disintermediated. At times of great technological advancement, he says, there are often more losers than winners.
** Yet another theme: growth by acquisition, and its cousin, questionable accounting. Chanos says that most large acquisitions destroy shareholder value, rather than enhancing it. He also sees the potential for accounting mischief when companies take large charges and reserves related to M&A, allowing things to look better than they are.
** Another red flag, he says is the use of “irregular accounting.” He points to Enron as a prime example of the use of “mark to model” accounting, rather than “mark to market.” Another example, he says, was the use of “gain on sale” accounting at sub-prime lenders like the Money Store in the mid-to-late 90s. One more example he cited involved Tyco’s ADT home security unit. He says ADT at one point was buying up subscribers from other security providers for about $900 each, at a time when others were only willing to pay $600 per sub. He says the sellers turned around and paid ADT $200 in fees which were booked as revenue; the result was a net cost of $700, and at the same time, a magic way to turn capital into earnings. “Make sure your companies are not turning capital into earnings,” he told the directors. “The market will be fooled by that for a while, but then the lawsuits start flowing.”
** Chanos advised the directors to ask management for a concrete explanation when there is a short position building at a company where they sit on the board. “I guarantee you the CEO and CFO know why,” he says.
** Chanos said he’s often asked why financial frauds continue to occur, despite the installation of new rules like Sarbanes-Oxley. He notes two decade-old surveys that found a shocking number of CFOs that had been asked at one time in their careers to falsify financial results. A July 1998 Business Week CFO survey, he says, found 55% had been asked to falsify documents but refused to do; 12% said that had been asked and agreed to. A similar survey in 1999 by CFO magazine found 45% of CFOs had been asked by the CEO to falsify financial results. “There is a lot of hanky-panky going on in corporate America, gang,” he said. “And it continues to this day. There is always incentive to shade the truth, to make things appear rosier than they are.”
APPENDIX II: Dr. Burry explains his CDS short thesis of mortgage securities in two investor letters.
2006 Scion Letter: http://www.scioncapital.com/PDFs/Scion%202006%204Q%20RMBS%20CDS%20Primer%20and%20FAQ.pdf
2008 Scion Letter: http://www.scioncapital.com/PDFs/Scion%202008%201Q.pdf
Michael Lewis on Burry (background): http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004?printable=true
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