Investing when there's Blood in the Streets
"The time to buy is when there's blood in the streets", Nathan Rothschild (attributed).
Micro or Macro?
Normally stock picking investors are interested in the microeconomics of firms; their earnings power, competitive advantage and so on. These factors will, over lengthy periods, determine whether companies outperform their peers or not. In recent years, though, a curious thing has happened: these self-same investors have become more concerned with macroeconomics; the trends and decision making processes within the overall economy. It appears that investors no longer worry much about the fundamentals of investments or even the wiggly predictions of charts, because they have a much more basic way of assessing the likely trajectory of stocks: political analysis. And the result of this may be that we will have blood running in the streets. Again.
Political Incentives
Of course, politicians always affect markets and stocks. They levy taxes, often seemingly at random, they engage in trade wars, introduce market distorting subsidies, build bridges to nowhere and direct business development, invariably with unfortunate consequences. We usually watch politicians in the hope that they'll do something truly interesting, like fall down a hole or walk into a lamppost or tell the truth, or something. Usually we're disappointed. Given that the average politician's grasp of economics is on a par with a child's understanding of quantum gravity, we shouldn't be too surprised when they behave like any other person who's been incentivised to spend other people's money in order to make sure they personally continue to draw a healthy stipend. Investment bankers, CEOs, politicians … you get the idea. Incentives matter.
However, the past decade or so has seen markets become increasingly politicised. Central banks, led by the Federal Reserve, have acted to prevent economic declines and limit the impact of recessions but this has led to the unintended consequence of markets being continually lifted by a flow of government funds. This started on Alan Greenspan's watch at the Fed: the so-called Greenspan Put, which, whether by design or not, put a floor under market falls at the cost of raising moral hazard. This has had some odd, and extremely sad, consequences as we saw in Moral Hazard, But Thanks For All The Fish. Humans being the fallible creatures that we are, we've responded to this kind of pattern by learning to expect it, and this has been particularly true over the past few years as quantitative easing has been applied in order to stimulate moribund economies..
(Note that although there seems to be a straightforward correlation between QE and market rises it's not entirely clear that this implies causality: it could, for instance, be a psychological boost in confidence that causes share prices to rise rather than an increased supply of money. The jury is (sort of) out - see, for example: The Financial Market Impact of Quantitative Easing).
Procyclicality
Even in less straitened times markets are known to be procyclical (see To Predict the Next Bust, Ask an Austrian): they overshoot on both the high side and the low side. Psychology is, as usual, implicated, as described by Borio, Furfine and Lowe in this paper:
"Cognitive biases could easily generate perceptions of risk that move procyclically. As the expansion proceeds, the memory of the materialisation of risk diminishes and incoming data are interpreted as reinforcing the view that the economy is moving along a sustainable higher expansion path. What are short-run cyclical movements are perceived as part of a new, longer run trend. This process then moves into reverse, as actual defaults and other incoming information unambiguously contradict the prevailing paradigm"
For example, if house prices rise then people should buy less houses, all things being equal, and house prices should then fall to bring buyers and sellers into equilibrium. Instead people tend to think that if they don't buy quickly they won't be able get on the property ladder so they buy more houses, not less, and push prices up until all young people can afford is a cardboard box, the market busts and everything goes into reverse. That's procyclicality in action and, incidentally, why equilibrium based economic models all too often go wrong.
Political Paralysis
The trouble is, now that investors have become accustomed to being saved from successive economic downturns, it's beginning to look as though the mechanisms available to the central banks aren't working as well as they used to while politicians, who've long grown accustomed to unelected officials bailing them out, are markedly unprepared to make the difficult decisions necessary to resolve the issues: and the uncertainty and paralysis in both US and European administrations doesn't inspire confidence that they have the wherewithal to address this any time soon. So, many investors who've become used to investing based on macroeconomic factors are faced with a dilemma that often to seems to resolve itself in highly speculative and, frankly, pretty hopeless political analysis. Basing an investment decision on what you think Silvio Berlusconi or Andrea Merkel thinks might be possible isn't so much irrational as utterly insane.
A Positive Bias
Invariably the positive discussions around markets are backed by microeconomic data but unfortunately a lot of this appears to be chosen specifically to support a positive investing case. Most market participants are biased to the long side, so at some points in the economic cycle this has to be evidence of confirmation bias. It's just hard to know when. Arguments abound about whether markets are currently expensive or cheap, but this is always the case. It's never safe to base such estimates purely on earnings forecasts because we know that analysts always lag the turn in markets. They only bring down their forecasts slowly, in response to actual data. See, for example, this paper by Peter Easton:
"A comparison of the estimates of the expected rate of return based on the analysts' forecasts with estimates based on earnings realizations suggests that analysts tend to be more optimistic than the market even when they are not making "buy" recommendations"
We also know that quite a lot of firms have been achieving record levels of profitability:
"Of the 50 largest market capitalization companies that outperformed the S&P 500 in 2010, a great many recently reported net profit margins above 20%, and of the others many reported margins near or above historical peaks. The 20 largest companies in the S&P 500 with the highest profit margins, ranging from Amgen and Google (at around 30%) to Cisco and Altria (near 18%), comprise well over 15% of the market value of the index. If the average profit margin of companies that comprise more than 15% of the S&P 500 well exceeds 20%, how is it possible that the S&P will exhibit its historical postrecession expansion of profit margins and earnings?"
Herbert Stein's Law
Now record margins are, self-evidently, a good thing for investors. Unfortunately margins are governed by Herbert Stein's Law:
"If something cannot go on forever, it will stop".
French and Fama showed a decade ago that profit margins are mean reverting:"Mean reversion of profitability is highly non-linear. Mean reversion is faster when profitability is below its mean and when it is far from its mean in either direction".So if profitability is at a cyclical high in historic terms for it to carry on improving something unusual has got happen. Now, look around. Do you see anything that's likely to positively impact corporate earnings at the moment, especially in the absence of any more deep pockets of government money to throw at the problem? No wonder markets are trembling.
Into the Labyrinth
If on a microeconomic basis we ought to expect earnings to fall this means, all things being equal, that stock prices will also fall, on average. In a world where central bankers have exhausted the mechanisms at their disposal this leaves us to fall back on politicians; which is hardly the basis of a sound investment policy no matter how versed you are in the byzantine labyrinths of power.Heaven forefend, of course, that we should make anything quite so vulgar as a prediction. This is the real world, where the only predictable thing is that unpredictable stuff happens all the time. But if you're relying on the whims of politicians to rescue your investments you're not investing, you're gambling. Unfortunately if it turns out that enough of us have been trained to do this by years of bailouts then we may yet really see blood running in the Street.
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13 comments
That counts Isaac out ! Not a man of few words :)
T,
"Well said, laid on with a trowel" Vir sapit qui pauca loquitur
-:)
edited
ee,
How comes you did'nt become CEO of a big bank like Credit Suisse ? From what I've read in Free Capital you came across as someone who had a succesful career.
Also think your a succesful Investor who gets most decisions right, so I don't really blame your kids for taking the same steps as you re business degree. I think your pretty succesful overall actually.
Probably because he had better ways to spend his time! :)
Hi Timarr,
Yes I agree with that - though often the risk managers weren't as au fait as one might wish.
As it happens, you have prompted me to remember that there were only two occasions when I was personally grilled about my business by senior management. Brady Dougan (then not even on the Board of Credit Suisse, let alone CEO as he is now....but a couple of levels above me in a different division) took the time to give me a grilling and find out what was going on. I'm certain he understood exactly what he was told.
The other occasion was when Derek Wanless (the then recently-appointed CEO of NatWest).... much to my surprise..... took the time to investigate my business and interrogate me one on one. Mine was probably one of the easier areas to understand - and the evidence of the rest of the 1990s suggests that he may have struggled with other areas......BUT at least he tried to understand the business by making a first-hand investigation, rather than relying on others. That was quite rare, in my experience!
Well I can understand why he says that - but the way a lot of "risk management" people work is NOT by taking carefully-judged risks, but by trying to eliminate risk altogether. Eliminate risk and you eliminate profit (unless you are working in a regulated monopolistic utility)......so IMO the concept of bonuses was important in encouraging people to work together and enable the bank to take carefully-balanced risks.
The problem with the bonus culture though was that the bonuses were bigger in front office than in risk management....and so the power all lay with the front office and not with risk managers, product control or compliance. And for that you have to fault the boards.......though the execs on the board were mostly in hoc to front office for their own bonuses - and the non-execs knew too little about the business to effectively challenge them.
Anyway - all a very sorry tale! Lets hope those in post now find ways of avoiding a repetition.
ee
Hi ee
A bit late back to this, but a brief comment. It's fairly clear that many bank managements ignored warnings from their own risk managers, and that said managers were at risk themselves if they made too much noise. Paul Moore at HBOS was allegedly removed for just such reasons. Part of the reason bank executives didn't understand the problem was that they didn't want to listen to the people who could explain it to them.
Of course, the psychological trickle down from the top made it clear to everyone that bad news wasn't going to be appreciated, so many people kept quiet and they and the executives were able to continue to reap their bonuses in blissful "ignorance". Most of us have experienced this, sometimes it has worse results than a banking meltdown: ask NASA: Risk, Reality and Richard Feynman.
As Taleb puts it: we shouldn't allow bonuses at risky establishments like nuclear power stations and banks: encouraging people to take risks in order to maximise profits when the real challenge should be to minimize risks is simply asking for trouble: The Six Mistakes Executives Make in Risk Management.
timarr
Hi ee
If I may say so, that is a bit simplistic.
You may and it is, but technically it's correct: Andrew Haldane at the BoE has shown that the "improved performance" of the banks from the 90's onwards can be entirely explained by them taking on more leverage. Essentially the managements got incentivised for taking on more risk with our money. It's an open question as to whether any of them really understood what they were doing (and another one as to why the regulators didn't spot this at the time) but it's certainly possible that they didn't and were gulled into a rush to the bottom by the rewards for beating the comparative earnings targets of their competitors.
However ... while I'm sure that many executives hadn't got a clue I'm absolutely sure that some knew exactly what they were doing!.
timarr
I think we are just debating over cause and effect. I view the increased debt as a necessary effect of management misjudgement of the business risks....not the cause of the problem. There is certainly a high correlation.
Not really. I am telling you (with a large slice of information from having worked with many of them) that at board level the risks weren't understood. If they had been, they wouldn't sanctioned the additional capital! The regulators is also an easy one - they didn't want to employ people who knew enough about the markets (I know, because I tried to find opportunities there on at least three occasions and have the letters from Tiner, Davis etc confirming they had no interest in such skillsets)
Certainly true. There was a very strong element of trying to out-do the competition....and a large slice of envy. The latter, IMO, eventually drew Lloyds into dabbling in areas that they had very deliberately eschewed under the leadership of Peter Ellwood (which ended in 2002) since the opportunities first arose in 1986.
Further down the food chain, of course, there was a happy recognition (as you say) that they were being offered a skewed bet on the rewards for growth......
ee
Ah luminoso, Steve Clarke was a fantastic investor as well as a good writer. I can, at best, only claim one of those qualities ... but thank you, that's very kind.
On emptyend's point about the poor quality of risk analysis by markets I think there are a couple of points worth making. The first is that the financial organisations that caused so many problems had business models that were essentially opaque. I don't mean that their accounts were impenetrable, but more that it was actually quite difficult to figure out what they were doing that was actually making the profits that were fuelling growth. In fact it was by taking on more debt, which should have resulted in a general de-rating, but the very opaqueness of the business meant that this wasn't obvious.
BP is a bit of a different case: I wrote an article on this: Investment Analysts, Sunk By Deepwater Horizon, which suggests that the weakness of BP's management was actually apparent long before the failure at Macondo. Again, however, you'd expect analysts to have spotted this and given BP an appropriate rating relative to its peers.
The main point is that neither the bank failures nor the problems of BP were unpredictable Black Swans - they were predictable if you had the time, money and skill to interpret the information. However, the very complexity and size of these organisations mitigated against private investors being able to do this, and the analyst community didn't step up to the plate. And if market participants can't analyse the data available correctly then there's little chance of market valuations reflecting real risks.
Of course there are multiple ways of dealing with this, but blindly believing that big is better isn't one of them.
Hi timarr,
If I may say so, that is a bit simplistic. You are right about the opacity but the debt was merely a by-product of the real reason ....which is that management didn't understand their businesses well enough and weren't considering the consequences of them and their competitors all throwing vast amounts of money at similar business segments simultaneously. The old saying that "Two is company, three is a crowd" comes to mind.....and there were a lot more than three involved in that particular groupthink error!
You are spot on with this though:
And neither is believing that because "everyone else is doing it" it must be alright! There is no such thing as "safety in numbers" when it comes to systemic risks!
rgds
ee
Thanks for another great article, Timarr. IMO, the void left by Steve Clarke on financial discussion boards is being admirably filled by you.
Good piece, Timarr. :-)
....putting in a nutshell why I hold a highly-concentrated portfolio of (relatively) special situations, focused on assets that (I think may) have high-level strategic value. And in some cases the asset base of those companies may have the potential for substantial organic growth.
Furthermore, the market is continuing to price them as if they were highly-risky gambles (as has historically been the case in E&Ps over the last 50 years)....and yet, IMO, they are generally no riskier than the rest of the market - and in some cases are significantly less risky.
One thing that should be a major take-away from the last 15 years is that market perceptions of risk have been EXTREMELY poor........many of the apparently safe companies (thinking banks, BP etc) have proven significantly riskier than investors would have expected 5-10 years ago.....and some of the apparently riskier companies have proven safer than expected thanks to having a profile of political and economic risks that were not particularly exposed to the problems that continue to beset the developed economies in the aftermath of the financial collapses of 2008.
Interesting times....by any measure!
ee