The More Things Change, The More They Stay The Same

Reading Liaquat Ahamed's Lords of Finance this weekend, I came across this bank run:

"[The Bank of England's] reserves fell from over $130 million on Wednesday, July 29, to less than $50 million on Saturday, August 1,when the Bank, attract deposits and conserve its rapidly diminishing stock... announced it had raised its interest rates to an unprecedented 10 percent. 

Yes, it sounds like the Black Wednesday that we know in 1992. Bank of England spent billions of pounds to raise rates to 10% and higher in a costly and futile attempt to prop up its currency and stay in the ERM. Soros made his billions and indeed his name by making over a billion dollars for his investors.

But this is not recent - the year is 1914. Full quote is below:

"[The Bank of England's] bullion reserves fell from over $130 million on Wednesday, July 29, to less than $50 million on Saturday, August 1,when the Bank, attract deposits and conserve its rapidly diminishing stock of gold, announced it had raised its interest rates to an unprecedented 10 percent. 

This occurred at the beginning of World War I, when the world was still following the gold standard and therefore banks were forced to honor a preset exchange rate with gold. Unfortunately, no central bank had 100% of deposits backed in gold (by design) and so when bank panics to a country-level as in a world war, no bank is safe.

What surprised me was that even though 78 years had passed, the same bank faced the same run and responded the same way, by raising rates to 10% (and beyond). Granted it was gold vs. foreign currency reserves, but does that matter? Isn't gold just another currency? One whose supply changes/fluctuates just like any other? Or actually, it continues to grow:

(Source: Gold Standard)

While the issue of the gold standard is more than just this bank run, it does seem like currency/bank crises are not that different. Whether it is pounds, dollars, gold, silver, or baseball cards, all currency/banking systems can and do come under pressure in similar ways.

Are Hedge Funds Too Big to Outperform?

Given that hedge fund assets are 8-10% as large as mutual fund assets, is the asset class too big to outperform? 

Soros's argument is that given the prevalence and power of hedge funds as an asset class, they cannot outperform. It is almost a tautology that not everyone outperform the market, but has this alternative asset class reached such a stage? The hedge fund tendency to lag equity markets are a recent phenomenon and to be fair, is a not exactly a fair comparison. After all, if alternative investments are meant to be less correlated with the market, doesn't that by definition include the possibility of under-performance?

Nonetheless, there is no shortage of studies showing how smaller managers outperform larger ones. Moreover, asset growth often goes to the larger, established ones and ones with the most best marketing/sales force. Perhaps the best example is this article about changes in the industry, quote below:

[Hedge Funds] need to excel in three areas which include: having a high quality product offering, a marketing message that clearly and concisely articulates their differential advantage across all the evaluation factors investors use to select hedge funds, and finally, a best-in-breed sales strategy. This sales strategy can be achieved by either building out an internal sales team, leveraging a leading third party marketing firm, or a combination of both. Firms that do not excel in each of these three areas will have a difficult time raising assets.

Compare this quote with this article from nymag from a few years ago:

It doesn’t take much. To run money, which is how managers refer to what they do, requires little more than a few computers. Zach’s boss likes to say, “I could run $100 million by myself.” The theory is that they’ve got an almost athletic gift for investing. They’re the type who can, as one manager did, call the direction of the market correctly 22 days in a row. They don’t want (or need) the kind of marketing, sales, and investor-relations apparatus that comes with, say, a mutual fund.

Now, the latter is of course hyperbole, but to me the intent is clear. The core of managing money to outperform is to focus on investing/trading, not top-notch third party providers, sales/marketing etc.

In short, the alternatives industry is not so alternative anymore, and in my opinion the institutionalization of the industry is exactly how most (and in aggregate) won't outperform.

*Funny doc I came across while researching marketing docs: this looks like a well-put together marketing presentation, and they have pwc as auditor + citco as fund admin, both large, well-known providers. Unfortunately, they had a sad ending.

The Most Bullish Article I've Seen This Cycle

State-Wrecked: The Corruption of Capitalism in America was a nice lunch read today. Written by David Stockman, former congressman and Reagan's budget director from 1981 to 1985, the article (in my opinion) accurately sums up the negative global economic viewpoints. The Malthusian warnings range from socioeconomic inequality in America to unsustainable debt/deficits that will cause this latest bubble to "explode," but the flaws in his argument make me far more comfortable owning US stocks. I now go line by line:

The Dow Jones and Standard & Poor’s 500 indexes reached record highs on Thursday, having completely erased the losses since the stock market’s last peak, in 2007. But instead of cheering, we should be very afraid.

Over the last 13 years, the stock market has twice crashed and touched off a recession: American households lost $5 trillion in the 2000 dot-com bust and more than $7 trillion in the 2007 housing crash. Sooner or later — within a few years, I predict — this latest Wall Street bubble, inflated by an egregious flood of phony money from the Federal Reserve rather than real economic gains, will explode, too.

Agreed - the market does rise and fall and the cycles may indeed be extreme. The market (let's say S&P 500 for specificity) may indeed fall greatly sometime in the next few years (1-10?), but isn't that true in general? Let's take the 13-yr period before the bubble years of 90s+, from 1977 to 1990. Surely, things were different then? Not really - S&P started '77 @ 107 and only began the year above that number in '80, three years later. Then the market made new all time highs for 3 years on the back of- you guessed it - debt-fueled investment and fell 22% in one day in 1987.

Point is - saying market is going to crash later is like saying it will rain later. Not exactly new information and given the vague timing says only one thing: fear without catalyst.

As for the Fed printing - where exactly is this phony money vs. real money? Is it at the central bank? Not exactly, Fed is essentially creating money to pay for the U.S. debt (in qe), so actual cash is going to whoever is selling the us debt has cash. Does the new owner of the cash ask him/herself - "this is fed money, I'm going to spend it on xyz vs. non-fed money, I will spend it on abc."? I don't think so. Cash = Cash. Admittedly, there is still a distortion to the free market, because that person may not have sold if fed was not bidding so high - the bear reasoning is that Fed is buying for non-economic reasons, and the best reasons are in the free market (I paraphrase). But is the free market always right? Or more specifically, are market determined prices best for long term economic growth in say gdp per capital or total GDP? But more importantly, the Fed is distorting the market, but since when has there been a market with no distortions?

I can go on with the later paragraphs (and can do so if there is interest), but what I think Stockman is saying is that the great "Keynesian" experiment failed - i.e. government meddling in free markets does far more harm than good. Never mind national defense, infrastructure as public goods for which the free market has shown not to be good at. Given that the experiment began (from this article) in world war II when gdp per capita was 12k vs 39k now, I think the below analogy is apt:

Joe (5 yrs old): I'm sick. I have xyz symptoms.
Doctor: looks like you have abc illness i- rest, get fluids, take this medicine for it.
Joe: Awesome! I got better in 1 week!

Joe (now 10 yrs old): I'm sick. I have wxyz symptoms.
Doctor: looks like you have abcd illness i- rest, get fluids, take this medicine for it.
Joe: Awesome! I got better in 2 weeks!

Joe (now 15 yrs old): I broke my leg playing soccer.
Doctor: will need to x-ray, put in bandage, you might not get full motion back.
Joe; WHAT? I need to play soccer! THIS IS ALL YOUR FAULT DOCTOR - MEDICINE DOESN'T WORK.

**As for my bullish view - these may be the sellers of equities in the market now. Would I take the other side? Probably.

Cyprus - When Politics & Economics Collide

With the n-th iteration of Euro-crisis now including taxes on depositors, felt it good to re-link an old video of Larry Summers:




While events are changing by the hour and so the agreement may be revised to be less severe, I can't help but believe that the the EU continues to make the same mistakes by valuing political decisions over the economics. This is a structural and indeed a behavioral/psychological issue, as having only a common currency benefits both sides (Germany with competitive exports, Greece with lower debt rates pre-crisis) but only if the former is willing to fully backstop the latter and if it truly leads to fiscal union (the original goal, I believe?).

In my opinion, this is exactly the same as 1992 and the exchange-rate-mechanism crisis, except that there is no way out (devaluation). Great Britain was weak economically but Germany did not want even the thought of inflation/money printing, pushing Britain into a recession. Had it not devalued, it would have been in for a deflationary/recessionary spiral - just like Spain/Italy/other PIIGS. After all, if there ~7% less money in the banking system as yesterday, it is not deflation? Devaluation is the normal market process, but because of structural limitations (spain euro = italy euro), there is no way to soften the blow. In other words, Europe is a man swimming with an anvil attached.

As a result, I don't think it's easy to say "buy Europe, it's cheap" and believe that bottom-pickers may be in for a tough struggle.

Why Investing Has Nothing to Do with Being "Right"

Over the weekend, I read this article about Andy Zaky, a well-known aapl (bull) analyst who raised $10mm and lost all of it. This is not unique, as traders/funds all over have fallen on the aapl road-kill highway. Nonetheless, Zaky is unique because he often lost money when aapl was going up and going down.

Quote for the article:
"...the fund missed both of Apple's big 2012 rallies -- in April when it hit $644 and in September when it hit $705. Zaky lost nearly nearly 50% of the fund's capital in one month (March) by buying bearish put spreads just before the stock rose 10%..."

 
 (Source: http://tech.fortune.cnn.com/2013/03/04/apple-zaky-bullish-cross/)

This is from the same analyst who often forecasted earnings better than wall street analysts for many years. It was this ability that drew investors and commentators'-awe. He was spot on for so many years - what happened?

The short answer: he went all-in on one derivative position (aapl calls). The long answer - he confused predictions with the ability to manage money. And he wasn't the only one, with up to 700 newsletter subscribers which paid up to $200/month (same article). It's never just about hit-rate - it's how much you make when you are right and how much you lose when wrong (simple probability no?). The problem is correct calls are what make the headlines (and dare I say get you investors?).

An institutional level equivalent could be Paulson & Co. - he made 1 giant call correct and investors flooded in. The result? $15 billion of gains in 2007 were nearly overwhelmed by roughly $13 billion of losses 2011 (I did assume net flows of 0 that yr). Paulson can still claim +10% etc. time-weighted returns, but dollar-weighted, e.g. how much money investors have actually made? I think it is far less (dare I say negative?).
 
This is not an indictment of either person/firm- they have definitely made a real impact in the world (far more than I) and may continue their profits. I do believe, however, that investor focus on % correct and famous calls are not good predictors of fund performance. what do you guys think?

Disclosure: no position in aapl

Remark

Late night thought: for certain companies, does a falling stock price reflect falling business prospects as much as cause them?

S&P 500's Worst Start to Year Since 2010?

That's right, according to bespoke (this is as of last week, Feb 18th). For all the talk of the "great rotation" from bonds/cash into equities and the melt-up reaction to qe3+, the market hasn't even kept up with the last two years. What does this mean, if anything?

The relative positions continue to hold this week in the resulting sell-off, with investor sentiment reflecting an abrupt reversal from highs (even before the indices fell):

 *Credit for both picture to Bespoke Investment Group

The previous two years' early out performance were matched only by the subsequent corrects - will history repeat itself?