Monthly Archives: October 2011

the tebow effect: Investing lessons from nfl gambling

The brilliantly-written Epicurean Dealmaker is one of my favorite business blogs, offering consistent insight into the details and psychology of major M&A transactions. Over the weekend, Mr. Dealmaker presented a persuasive argument that the NFL/investment business metaphor was of limited value, and I take his point entirely.  There are, however, similarities between equity investing and gambling on football that deserve explication. For this post, I will be stealing shamelessly borrowing heavily from Michael Mauboussin’s “Decision Making for Investors” which remains, to my mind, the single best report on general investing written since Graham’s Security Analysis.

For our purposes here we will equate bets on individual games as option trades, expiring weekly, and equate equity investments as the pre-season selection of a particular team to make the play-offs (ie beat the market). By far though, the most important element of the exercise is the analogous nature of Vegas odds and valuation levels.

Most portfolio managers will claim to own a “portfolio of high quality companies” and, in the same way, a gambler will be more comfortable with a portfolio of bets on teams like the Patriots and Steelers with good coaching and long-term records of success.  The success or failure of these transactions, however, depends much less on quality than the price paid for this attribute. The “options” gambler who took New Orleans last weekend minus 10.5 points is now in a similar position to the investor that paid 50 times forward earnings for Netflix.  In the same way, the “equity” investors that got 40-1 for the surprisingly capable San Francisco 49ers in August to make the Super Bowl is sitting on a considerable gain whereas his counterpart with Baltimore, much more of a pre-season favorite now struggling, at 6-1 to make the big game is under water.  Investing and gambling success is predicated less on expectations but changes in expectations.

Tim Tebow and the Bandwagon Effect. The destruction of the Broncos at the hands of my beloved Lions over the weekend also implies a number of cautionary elements for investors. It is completely understandable if the sizable Evangelical Christian contingent of football fans feels enough of a vested interest in his success to make the Broncos #15 jersey the top-selling in the country despite his until-recent back-up status.  It was also completely predictable that his leading the Broncos back to victory in the fourth quarter two weeks ago had his legions of fans in full froth – leveraged nicely by a significant upsurge in media attention through the week.  I haven’t checked*, but I assume that the hype machine, by attracting gambling dollars to the Broncos, did affect the point spread for Sunday’s Lions/Broncos tilt, making a bet on the Broncos more expensive.  This options bet expired worthless.

The Tebow rule of investing then entails an increased level of caution when media hype is evident. More subtly, it also implies that investors should be careful when they have a rooting interest and are liable to see what they want to see, ignoring potential problems.  That the Broncos quarterback reflects Christian values that you may share has nothing to do with his success on the field. The fact that you feel an emotional hole in your life at the passing of Steve Jobs does not make Apple stock cheap.

The corollary that occurs immediately here is the cyclically-popular notion of socially-responsible investing. In a perfectly ethical world, a sharp increase in socially-responsible asset pools would have a salutary affect on overall business operations. The problem, however, is that managing large pools of money without restrictions is difficult enough and inevitably, limiting the universe of potential investments by environmental or political criteria results in poor relative performance.  My advice to the well-intentioned people advocating political goals through investing (usually small and medium sized company pension funds) has always been the same – don’t restrict yourself initially and use the gains to support any cause you like. Do not, as Josh Brown has pointed out, involve your politics with the market. Or your sports gambling.

There are grounds for stretching the NFL gambling/investing even further. Delusional expectations for the home team may reflect a similar sentiment regarding your current portfolio and conservative running attacks work better in bad weather. I won’t try your patience, however.  The point in the end is that whether perusing the sports page or the business section, success with money is more likely if careful attention is placed on the price of admission when climbing on any bandwagon.

Oh, and read the Mauboussin piece. Repeatedly. Trust me on this.

*update: I didn’t have to check. i just remembered this game didn’t have a line due to exogenous factors – Lions QB Matt Stafford’ injury status.  We’ll have to assume the spread would have been affected as I mentioned which, ummm, yeah. Bit sloppier than I would have liked. .

ceos and investors: strategy/execution distinction separates good from bad

Poll the more competent employees in Operations and any company is likely to find 20 good ideas for improving efficiency.  Do the same thing with senior management and you’ll be lucky to get one. The reason is not that Operations employees are brighter and more innovative, although this is infinitely possible, but that senior managers are much more cognizant of what can be accomplished. They may very well, for instance, have a great idea for tracking revenue but also know that the IT department is either too busy or too incompetent to ever implement it.  The CEO responds “Wow, you got 12 months to get that done” and you’re fucked.

The confusion between the brilliance of a strategy and the ability to execute on it is at the heart of every poorly managed company. Far too often, a lack of corporate performance is blamed on a bad strategy when the strategy was perfectly fine. In other words, the architect is always blamed when the house falls collapses but the fault is more likely to lie with the builders. Politically-minded executives (ie all of them) in underperforming companies will furthermore willfully blur the line between strategic design and execution to suit their own agenda.

There is a pervasive myth, propagated rabidly by biz schools and business consultants,  that a new “great management paradigm” has just arisen (coughsixsigmacough) that will transform your company into a global behemoth. The truth is that there is no premium on corporate strategy ideas – they are everywhere. The talent that is almost nonexistent is execution.

Jack Welch’s tenure is instructive in this regard. I worked for a manager who hand wrote his Christmas cards because he read that Welch did the same, as if copying Welch’s affectations had anything to do with his management skill. In truth Welch succeeded because he was an absolute ruthless bastard. The strategies he implemented were familiar to any four year old playing with their toys – break the three boring ones and beg for new ones. What Welch actually did in practice was fire entire buildings full of people in underperforming businesses, to the point where he was given the nickname Neutron Jack.  Anyone could have come up with the idea of getting rid of poor businesses and focus on their successful counterparts, but it took a singular talent like Welch to execute.

The same phenomenon is eminently present for investment strategy.  There are any number of historically profitable stock selection methods across the risk scale, which the majority of individual investors just do not execute well. What Buffett does, for instance, is about as complicated as Welch’s strategy – buy companies with consistent long term ROE assisted by competitive advantage when they are trading, ignored, at lower than historical valuation levels. His execution of the strategy, the unparalleled discipline, is what sets him apart.

All of this is not to say that managing money or global industrial companies is easy. The point is that, while there are multi-bazillion dollar industries trying to convince you otherwise, “The Plan” doesn’t really matter, it’s the person implementing the plan that does.

death wish, dirty harry and how the bank lobby resembles the 1970s uaw

Feel free to talk about the glory days of Led Zeppelin all you want, but the point remains that growing up in the 1970s suuuucked. We had no idea at the time that the explosion in crime rates was a function of the high percentage of males in the 18-24 age bracket, we just thought social order was collapsing. Imagine me, at seven or eight years old, flipping through Time magazine and finding a picture of an American soldier carrying the severed head of a Viet Cong.  You had to be there, at my age, to understand how unrelentingly bleak the news backdrop was but looking back at the Hollywood heroes of the era can give some indication. Charles Bronson was the Mr Average-turned vigilante who had had enough in Death Wish. Clint Eastwood hit his peak as Dirty Harry, “with his finger in the dike while the whole thing was caving in on him”.

Economically, the wage/price spiral that crippled the economy of the 1970s is now a matter of record. People like my parents, granted a 16% mortgage in the mid 1970s, didn’t start making a dent in the principal until a decade later. There was, over all, a desperate feeling of falling behind as prices skyrocketed that combined with the crime rate , geopolitics and poor general  hygiene to make the 70s just miserable.

The UAW, Teamsters and organized labor in aggregate were front and center during this period of economic malaise. Their political power was more or less unassailable – they mobilized members and delivered the votes to the Democrats who dominated Congress.  Strikes and job actions seemed a weekly occurrence in memory and their demands were always met.   Again, you had to have been there to understand how Ronald Reagan’s first act as president, the threat to fire every air traffic controller, was such a giant relief.  The sense was that a pall was being lifted and that some hope existed of the madness coming to an end.

So here we are now with two major market upheavals in recent memory and a political morass where the financial services industry has replaced organized labor as the seemingly unstoppable, Congress-owning corrupting force.  A decent-sized segment of the population has taken to the streets, the modern anodyne to the NOW and anti-Vietnam marches, leveraging their influence with modern media.

The problem for me and for any my age is that we saw in the 70s what happens when the lunatics demand to run the asylum and we have no interest in repeating the experiment. We do not, for instance, want to see a new form of soldiers returning from duty covered in the human shit of student protestors. The current generation of protestors learned about activism in books, where the inconvenient details of the 70s can be glossed over or repressed – for them it’s a romantic pursuit akin to the Civil Rights efforts of the early 60s. They know nothing, in other words, about what it was like to live through the excesses of emotion that accompany periods of significant upheaval combined with economic stagnation.

If there is hope in this comparison of eras, it lies in the UAW/Banking lobby equivalence. The rise of the Republicans in the 1980s was in direct response to the excesses of organized labor in the previous decade, and the hegemony of Big Labor in Washington was steadily removed. At some point, which may or may not be now, the same process will occur for the bank lobby. Things change. The inevitable arrogance of having everything your way, and demanding more and more until forced to willfully ignore the dangers of killing the host implies that current trends are not unsustainable.  Let’s just hope that the process is less depressing than the 1970s.

Has wall street “Abstracted” itself from america?

I have been exceedingly fortunate in my career to have met and spent considerable time with some of the big hitters in global finance, some now disgraced and others who remain in the Market Wizards pantheon. It is still the case, however, that the most impressively brilliant human being I’ve ever consistently been around is a Philosophy of Literature professor who’s name, while it deserves to be mentioned, in the interest of my continued anonymity I’ll change to SOAT – Smartest of All Time.

One of professor SOAT’s primary influences on me was an explication of the now-consensus view that the Protestant Reformation was an outgrowth of movable type and the printing press. Mass printing of bibles ended the Roman Catholic church’s monopoly on biblical interpretation and individual clerics, led by Martin Luther, used their intellectual freedom to begin a series of revolutions against an unfathomably corrupt Catholic Church. The True Church quickly became five – add Lutherans, Calvinists, Anabaptists, and Anglicans – which begat a whole host of eventual spin-offs including Puritans, Pietists, Baptists, Congregationalists and Republicans Luddites. For our purposes it is only important to remember that A) a media explosion started the whole thing and B) By the mid 17th century the entirety of Western Europe had split into heavily armed camps ready to stab and/or roast anyone who disagreed with them.

If I’m ever going to get to my conclusion, the concept of Abstraction in Computer Science will also have to be described in brief. When Bill Gates wrote the precursor of Windows, it was in machine language, the series of 1s and 0s that hardware understands without a translator. When we recognize that the word “START”, for instance, had to be entered in pencil, on little cards, as “01110011011101000110000101110010011101000000110100001010”, it is not difficult to understand what an excruciating process this must have been. Abstract programming languages, those that act on machine code without the author having to know machine code, alleviated the problem. Further languages acted on the level two programming language and so on and so on until modern languages like Java and C+ are now five or six steps away from machine code.

The closest metaphor I can think of for this abstraction principle is biological, with the doctor as machine code writer and nurses, pharmacists, medical equipment designers and drug company researchers as somewhat analogous to the abstractions. The latter act on complex segments of the whole without holistic understanding. So, we understand the thankfully misplaced freakout over Y2K as an outgrowth of the problem that very few current programmers were capable of working at the machine code, lower languages. If the screw-ups occurred at those lower levels there wouldn’t be enough “doctors” to prevent a global epidemic where pharmacists would be completely unhelpful.

Those few of you still reading are wondering why I just subjected you to a medieval history lesson and a description of a systems concept that was last really important eleven years ago. It is to posit this: Wall Street and the financial industry as a whole has profitably “abstracted” itself from the lives of the average American and that the Internet, as the modern equivalent of the Gutenberg Bible, is the primary catalyst for the OWS backlash. Finance, after all, facilitates economic activity but in a tangible sense produces nothing. Industry employees certainly go grocery shopping and buy cars, but for them the daily lives of  people employed in the slaughterhouse or the auto assembly plant are obscure to the point of theoretical. The lack of empathy displayed by financial leadership, while regrettable, is not that hard to understand in this interpretation nor is the vehemence of their defense of the status quo.

The printing press/Internet equivalence is largely self-evident. Sudden, all encompassing changes in mass media consumption have through history caused major social upheaval. (The television/60s relationship works here also). Contrary to intuition, these technological changes that allow exponentially higher levels of individual participation in cultural discourse can result in the paradoxical effect of splintering away from the whole into like-minded, dogmatic sects – formerly the formation of new churches and armies, now evident in the cocooning effect that fertilizes the OWS movement and others.

I have no conclusion here, its just my way of trying to understand current events. I have no doubt made errors in representing the programming analogy (its not my area, clearly) and stretched some historical precedents too far. I don’t, for what its worth, expect 200 years of armed, theological/political conflict. But the analogies interest me greatly and possibly above all other blog posts I will write, I welcome corrective feedback and discussion on this one.

Portfolio Manager search pro tip: find the worst public speaker possible

I want to emphasize that all of this is a rule of thumb, and there are plenty of exceptions. That said, given the amount of time the average investor can allocate to investment decisions, rules of thumb can turn out to be extremely important.

To understand the thesis it is important to acknowledge that becoming a lead portfolio manager at a prominent fund of any kind is a process similar to any other business –  you start at a junior position and work your way higher. In this case, a fresh-out-of-good-or-local school plebe begins by learning how to extract data from Factset or Bloomberg and enter it without error into spreadsheets for the perusal of the important people. At this level you also get to return phone calls on the manager’s behalf (again, without screwing up) to minor or really annoying acolytes. Next, success or attrition leads to a junior analyst position where participation in the stock selection process begins. Success here leads to a senior analyst position where lead PM becomes a possibility.

Two basic personality types rise to the top in these instances:

Type One: Physically attractive, Ivy League (Harvard or Wharton, almost always), momentum-based investment strategy. They are tireless – they are too humble to mention it themselves, but the minder who introduces them to your little group will just happen to mention that the star is just off the plane from [insert city name here] and has only had three hours sleep. Most importantly, the Type One will have Bill Clinton-level public speaking skills. They will be compelling, energetic, will pause and answer your question in a non-patronizing way. They will linger after the presentation until everyone has left, happily chatting about markets or whatever else the fellow-lingerers want to talk about. They will likely choose someone during a long day of presentations as a “person of influence” – analyst, strategist, whoever – and invite them to a dinner during which the sentence “I went to school with him, I’d be happy to call him for you”, is inevitable. They are, in short, marketing machines.

Type Two will be older, having spent far more time as a senior analyst due to a dearth of personal charisma. They will likely not be Ivy League. Type Two will execute a more fundamentally-based investment process. Their longer performance track record has a better chance of being stronger, beating the index by a few percentage points per year by holding value during bad years. Type Two’s presentation will be so dull that you’ll want to gouge out your eyes after half an hour.

Outside of the entertainment factor, the primary differences between the two archetypes is that the first has risen to their position by attracting new money while the latter holds their position by effectively managing money. Type One, with a travel schedule encompassing 150 days annually is dependent of their model for performance because they have much less time for specific analysis – hence the preponderance of more black box, momentum strategies. They are also much more dependent on their analysts and traders back at the office who must make the majority of the day-to-day decisions. Type Two on the other hand, only really cares about the analysis. They are pissed when the marketing department drags them put of their cave before they’ve finished investigating a fishy footnote in the last quarterly statement. (Don’t think I’m exaggerating with that, btw. I personally know PMs that will spend weeks on a single footnote).

Here’s the important part: the industry loves them some Type One PMs. Momentum managers trade a lot more than value managers and this keeps the trading desk commission train rolling. The accommodating Type One manager is, unbelievably, available for evening functions where Financial Advisors can bring their top clients who, inevitably will be running around with blank checks by slide eight. Everybody makes money.

If you’ve read this far you have probably guessed where my preference lies. For my own money, I would much rather have the plodding, boring manager who obsesses about every aspect of a potential or existing holding, rarely straying from a concentrated portfolio of companies they are completely comfortable with. Like Buffett, they do not feel compelled to make changes (and thus rarely get referrals from capital markets) and will literally wait years for a stock to drop to valuation levels they find attractive. Type Twos will also avoid hot sectors and thereby escape the attention of the individual investor until the market craps out, and they don’t feel like putting more money into the market anyway. I pay Type Twos, in other words, to exhibit the discipline that I don’t have.

Again, I have to emphasize that there are a lot of cases where Tony Robbins-type managers are also very good investors and, alternatively, Ben Stein-in-Ferris-Bueller clones who should never be trusted with your money. But it remains important to understand the industry’s bias in this regard and that “best manager” may mean something much different to the average investor than on the trading floor.

zero hedge, steve jobs and who’s really responsible for the despicable cesspool of new stock issuance

I like Zero Hedge, I don’t care what anyone says. Most established writers on the financial sector start with an assumption of general trust, possibly because they are understandably dependent on industry sources who seem entirely plausible, and are then subject to the erosion of this trust as the sausage-making details become evident. The multi-headed Tyler Durden at Zero Hedge is exactly the opposite, assuming at the outset that every executive sits in their offices twisting their mustaches, hatching plots to steal from the unwitting public. They start with conspiracy theories, and then tack back towards a depiction that makes sense and if they sometimes get stuck out in the fringes in the absence of new information, that is a price I’m willing to pay.

One of Tyler’s best contributions to general financial knowledge has been a detailed explication of the despicable cesspool that is new stock issuance. (See HERE for a particularly egregious example from 2009.) Human psychology being what it is the investing public would love a convenient scapegoat for the process. The following quote from the late Steve Jobs provides a hint as to my theory in this regard:

“When you’re young, you look at television and think, There’s a conspiracy! The networks have conspired to dumb us down. But when you get a little older, you realize that’s not true. The networks are in business to give people exactly what they want. That’s a far more depressing thought. Conspiracy is optimistic! You can shoot the bastards! We can have a revolution! But the networks are really in business to give people what they want. 

You can see where I’m going here. There is no conspiracy as to the selection of IPOs and secondary offerings beyond popularity. They are giving you what you want, what they can sell, and in a number of instances its crap, either in terms of objective business quality or the valuation levels stipulated at issue. Its also true that these deals are marketed in a way that emphasizes the positive aspects and minimizes the negative but that is also true of late night infomercials. What amazes me about the complaints about the poor performance of IPOs in particular is that it is often the same people who place the blame for failed subprime mortgages entirely on the borrowers who “should have known better than to sign them”, in a conveniently subjective application of the Caveat Emptor rule.

It is an axiom among professionals marketing investment ideas to long-only funds or individual investors (for all their faults, hedge fund managers are much better at this) that you know you have a great investment idea when it is completely unmarketable. Publish as many copies as you want, but stock ideas in out of favor sectors will sit and gather dust until the paper rots. What sells, both in term of ideas and new stock, are those in sectors that have been gapping higher for the longest time, despite the risk that said trend is nearly exhausted and valuation levels are approaching the ridiculous.

Referring back to Jobs’ quote, the fault is not in the networks or the investment banker, its with the audience. If PBS started getting monster ratings for in-depth, intelligent documentaries, the other networks will quickly follow suit. In exactly the same way, if investors stopped buying secondary offerings in hot sectors, which they freaking know is a bad idea but can’t help themselves, and entertained the better risk/rewards potential of out of favor ideas, they would get more of them.*

Indecent Proposal

Human behavior where money is concerned has been largely unchanged since the dawn of history and I would be completely delusional to believe this blog post will have any effect in that regard. I do, however, have a simple idea to mitigate the problem that makes enough sense to be fought tooth and nail by the industry: the back page of every greensheet should list the previous equity issues of the underwriter for that calendar year, the date of issue, and the subsequent performance. I am particularly interested in how the industry would fight this as every objection would so obviously be focused on hiding bad performance.

To be fair, it is important not to forget that underwriting is arguably the most important function for investment banks in terms of their benefit to the economy as a whole. The process is designed to allocate assets from aggregate savings into the hands of effective CEOs needing funds to expand. The process often works extremely well, to everyone’s profit whether they are investors or not, but is dependent on an informed, judicious investing public.

*at the risk of fawning over Richard Bernstein to excess, he does have an investing tenet that perfectly encapsulates this: “Returns are best where capital is scarce”

corruption is boring: the primary hurdle for OWS

Felix Salmon did a tremendous job yesterday detailing the latest accounting skullduggery at BofA, summarizing a shift in derivative assets from subsid Merrill Lynch to the balance sheet of the BoA retail bank. The end effects, although admittedly  unquantifiable, are that a combination of the FIDC/taxpayer and unwitting BofA depositors are now fully insuring the counterparties to a multi-bazillion dollar portfolio of dodgy derivative positions. This is, of course, outrageous on two fronts, both increasing the taxpayer liability for bad investment bank decisions at a time when previous support is generating angry protests, and also because the move highlights the complicity of government institutions who have an actual legal obligation to the state, not the industry.    To the extent that it improves Merrill’s balance sheet, it is also likely to facilitate further aggressive lending with the implicit guarantee that, if the loans go bad, the accounting swap can just happen again. I’m won’t re-hash the details – read Felix’s “BofA puts taxpayers on the hook for Merrill’s derivatives” HERE.

For the majority of Americans, this story is eye-wateringly mundane. Accounting changes do not make for highly-rated CNN exposes. And here, for me, is the central problem for OWS – corruption is boring. Like most things truly tragic in the human sphere (obesity and substance abuse come immediately to mind), corruption occurs through the steady accumulation of small, seemingly meaningless decisions – cheeseburgers versus broccoli to extend an already tortured metaphor – rather than the sudden appearance of a Stalin-like villain that can be replaced.

The idea of a revolution that will end with Lloyd Blankfein’s handcuffed parade through a rotten vegetable-wielding mob is a satisfying one for adolescent minds. Much less satisfying is the prospect of strapping on a tie and beginning the excruciatingly detailed and largely anonymous process of lobbying for accounting reform or, at the very least, the enforcement of existing laws. There is little doubt that the OWS movement would be far more successful from this point forward if, instead of marching on a neighborhood where bankers don’t work anymore, it went door to door raising money for a small army of motivated accountants and lawyers to besiege congressional members. It is, admittedly, a task where recounting your day is unlikely to get you laid on campus and a “No Free Swap into Hold to Maturity” placard is decidedly not going to show up on Tumblr.

I don’t mean to be patronizing, I have no right. I am not willing to head into the bureaucratic pit and slug it out for my interpretation of accounting or regulatory justice any more than the now freezing OWS protestors are. OWS has likely proven the most successful protest movement of the millennia, entirely productive in garnering and focusing attention. But, if anything lasting is to be accomplished its time for the less boredom-prone adults to take over before the wave finally breaks and rolls back. The revolution won’t be telegenic and in the unlikely event that it ever happens, it will be won by dogged lawyers in cheap rumpled suits and over-full briefcases. The real world is just not that exciting.

clarification, research reports are not written for you

Yesterday morning at this time I was just some mope with a work history and more free time on his hands than usual. This morning, thanks to Josh Brown (who I can’t thank enough) and the freaking FT, I’m….well, I’m still just some mope with free time. But, had  I known people were actually going to read what I wrote at this early juncture, I would have been clearer on a couple of points.

The Institutional Sales scenario I outlined has similarities to conversations between Financial Advisors and individual investors, but not many. It was not my intention to suggest that outgoing calls from the sales desk were analogous to a used car saleman moving a wreck into poor Widow Smith’s garage. The licensed portfolio manager on the other end of those calls has heard thousands of pitches and is perfectly capable of verifying every aspect of the trade idea, and they are obligated to do so.  It is also highly, highy unlikely that a salesperson would attempt to deceive a PM – the risk of never having the PM pick up their calls in the future is too big a risk. Will inconvenient details be omitted? Definitely. But both sides of the conversation know the rules, and the PM knows that they alone are responsible for the effects the trade may have on their clients’ performance.

Some of the comments and emails I received on Over – Optimism post implied that I was accusing sell-side analysts of willfully misrepresenting their opinions. In my experience this does not happen, the multiple layers of (potential litigation-focused) fact-checking and Compliance are persuasive in this regard. I do believe that reports can be tilted towards the bullish for business reasons, but outright fabrication and cynically deceptive research is very, very rare. Capital markets does, for the record, have a structural bias that benefits the optimistic and it is that bias that I was trying to describe.

This brings us to another point, one that I’ve made to Financials Advisors hundreds of times; most of the frustrations individual investors have with research arises from the fact that, while they have access to research reports, they are not the target audience. Research is written for institutional portfolio managers. This is easily proven by the fact that success or failure within the retail brokerage arm of the firm has little or no impact on an analysts’ compensation. Portfolio Managers are well aware that, for instance, the twelve month target price is not a prediction but a guideline. A target price is merely the output from the analysts’ model in an “all things being and remaining equal” state that neither the analyst nor the PM for whom the report is written believe will actualy take place. So, DON’T PICK STOCKS BY TARGET PRICE.

Importantly, I am humbled and vaguley terrified by the response to date from “Over-Optimism” and I want to thank everyone who has taken the time to read.

sell side over-optimism explained as the trend fades

As though we needed another reminder, the early-year plethora of “second half recovery” economic and corporate earnings forecasts highlighted the consistent over-abundance of optimism  among sell side analysts. In order to understand this phenomenon it is important first to throw out any assumptions you have about investing and then fully comprehend that the goal of every capital markets participant is not to correctly predict the course of markets  – it is to generate commission today. The entire structure of the industry, from the personality types favored by HR to the compensation structure to the seating arrangements are all designed to facilitate this.

Consider the daily routine of, say, a typical institutional equity salesperson. They are generally at their desks reading news feeds and research published overnight by 7:00am. The research meeting starts at 7:30 and the analysts present any changes to the earnings forecasts of their companies and the economists and strategists may outline their predictions. At 8:00 they return to their desks and at this point the truly rich separate themselves from the merely wealthy. Between 8:00 and 9:30 the salesperson calls their best clients (ie the most aggressive traders) – mutual fund, hedge fund and pension fund managers – and attempt to leverage any information they’ve learned since 7:00 to get these clients to make trades. Their careers are dependent on these calls – it is, in other words, their entire job.

You may have been under the assumption that analysts, economist and strategists are compensated to the extent they are correct in their forecasts. This is only true to the extent that accurate predictions generate trade commission. In the end, analysts, strategists and economists are paid directly in accordance to how much trading commission can be generated from their reports. Importantly,  bearish news is not conducive to trade generation. Even in the rare instance where bearish news does instigate sell ticket commission, unlike buys a sell does not imply repeat business. Stocks that are bought need to be sold, with commission on both sides. The cash realized by sells may never return to the trade desk again.

It follows then that the career risks in being bearish and wrong far outweigh the benefits of being bearish and correct. The experience of Quant Strategist Richard Bernstein while at Merrill Lynch in the 1990s is instructive here, illustrating the importance of timing. (For the record, Bernstein is my pick as the best strategist alive, but thats a story for another day). In 1997, Bernstein stridently made the case that technology stocks were drastically overvalued, in a bubble, and poised to fall more than 50%. The trading floor and investment banking departments were understandably displeased that their strategist dared to step in front of the money train, and struggled to explain away the conclusions while the steady conveyor belt of .com new issues (the true high margin cash cow of the industry) remained 400% oversubscribed.

By mid 1999 there were rumors that Merrill would replace Bernstein with a more malleable Abby Joseph Cohen “buy at any price” clone. Ms Cohen had assisted Goldman in generating steadily higher market share in tech stock trading and underwriting with a relentlessly bullish, “tree will grow to the sky” outlook for the industry. This outlook, supported by 60-slide presentations outlining future growth, helped portfolio managers assuage their anxiety over insane valuation levels and allocate more of the oceans of client funds coming through the door into the most overpriced market darlings of the day – Cisco, Intel, Oracle, Amazon, Yahoo!, Microsoft and the whole host of hot money hangers on. The 8:00 calls from Goldman institutional sales people were much easier and more profitable to make than for their counterparts at Merrill (although admittedly Blodgett helped offset the difficulties). Ms Cohen was made partner just as the implosion began, again, not because of prescience but because of successful, commission-generating cheerleading.

Vindicated but still unpopular, Bernstein hung on long enough to re-make his career both by successfully predicting the extent of the carnage and, more importantly, making one of the greatest calls in investing history with “Investment Bankers: Leave Silicon valley and head to Texas” in early 2000, successfully predicting the rise of the energy sector. Nonetheless, his experience is instructive – to be bearish on Wall Street you not only have to be right, you have to be right at exactly the correct time or face the risk of losing your job. Abby Joseph Cohen on the other hand, shows that being bullish and wrong is much less of a problem; the company makes money, you get made partner, and then you shrug your shoulders and say “no one could have predicted…” even though others did.

There are reasons to believe that this structural bias towards sell side optimism may be coming to an end. Demographic factors and the 20-year rally in bonds, the latter having successfully shoveled trillions of dollars into the equity market, are not only declining in terms of their positive effects but actually reversing into negative forces. Even discounting the risks of regulation and protestor pitchforks, the size of the financial services industry is likely to decline along with average market performance. If this comes to pass, the more bearish of forecasters may begin to gain respect. We can only hope.

Why, after 20 years in finance, I support Occupy Wall Street

I have spent my entire 20 year working life in the financial services industry and therefore have little or no idea how, in terms of corruption, the industry compares with any kind of global average. Certainly many corporate sectors appear to have their issues, from admissions of bribery by global industrial giants, environmentally sketchy behaviour in mining and resources and, for most, the participation in de facto influence peddling affecting political legislation.  Nonetheless, it is also true that I have never encountered a single financial services employee at or above the VP level that has not, as a function of their career ascendance, successfully and frequently averted their eyes from blatant client assreaming. As one example, the travesties of the Syndication process still result in retail brokers being handsomely paid to ram the detritus unacceptable to institutions into the private accounts of their largely ignorant (even if they don’t think so) clients. Inexplicably, this continues after a prolonged period of Syndication-related outrage after the tech bubble imploded.

The root cause of greed in capital markets is immediately intelligible. The flows of money through a global investment bank are so incomprehensively vast that the diversion of one hundredth of one percent of it into a bonus pool is easily sufficient to support a small group of people (ie a trade desk) in a life of obscene luxury. The temptation to do so, easily rationalized after years of Ivy League schooling and 70 hour work weeks in an environment that encourages avarice, is most often too much for mortal humans to avoid. I would suggest that most participants in the OWS would also fail this test of character, but that is possibly just a rationalization for the fact that I did as well.

If we accept that all bank executives are well aware of corruption and weigh outsized compensation as, to some extent, a suitable offset, this can lead to the misguided assumption that the hundreds of thousands of financial services employees represent a unified front against any type of new, more punitive, reform measures. But while there are a disproportionate number of narcissists and psychopaths on trading floors and within broker offices,  a good segment of people inside the industry spend a significant amount of time disgusted, both with the actions of the less scrupulous and the bureaucratic structures that encourage them. Who better to know the details on this serial rapistry of the general populace than those who make the accounting entries?  Virtually everyone within the financial services industry I have spoken with – brokers, investment bankers, and in institutional sales – have professed a degree of sympathy with OWS that would likely stun the protestors themselves. We have all seen things we were not proud to be a part of.

To date, the primary criticism of the OWS movement from within financial services has been the lack of specific, coherent reform demands.  This is, of course, completely disingenuous in that the industry has employed its considerable intellectual capital into disguising the means by which they have been steadily fleecing the peasants. Did we really expect that a group of young, pissed off unemployed would demand tighter bid/ask spreads in the portfolios underlying structured products? Would the industry not have panicked if they did? The answer to the latter question is probably not – the political influence necessary to prevent the enactment of legislation enforcing corrective measures remains intact.

The argument that OWS is pointless because they can’t re-design the banking system themselves is a ridiculous attempt at tactical ambiguity and Orwellian dissembling, one assumes directed at buying time until the New York weather turns icy and whole thing goes away.  And to be fair, this remains the most likely outcome barring some type of charismatic leadership that can hone the collected outrage into focused political power sufficient to terrify the heretofore unchallenged hegemony of the K Street bank lobbyists.

The Occupy Wall Street movement is justified on many fronts. An extraordinarily wealthy segment of society, after claiming and accepting the right to operate unfettered after the repeal of Glass Steagal, completely failed to accept the responsibility that this entailed. The fact that a protest movement has not produced a solution to the money/influence construct that has been present since civilization was formed, has little to do with the validity of their cause. And perhaps most importantly, they will find a more sympathetic audience within the banking world than they suppose.


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