The Reformed Broker
This whole week's action is likely to be a giant exercise in holding our collective breath. Later this week we get speeches from the two most consequential people in the world right now - the Jackson Hole address from Benjamin Bernanke and an address from the ECB's Mario Draghi.
Bernanke famously signaled QE 2 at the 2010 Jackson Hole speech and the markets direly want to see a repeat performance this year. I know that sounds silly with the major indices within Snooking distances of four year highs, but trust me on this. A lot of the year's gains could be washed away like a child's sand castle very quickly should the bratty traders decide to use the S&P futures market as the tool of their temper tantrum over a "disappointing" slant to his commentary. On the Euro side, we want to hear a renewed commitment that the ECB will continue its metamorphosis into more of a Federal Reserve-like body, complete with full bailout authority.
Is QE 3 on the horizon?
Will the market get another shot of that junk, the junk it so desperately needs and craves?
This will be the focal point into Labor Day weekend, the central planners are in the driver's seat for the moment.
"Are there still commission-only brokers left?" an incredulous reporter asked me the other day at lunch.
It seems impossible that are still customers for these guys given how much information is available at our fingertips in 2012. But I had to tell her that yes, they still exist. And in some form or another, they probably will forever, even as their ranks continue to shrink.
The boiler rooms have survived the late-90's Mafia-related crackdowns, the penny stock scandals, the market-making inside commission rip scandals, the dot com blow-up, the credit crash, the private placement witch hunts and now Dodd-Frank. You simply cannot shut these things down in their entirety. The owners of these firms just switch tactics, when one thing stops working, they do another. They went from penny stock manipulation to churning legitimate stocks, from IPOs to Reg D private placements. The products and tactics change but the one constant is that all accounts are eventually blown up, hence the relentless apparatus to procure new ones. The broker is not really "building" his business through prospecting, he is replacing it. Even still, there is a cloak of respectability thrown over the whole enterprise - nice suits, nice business cards, nice street address, etc.
But I know four surefire questions one can ask the compliance officers of these last holdouts that would surely put an end to it all immediately. Because while tactics may change, the underlying filth and grime is so ingrained in the fabric of this business that it can never truly be bleached out or scrubbed away.
Here are the only questions that need be asked:
1. Why does there appear to be a strange uptick in gross commissions during the last two days of each month? The trades appear to be taking place randomly, as though they could have happened at anytime during the month - but it seems like they needed to get done before the monthly pay period closed out (the Tuesday before the last Friday of each month) based on this pattern. Is it possible that these transactions were done strictly so that the broker could get his gross above a certain number for the month, perhaps to qualify for an increased payout percentage? Forget possible, isn't it likely?
2. What qualifies your brokers to promise "consistent returns of 20% a year" when they're speaking with prospective clients? Have they ever actually delivered that? Can you provide evidence? If they have provided even half of that rate of return, why do they ever need new clients. Why are they buying telemarketing lists of business owners in Southwestern Minnesota? is this some kind of a charitable outreach program the firm has set up to democratize the consistent winning of Wall Street around the nation?
3. What qualifies your brokers to select individual stocks to sell to prospective clients they've only spoken with once? Is this in the best interest of any customer in either the short or the long-term? Why are the single stock selections of a broker a product that is worthy of a premium commission to begin with? Given that order execution is essentially free in the modern era, what value-add is happening with this particular trade that merits a 2.5% commission of the total purchase amount and then another 2.5% commission on the proceeds once it's sold?
4. Why does your firm, domiciled as it is in lower Manhattan, have a disproportionate amount of clients in rural states or the deep south. Does this have anything to do with the fact that people from those regions are:
a) More likely to be impressed that someone from NYC's financial district is calling them?
b) More polite and congenial and hence less likely to hang up the phone mid-conversation?
c) Less likely to know other financial professionals personally or have one in the family?
d) Less likely to be web-savvy enough to background check your firm and research the recommendation?
e) More likely to have a landline phone with a number that is publicly listed and that they will take calls on?
The truth is, a compliance officer from a retail broker-dealer cannot answer any of these questions without admitting the truth about the what the firm is actually adding to (or subtracting from) society.
And when the answers to these questions come forth, the reality is an ugly one.
I can't believe I'm about to defend the hedge fund industry, but here goes...
I like Matt Taibbi's work although a lot of my peers on the financial web despise him. Even when they agree with his basic premise (The Street does more harm than good in society) they tend to take issue with his use of over-generalizations or seemingly devastating barbs which are much less so once put into context. But even so, the truth he gets at is undeniable and I always read his stuff when it hits.
But his latest, on hedge funds, caught my attention because of how uncharacteristically sloppy it was. He riffs on the fact that only 11% of hedge funds are performing ahead of the S&P 500 year-to-date and that they're basically all buying Apple to catch up at this point.
all those super-rich people who turned to hedge funds with their millions in the hopes that bunches of Whiz-Kids from Wharton and Harvard and Yale would find unseen and wildly creative investment ideas to fatten their fortunes – all those rich clients are actually finding out now that those same Whiz Kids are buying Apple just like the rest of us. Hey, it has to be a good stock, right? Everyone has an iPhone now.
Jesus. After all that craziness in the last decade or so, after MF and the London Whale and all that nuttiness, this is what it comes down to? These guys are buying Apple? Couldn't we have just started off doing that and saved ourselves all that trouble?
Clever, but here's the problem:
1. Yes, Apple is a hedge fund hotel, but we're talking about only hundreds of funds long the stock in a business of thousands of funds. There is $2 trillion or so in the hedge fund industry and most of it is not chasing Apple or even the stock market. There are funds trading volatility, credit arb, emerging markets, commodities and on and on. The boldfaced managers you read about on Page Six tend to be the swashbuckling long-short equity types, but they are not the market.
2. Any vehicle with the term "hedge" in it, by definition, should not be expected to beat a market that has been melting up. Hedge funds came about as an alternative for wealthy investors so that even in tough times, they have someone who can play the short side or find other ways to make money when stocks aren't rising. You can't have both. There are some hedge fund managers who are simply beta + leverage, but these guys don't last long and they certainly don't reduce overall volatility in a wealthy person's portfolio.
3. Returns are not returns. There are other considerations that drive people to hedge funds and alternatives. One key factor would be risk-adjusted returns - if a fund only took half the amount of risk of the overall market but achieved 85% of the upside performance (aka upside capture), that's a win for many institutions and pension funds, for example.
4. Hedge funds are not Wall Street. Wall Street is JPMorgan, Goldman, BAML, Morgan Stanley. Hedge funds are hedge funds, they are clients of Wall Street for research, financing, product, custodianship and prime brokerage services. There are a lot of overlaps but hedge funds were not bailed out in 2008, are not meant to be systemic to the financial complex serving America and they certainly don't sell things to or transact with Main Street (they'd rather be dead). The amount of money hedge funds hold for retail investors directly is a grain of sand compared to the amount of money held by the banks and i-banks and mainstream asset managers/mutual funds. Mom and Pop may think it's all the same thing but I'm sure Taibbi knows better.
So while I agree with his premise that many involved in finance are not worth the money, let's be specific. There are enough actually damning things to say about The Street as it is.
There's a new hot trade on The Street I continue to hear about more and more that involves one of the most hated areas of the global markets: Europe. Hedge funds and go-anywhere asset managers are increasingly circling the concept that the time is now to dig through the rubble for quality euro stocks.
Before I go any further, please understand that I am not advocating that anyone go out and try to put this trade on, I'm merely relaying the fact that many institutional players are talking about it behind the scenes.
The idea is to buy European multi-national companies, which are trading at very low valuations in some cases (see the Bank of America Merrill Lynch chart at left depicting EU equity yields relative to German bunds) The thinking behind it is that Euro multi-nats have been unfairly punished by investor fears over the debt and banking crisis. European stock indices are very heavily weighted toward financials, but not all European companies have big exposure to financials - or even the economies of Europe. Just because they are domiciled there, it doesn't mean they are doing a majority of their business there. I mentioned this idea a few weeks back after speaking with a huge global fund manager who was actively buying European multi-nat large caps at steep discounts:
A great example would be something like Nestle, a global food company if ever there was one. Nestle reported profits for the first half of the year up 8.9%, thanks to strength in the many emerging markets in which it sells ice cream, coffee etc. Europe is loaded with companies like this and many of them have been thrown out with the bathwater thanks to the problems of the continent's banks and sovereigns.
Jeremy Schwartz at WisdomTree has done a lot of work looking at Japanese equities and their trailing twelve-month dividend yield as a portent of good buying opportunities. When this yield is high for a given country's stocks, it has historically been a great entry point.
You'll see a trailing dividend yield for local currency EU stocks that is more than double that of the S&P 500.
The other dimension to the trade is that a weakening euro currency benefits European companies selling overseas - the chatter about eventual euro-US dollar parity has gotten louder of late. WisdomTree believes that the ability to hedge the euro currency as it heads toward dollar parity would serve to enhance the long-euro stock trade even further - you end up long companies that benefit from a weak euro and you net out the eroding effect of this decline in the local currency simultaneously. The fund family is so excited about this idea that they are about to restructure an existing ETF (Hedged Equity Fund) to become a vehicle that owns European stocks and hedges out the currency risk (versus the dollar).
Their plan for the fund, HEDJ, is as follows:
The new Europe Hedged Equity Fund (HEDJ) will provide exposure to European dividend-paying companies that derive more than 50% of their revenues from countries outside Europe, while hedging the single euro currency. The changes to the Fund’s objective aim to:
- Focus on one theme: The Fund will change its objective from hedging multiple currencies versus the U.S. dollar in a broad international basket to an export-oriented portfolio of euro-traded, dividend-paying companies while having to hedge only the euro vs. the U.S. dollar.
- Provide access to exporters poised to benefit from a weakening euro: In a weakening euro but healthy European export scenario, a euro hedged equity strategy may provide greater returns than an unhedged portfolio of European stocks. Conversely, in an environment in which the euro is appreciating and global demand for goods is low, the Europe Hedged Equity Fund may underperform an unhedged portfolio of European stocks.
- Improve operational efficiency: By hedging a single currency rather than multiple currencies, we anticipate tighter trading spreads3, which may result in greater trade volumes and interest in HEDJ.
There are, of course, plenty of risks to this strategy. For one, European stocks are up roughly 14% in the last two months and may need to cool off a bit. Second, September is going to be a very headline-driven month, German votes on the ESM's legality on the 12th while disgruntled voters in Holland go to the polls for a general election. In other words, expect whipsaws and volatility to return for the near-term.
I want you to take a moment to think about this - never before in my entire career have stocks outpaced the forecasts of Wall Street strategists to the degree to which they have this year. It's almost always the other way around, forecasters' outlooks much rosier than what the indices have actually been able to deliver.
This is pretty historic, now I've seen everything...
Shares have climbed 2.1 percent above the average projection of 1,389 from 13 firms from Morgan Stanley (MS) to JPMorgan Chase & Co. (JPM) tracked by Bloomberg. That’s the biggest premium on record for this time of year, according to data going back to 1999. Estimates by strategists in August have come true the last three years, with the S&P 500 rising 11 percent on average through December, the data show.
We've come to expect The Street to always be more optimistic than market realities, what can we infer from the fact that this paradigm is now flipped upside down? Any thoughts?
Bernie Madoff's ponzi scheme ran for multiple decades and was, at one time, estimated to encompass roughly $50 billion dollars - a record-breaker. Underlying it was a legitimate business (broker-dealer, investment advisor, hedge fund) but the returns were faked and so was most of the activity. I bring this up because I keep hearing a persistent undercurrent of furor about how "Facebook's IPO was the largest ponzi scheme of all time." Upon researching all available definitions of the term, I believe that it was not. But it took me awhile to get there, I admit.
Facebook stock attained a valuation of almost $100 billion dollars and when it ran out of new investors (upon coming public), it's value promptly collapsed. In half. In an extremely short period of time (90 days). Everything about that feels scam-my. But a ponzi scheme? Let's look at what that term actually means:
"A fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This scam actually yields the promised returns to earlier investors, as long as there are more new investors. These schemes usually collapse on themselves when the new investments stop."
"an investment swindle in which some early investors are paid off with money put up by later ones in order to encourage more and bigger risk"
"Scam in which gullible public is enticed with the promise of very high returns in a very short time, but is based on paying off the early 'investors' from the cash from (hopefully ever increasing number of) new 'investors.' The whole structure collapses when the cash outflow exceeds the cash inflow. The originators of the scheme, however, usually disappear with large sums a few days before the crash."
So far, all of this lines up almost perfectly - Facebook resembles these descriptions almost perfectly. Early investors (venture financiers) being paid out an amazingly high rate upon the recruitment of new investors (the public in IPO day and in subsequent lockup expiries). But there is one aspect of a traditional ponzi where Facebook differs drastically - there were never any promises made in terms of rates of return.
One of the classic features of a ponzi are the promises of a high payment to investors on an ongoing basis, which is the very reason why new investors must be recruited all the time. Outside of the analysts' expectations from the underwriting banks, it would be hard to say that anyone from Facebook ever promised anyone anything. In fact, the prospectus is even more loaded with warnings, risk factors and caveats than is usual for new issues.
The SEC's definition of the term "ponzi scheme" features this promised returns aspect rather prominently:
"A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity."
And so while Facebook's IPO (not the company - the stock offering itself) does truly resemble a ponzi scheme from almost every possible angle, there is one respect in which it is not one: They never promised their investors anything, they never pretended there was a rate of return coming to anyone.
And so as disgusting and unforgivable as the whole episode was, the ponzi label seems not to stand up upon closer investigation.
One of my favorite financial bloggers, Felix Salmon at Reuters, has a post up that might be my least favorite thing he's every written. In it, he manages to (inadvertently, I think) insult every hardworking investment professional along with every truly talented artist, musician and writer in less than a dozen paragraphs. That's quite a feat!
Riffing on a new attention-craving paper by Nassim Taleb (remember when Taleb said was no longer writing about financial markets?), Felix takes issue with the pop-philosopher's gambit that working in investment management is going to get harder because it will be more crowded and dependent on luck. Contra to Taleb, he says the investment industry is relatively easy to participate in versus breaking through in the arts - where success based on randomness is a naturally occurring force.
While Felix rightly points out that participation in the investment business is shrinking, he wrongly characterizes the industry as a walk in the park in which most workers have it made.
I suppose I have two issues with this:
First, the notion that being in the investment management business carries little risk of failure and is easy belies the fact that thousands are washed out each year after failing to hit firm targets or client expectations. In the meantime, countless thousands who attempt to break into the industry find themselves competing in a draconian, Hunger Games-esque popularity contest/ Kobayashi Maru exercise with a lottery-like chance of moving forward.
And for the lucky few who can establish a foothold in the business, here is what awaits them: self-medication and whatever the opposite of zen is. There's a reason the investment industry carries with it elevated instances of drug abuse, divorce, alcoholism, stress-related illness and the like. And that reason is not that the work is simple and everyone's sitting around waiting for their lucky break. The handful of practitioners who seem to have found a way to balance success in the industry with a state of overall well-being - your Gross's and your Dalio's - are notable insofar as they have actually done just that. Talk about black swans, they are black swans who can rollerblade. The majority of us are losing our hair and our waistlines at a faster rate than many other professionals, let me assure you.
As to the idea that most artists and creative types who break through are merely lucky, I would amend that by saying most mediocre artists who break through are lucky (like Carly Rae Jepsen or Jessica Simpson). But most truly gifted artists who break out were going to break out no matter what. And then sometimes an amazing artist or writer or musician who deserves to break through gets unlucky, but this is the exception - it is the reason why we know names like Jeff Buckley and Mitch Hedberg and John Kennedy Toole. But the cream rises to the top in most cases, while force of will along with undeniable talent plays a significantly larger role than random fortune. Led Zep wasn't lucky nor was Alicia Keys and the possibility of there being a great many similarly-talented artists who we've not heard of is undoubtedly a slim one.
I doubt I can get Felix to come around on either of these points of dissent, but I think the argument is an important enough one that it merited an opposing point of view.
Today's big story is John Corzine's new hedge fund the Facebook lockup expiration. In case you're living in a cave or you were Amish up until last night, Facebook currently has 420 million shares and as many as 271 million more just became eligible to hit the open market.
We've been told for months that this would be D-Day (doomsday) but like most things, when everyone thinks something, it rarely ends up being the case. Don't get me wrong, my view on the stock hasn't changed, but let's be honest and admit that it's a very positive sign that the stock was able to get back above 20. As of this mid-afternoon writing, it seems like it might even stick.
I explained just after the IPO opened and then went down like a Clinton intern that I'd rather pay up for Facebook once momentum returned than try to catch a bottom. It seems counterintuitive to not want a "cheap" price, but when you can't value things fundamentally, like untested businesses, the supply / demand picture and momentum are the only tools you have.
So Mark Zuckerber, if you're reading this, Smile! It gets better.
Being a pragmatist in this day and age is pretty difficult in light of the fact that there simply aren't any answers to the most pressing issues of our time.
No, really, there are precisely zero solutions.
Let's take our deficit and national debt issues - they are different but also they go hand in hand. Now it's very obvious that defense spending and health care costs are crushing us. Social security and unemployment benefits aren't doing us any favors either. And it's not just the static amounts of these debts, it's the upward trajectory with no end in sight that's really the most vexing part of it all.
But these are protected budgets for political reasons and quite frankly, the time to slash this spending is when you can (in a good economy), certainly not now when to do so would cripple what's left of the recovery. And so you hit on another solution - raise revenue. Obviously no one can do that with the middle class because everyone thinks they are in the middle class and a pol can't do the type of 11-months-a-year fundraising he or she must with a middle class tax hike on their record. You can't raise taxes on the low income earners because they can't (and don't) pay any taxes to begin with.
Which brings us to the Bush tax cuts which are set to expire anyway beginning in January. They were a scam from day one and did nothing of lasting import for the economy other than shift more wealth upward to where it wasn't needed anyway. The whole reason these cuts are sunsetting to begin with is because of the way they were passed, by Parliamentary trick (reconciliation) rather than by legitimate congressional ascent. Please don't take my word for it, listen to Paul O'Neill, Bush's SecTreas at the time of their passage:
President George W. Bush didn’t want to deliver a tax overhaul. He wanted to deliver the tax cuts he’d promised as a candidate, Bloomberg Businessweek reports in its Aug. 6 issue.
He did, in 2001 and then again in 2003. Yet the kinds of cuts he’d promised -- large ones -- would create unsustainable deficits after 10 years, the Congressional Budget Office projected. So they were designed to expire in a decade, at least on paper.
It was “baloney,” says O’Neill, who publicly supported them at the time. Republicans never intended to let the cuts lapse. “It was put in there so they could make a fiscal claim that it wouldn’t damage us. It had nothing to do with reality.”
But there are two problems with these tax cuts sunsetting - to paraphrase a popular song lyric from 1956's My Fair Lady, we've grown accustomed to their face. Allowing these tax cuts to fade all at once could be catastrophic for spending, capital formation and markets, etc.
And besides, the idea that we can simply take more from the rich might be socially satisfying in such a lopsided economy, but it doesn't actually solve the original problem of debt and deficit anyway.
Here's TaxBytes (IPI):
But can tax increases on the wealthy provide enough funding to maintain the status quo?
The president’s wish to abolish the Bush tax cuts for those making over $250,000 per year is projected to bring in only $0.7 trillion over the next decade. Remember, the deficit over that same period is $13 trillion. So that doesn’t come close.
How about the so-called “Buffett Rule,” which would apply a minimum tax of 30 percent on individuals making more than $1 million per year? It would, according to the Joint Committee on Taxation, raise only $46.7 billion over 10 years. Even its most adamant advocates only claim that it would bring in $0.5 trillion over ten years. With a $13 trillion deficit, that doesn’t work, either.
And these are all static estimates that assume we can raise taxes on the wealthy with no harmful impact on investment and economic growth, which ignores the real-world impact of tax increases.
In other words, none of these “tax the rich” solutions makes a dent in our deficit and debt problems, because there just aren’t enough rich people to soak in order to plug a budget hole this big.
And so the pragmatist comes back around to the fact that we probably need a combined effort to cut wasteful spending, raise tax rates on the wealthy in a modest way, make hoarding and saving even more uncomfortable and avoid giant budget cuts until we're out of stall speed and on a sustainable growth track. This is easier said than done, politically speaking. There's also the fact that austerity and growth do not actually ever co-exist in real life. When you hear a politician, like Geithner, talk about growing through shrinking, you know he is either lying or naive.
Intellectually speaking, the most logical approach might be to allow the "system to clear" and let the chips fall where they may. But in actual practice that is really the ugliest option and perhaps the most unrealistic - everyone has too much invested in the current world, the post-apocalyptic world on the other side of economic purging is not something most would like to explore.
There are indeed no answers, only incremental opportunities to make things less bad along a bumpy road. There will be near misses and scares and moments of chaos ahead, balanced out by the fact that the Fed is willing to go the distance with interest rates. I'm not sure I like it, but I don't know what I would alternative I would like any better.
So we learn to live with it, the problem with zero solutions. We invest around it and work around it and get up each morning to get the kids fed and dressed and out the door. And keep the faith that time - and only time - will provide an answer eventually.
This is a tough year for all investors, despite what the index says it's done year-to-date. This morning's daily affirmation comes in the form of a reminder:
Even the most brilliant investors don't get 'em all right. The world's best asset allocator, Ray Dalio has negative YTD performance numbers for the first half of this year. Louis Bacon just gave his investors their money back rather than feel the pressure to perform in this environment.
And get a load of the of the value traps David Einhorn, one of the most brilliant equity guys in history, has just unloaded...
David Einhorn sold his entire stakes in Dell (DELL) and Research in Motion (RIMM) as of the end of the second quarter, according to a filing his hedge fund Greenlight Capital made with the SEC. As of the end of the first quarter, he had owned 11.9 million shares of Dell and 1.6 million shares of RIMM.
Einhorn also decreased his stake in Best Buy (BBY) by 84%, according to InsiderScore.com.
Remember: No matter how good or smart you are, how much research you've done or how long you've been in the game, you will still get a few stocks wrong and you will still be positioned incorrectly sometimes.