Category Archives: What Would Spinoza Do?

Do let’s be optimistic . . . even if we don’t feel like it

 

Tis (or, by the time I finish this post, ’twas) the season for pundits to give specific predictions for 2012 and a more pointless exercise has yet to be devised. Baruch isn’t going to waste your time doing this, for various reasons. The main one is that Baruch has long been convinced he is almost always wrong about almost everything. His only solace (and it is a big one*) is that everyone else is always wrong as well, and unlike him they don’t know it.

This year prediction seems a lot more difficult anyway. If Baruch is at all representative of bien pensant investor opinion the overriding emotion among practitioners today is a lack of confidence in anything, especially themselves. This is because almost without exception everyone traded like an idiot in 2011, both on the hedge fund side, where “slightly down” is the new “up”, and on the side of benchmarked long only funds. As you may know, Baruch is a professional investor and helps run one of these latter things. Looking at his peer group he is amazed, despite a mild underperformance, to find himself firmly in the top quartile in YTD relative returns. Despite this, he feels like a schmuck. How much worse must the average PM have fared, he asks himself. Just why has everyone done so badly this year?

Baruch has some ideas about why this is; a lot of it can be put down to the narrative of the year and investor positioning.  Overall, the majority of the active management community were extremely badly positioned for the key moves in the market in the back half of 2011. They were mostly long for the big August swoon associated with the US credit rating cut, and many compounded this by adding exposure into the decline too early — catching falling knives, in the parlance. Having finally understood the appalling ramifications of the European debt crisis, investors were nice and short, or in cash, for the quick but steep October rally that brought the major indices almost back up to the point at which they had broken down back again in August. Shellshocked, with what seemed had seemed a decent year now in tatters, all they were able to do in November and December was curl up in a foetal position, to derisk, and hope the kicking stopped.

A time of derisking, by the way, is a terrible time for those who are not derisking to make money. It means PMs selling positions that they like, and buying the ones that they hate. If everyone is doing this it makes for the market of Bizzarro World, where down is up and up is down. Good stocks, at best, make no traction, while bad stocks are likely to squeeze. November and December were marked by this worst of enviroments, what Baruch calls “high amplitude chop”. This had the effect on putting the kibosh on the few players left who still had any profits, and who had thus been less inclined (the fools) to join the mass huddle.

By the end of 2011, then, the performance-led derisking must have been largely complete, and at least some investors, if not the majority of them, are probably looking at trying their luck in a new year, with slates wiped clean, and having another go at earning those management fees again. Indeed the last datapoint in 2011 from ISI, who tracks these things, had the gross at hedge funds (a measure of how much of their capital they have deployed in short and long positions) at the same level as June 2008 — ie very low, crisis levels. Not at all what you would expect at the end of a year in which the S&P was only flat.

Just off that then, it would seem that maybe we don’t have to worry too much, and we could have a return to something approaching a normal environment where active management works again. In fact it is necessary to be mostly optimistic in this business, as a general rule. But then again I suspect I am merely trying to reassure myself because while people may be underinvested, there is also a very high degree of nervousness out there. It won’t take much to bring us back to derisk mode again, and if 2012 is another chop-filled  year like 2011 for active managers, well the only people who are going to be happy are the indexers. And they’re the enemy.

I would like to end the blogpost right there, and not talk about the things which are actively making me worried, such as $200bn in dodgy European sovereign paper to roll over, the apparent Chinese slowdown, nasty commodity trends and record high corporate margins etc etc, because thinking about these things makes me stressed out.

Happily, others have done that better than me**. So I sign off and wish my reader(s) a very happy and prosperous new year.

* knowing that whatever thesis you have in your head is likely to be wrong makes it much easier to discard it when it gets falsified, or when you think of something better. Knowing also that you are really quite thick makes it harder to worry about looking stupid (why live a lie?), and more money is lost trying not to look stupid than in any thing else you are likely to do in the stockmarket.

** Baruch is not sure whether The Interloper makes him want to retire from blogging or want to blog a lot more. Either way, it is grand he is around to be read. If he wants a hand on Euro Telcos he can drop me a line.

What next for Apple?

You might forgive Bento for gloating. It’s true that he doesn’t write much around here, but when he does, it tends to be about Apple, and he tends to be spot on. Cases in point: A prediction of run-away success in China way before it became a mainstream opinion, and a prediction of run-away success for the iPad when it was being trashed by the technoramuses, pointing out that it is an ideal device for baby boomers.

As a long-time owner of (a very small chunk of) Apple stock, the past decade has been an absolute pleasure, with Jobs et al reïmagining and then dominating a whole run of product categories with apparent ease — music players, mobile phones, tablets, and now ultralight laptops. But in this success lies the seed of a problem: While the empire that is Apple has plenty of expansion left in new geographic markets and within existing product categories, Apple is exhausting the universe of gadgets it can colonize. I now have an iPhone, iPad and MacBook Pro on me most times, and go running with an iPod Nano. My next laptop will be Air-ish. But what additional new thing can Apple sell me that I must have as soon as I see it?

Even if Apple never again introduces another revolutionary iDevice with concomitant new revenue stream, it will take some time before Apple’s growth trajectory retreats from the exponential to the merely geometric. With Steve Jobs gone from the helm, however, there’s the possibility that Tim Cook will get the blame for this shift; when in fact all the low-hanging fruit has now been picked.

Yes, it has. All the product categories Apple has revolutionized have long been on the radar screen. Microsoft tried and failed to kickstart tablet computers during much of the naughties. Apple’s Newton was ahead of its time. Walkman music players were poised to be replaced by something digital. Laptops have since the start been massive compromises between weight, power, and battery life.

What might Apple do next? Television has been mooted as a candidate; the self-described AppleTV “hobby” has been a modest success, and there are rumors that Apple might use its lessons to try to properly reïmagine home entertainment using what it has learned from AppleTV. We’re halfway there with Airplay, which streams sound and video between wifi-connected gadgets around the house, but it is not yet seamless. (I’m an early adopter of it). If it becomes seamless, and stays much cheaper than competing Sonos’ systems, and the AppleTV OS turns into something of a platform that multimedia content providers can build apps for and stream content to, then we may have a proper new product category for Apple to dominate. Price here would be crucial, but that is something which Apple’s fabled manufacturing prowess could trounce the competition on, not least when it comes to screens.

And beyond that? Where else could Apple inject itself into my daily use of technological tools to be creative or to consume others’ creativity? Might it take on premium camera manufacturers like Nikon and Canon? Revolutionize (electric) car design? Develop connected appliances such as fridges that scan and refill themselves using the web? Jonathan Ive may well be chomping at the bit to bring Apple design to any of these areas, but somehow I doubt it can happen. Nikon and Canon already produce finely honed ergonomic masterpieces that are too niched for Apple; electric cars would be too large an adventure beyond its core competency, and while a connected intelligent home surely lies somewhere in our future, it is about as useful to speculate about this as to wonder when we’ll all be installing fusion reactors in our cellars (and what role Apple would play in their design.)

A more subtle worry of mine is that Apple will continue to produce gadgets and software that encourage content ownership, despite the fact that for the upcoming generation, “purchasing” digital content is increasingly anachronistic. Apple risks losing relevance among this group if it does not adapt, and it shows no signs of doing so (yet) despite the fact that the technology for alternate forms of paid consumption is mature.

My anecdotal evidence: As a resident of Sweden (which lives perpetually a little in the future) I have been using Spotify for several years. That Swedish start-up lets me legally stream and even download any music I choose from an iTunes-store sized library for a flat monthly fee. The service is social, mobile, and has become ubiquitous in Sweden; since signing up, I have not bought a single song on iTunes. Nor do I know any Swede who has (I asked again at a dinner party last night.) I’m sure that Apple’s internal iTunes store statistics for Sweden reflect this change on the aggregate level. And now Spotify has just launched in the US.

Movie rentals in iTunes are not the future either; the Netflix model is.

So these are the fears I hold for Apple in quieter moments. Emphatically, Windows 8 is not among them — the hardware is just as important as the software, and Apple, uniquely, is strong in both. I do see a danger of Apple making ill-advised concessions to Chinese censors for its future devices and cloud services sold domestically (it already did so with the Chinese iPhone 4), but the resulting negative publicity would not have an effect on the bottom line.

Of course, $76 billion in cash buys a lot of insurance against technological riptides. Baruch, what product category do you think Apple should colonize next? (I would certainly love it if Apple reïmagined driving. They could buy Volkswagen-Audi AG (market cap conveniently $63 billion) and soon thereafter announced the beautifully designed all-electric iAud. Considering that Google is already working on autonomous electric cars, surely that raises the odds of this happening?)

Homicidal zombie markets reconsidered

Baruch received old media brickbats for his bloggy frettings last year about the impact and meaning of QE2. At the time, while understanding why people thought it was necessary, he worried that we were opening a can of worms which were going to wriggle off in all sorts of undesirable directions. He wrote:

in his darker moments that Baruch thinks a very good analogy for where we are right now is Pet Sematary. The people who buried their cat (and later their son) in the Indian burial ground to bring it back to life got something which looked ostensibly like a cat, but was so only on the outside. On the inside their little puddy tat  was really an undead homicidal zombie cat, as became clear through its increasingly odd behaviour. Unintended consequences followed (mayhem, murder, horror, the Wendigo — all that Stephen King stuff).

The Bernank is like the guy who buried his cat, but in this case instead of a resuscitated cat he wanted his rally back, a healthy stock market and the wealth effect that would bring. I worry we have got something else.

Pointing to potentially horrible unknown unknowns tends to capture the imagination much less than pointing to the definitely unpleasant known knowns of an imminent economic slowdown. The QE2ers’ argument at its core was the eternal and seductive call that Something Must Be Done. No less than James Suroweicki at the New Yorker picked up Baruch’s idea of the “undead homicidal zombie market”, tautology and all, and lumping me in with the Tea Partiers, House Republicans and the other dead-end no-brained foes of QE, labelled us  “hysterical”. Baruch loves the New Yorker, but knowing their editorial stance and lack of track record when it comes to advising macro funds and governments, Baruch concluded their love of QE was less a well-thought-out economic analysis, and more a gleeful response to finding their political foes against an idea that felt “right”, Colbert-like, in their gut. In his response, (Felix also had a good one) Baruch bemoaned the politicisation of monetary policy by anyone. This hasn’t got any better — having an (admittedly Texan) presidential candidate threatening the Chairman of the Federal Reserve with a tarrin’ and a featherin’ if he buys any more bonds doesn’t seem conducive to a mature conversation on the subject.

So, was Baruch right? Or were the Suroweickians? An interesting thought experiment would be to think of where we would be without that second round of easing. With the benefit of hindsight I’m inclined to think we would have been better off right now had we not done QE2. Why? Continue reading

No Stock Recommendations here; move along

Baruch recently found himself commenting on Wall Street Cheat Sheet, on a post by Damien Hoffman, who seems to really dislike Jim Cramer. The post was about some investigation of TheStreet.com by the SEC, which Damien thought highly amusing, perhaps because he also runs a competing subscription-based financial edutainment site. Now, Baruch doesn’t pay attention to Jim Cramer on TV, but in fact quite likes him in print. He reads his posts on theStreet.com, and respects his track record as a hedge fund manager and pioneer econo-blogger.  So Baruch felt a brief moment of annoyance about seeing someone he liked being unecessarily trashed, but soon his heart was filled with forgiveness and understanding again. We must not be too harsh; snark is Damien’s job, what he gets paid for. He is a financial blogger-journalist, and being cheeky about mainstream media figures is part of that David and Goliath thing blogging used to be all about.

Anyway, this post is only a bit about Jim Cramer and Damien Hoffman. The exchange got Baruch thinking about the differences between journalists/bloggers (or whatever you want to call them) and investors, and what it means to communicate about investments with the public. Baruch finds this terribly interesting, because of course as an amateur econo-blogger and a professional investor, he has a foot in both camps.

Some of Baruch’s best friends are, or have been, financial journalists and commentators, on blogs and print. Being a financial journalist is a good, interesting job, and very important to the proper functioning of a marketplace. Journalists can do things, find things out, and explain things the public and investors need to know in ways investment professionals can’t, at least without risking jail.

But in the end journalists are explainers, commentators. They are dependent on market participants to provide them with things to write about. They review what others do. They work with the huge advantage of hindsight. And when it comes to giving advice about what what should be done, most media commentators are no better than the rest of us. Probably worse; they don’t get as much practice at it.

The major problem that commentators have is that rewards are based on reputation. Praise from peers and increased readership is the only way they have of knowing how good at their jobs they are. This is dependent on how smart the writer sounds, rather than how good he or she is at giving actual foresight. It’s a difficult thing, having to appear smart all the time. A well publicised prediction gone wrong can be pretty devastating to a reputation and undo lots of less well-publicised predictions which went right. Many writers solve this problem by not making many predictions at all. This is why most analysis pieces in newspapers and mainstream blogs end up in prevarication and fence sitting. Most journalists these days are smart enough not to end their articles with the words “only time will tell” — but they may as well.

The need to constantly appear smart also incentivises some to find a shortcut. A good and quick way of appearing relatively smarter is to find some fellow commentator who has broken the cardinal rule of journalistic punditry and actually had a stab at predicting something in a clear, falsifiable way — and got it wrong. Pointing out someone’s errors is a good way to come up with copy when you can’t think of anything constructive to say.

Ironically, consumers of financial media are actually crying out for someone to tell them what to do, rather than the prevarication they are confronted with everywhere. So pundits who do state clear positions tend to get eyeballs pretty quick. This unsettles their peers, who are universally relieved when these outliers inevitably cock it up, and they can now write gleeful articles about how it was obvious their colleague didn’t really know what he was talking about in the first place. Realising this, even sites which purport to give readers actionable intelligence, such as Lex, don’t actually tell them what to do, which would be too risky. A conclusion is always hinted at, but never made as plain as ” we think you should sell”. Instead you get some coded priggishness, like the chairman of company X “should enjoy the view from the top while he can”. Which gives the Lex writer enough wiggle-room to appear clever whatever the outcome for shareholders. This is, after all, the point of his writing, which he would freely admit to you as well if you bought him a pint.

Compare financial journalists now to actual market participants. While every now and then hedge funds get in a feeding frenzy and will short your longs and go long your shorts if they think you are in distress, the rest of the time professional managers are remarkably civil about each other in print, in person, and in front of clients. They don’t have cat fights very often. Continue reading

Econobloggers need their crisis back

I think so, dear readers. With the advent of peace and plenty, as we move to the broad sunlit uplands of The Recovery, I fear some of the spice has gone out of the commentary on sites like this one, and its friends. Where people used to read econoblogs to actually understand a crisis that CNN and Fox News soundbites didn’t seem to encompass anymore, as the meltdown recedes into the past there’s now just a dull ennui.  And with that, the econoblogosphere is moving back to where it used to be, which is to cater to a niche, broader than most, but a niche nonetheless, with a circumscribed influence.

The high point of bloggy “power”, we shall probably find in retrospect, was when a number of bloggers were invited to the US Treasury department and fed some by all accounts delicious cookies, as well as being ferociously spun to by the Goldmans guys whose turn it was to be on sabbatical at the Treasury that when it came to financial reform and what had gone wrong in the banking sector they did in fact Get It, whatever It was.

Since then, of course, we have had Obama praise the bonuses to “savvy businessman” Lloyd Blankfein, who as we all know is doing god’s work;  mind-numbingly massive “trading” profits from all the big commercial, investment, commercial investment banks at the same time as accepting government and Fed largesse*; an even more hideous clusterfuck over finance reform than exists over healthcare reform in the US; and this despite none of the proposals under discussion seeming likely to properly change anything worthwhile, other than maybe the Volcker prop trading rule and this last seems fairly dead in the water.

What really rankles this blogger is that the Great Spinozist Republic is being subverted again. Regulatory capture is one thing, the total inability of a political system to make any steps to reform itself when what is wrong is staring at you in the face, is quite another. Political money and public ignorance has corrupted civic decency in the US to such an extent that doing the right thing for the Republic appears quite impossible.

All these things should make econo-bloggers all quiver with righteous anger, which we would communicate to our readers who would then rise up en masse against the legislators captured by Big Banking, and some form of actual reform might even take place.

But something along the chain has broken. Either we have lost interest or, more likely, the world has. To be sure, there are brave souls who carry on the fight. Felix does an admirable job of keeping us up to date with the nuts and bolts of finance reform. Taibbi provides the rhetoric (“vampire squids”, indeed). Calculated Risk and Naked Capitalism carry on doing their thing, as does Zero Hedge in its batshit sawn-off shotgun way. TED gives us the lowdown and I mean low, on what it really means to be a banker (though TED’s next post is just as likely to be about his favourite type of upholstery. Thanks for including us in the list of blogs you read, BTW). There are others, and Abnormal Returns continues to aggregate them. But the rest of us seem to have stopped caring so much. The minutiae of practical policy is much less amusing than making lots of money in financial markets that really, truly appear to be on the mend.

The wider global economy seems to be much better too. Sure, the US seems a bit screwed up still, and unemployment is high, but frankly that’s not where the action is at anymore. Baruch was astonished to read that Gartner is predicting 20% year on year growth in PC units globally. We can talk about overleveraged consumers until we’re blue in the face and we’ll still be wrong. That’s a crapload of PCs, and someone’s buying them. You don’t sell craploads of PCs like that unless there was something going fundamentally right in more places than where things are going fundamentally wrong.

But a better economy just makes people fat and happy, and fat and happy people aren’t likely to be roused by righteous anger. Fat and happy people are not likely to want to change much. Fat and happy people are much more likely to assume the light at the end of the tunnel gives out onto a large outdoor buffet than the next oncoming crisis. Hell, fat and happy people are more likely to do the stuff to bring on the next crisis, to binge, to borrow more, stoke the next bubble wherever that may be and feel pretty smart doing so, just like we did in 2006 and 2007. Reformed Broker Josh captures the new Zeitgeist rather well just today when he lists the things people no longer appear to be interested in e.g. financial reform, unemployment, etc and says

most market participants have instead turned their focus to finding secular growth stories, deep-value high yielders to replace the lack of money market interest and other such assorted baskets to put their eggs in.

Fine with me.  I could use a break from the “news” myself.

I can’t say much better. Josh is saying what lots of us think.

Baruch isn’t really the person to do anything about this himself. He isn’t Spartacus. It was no co-incidence he was not invited to hob-nob at the Treasury; David at Aleph Blog was kind enough to suggest he and some others should be next time, but Baruch would probably have just eaten more of the cookies than was fair and got bored and played Homerun Battle 3D on his new iPhone until it ran out of power, annoying everyone. Baruch is one of those who likes to analyse what Is and try and make money out of it. He is not very interested in, or good at, what Should Be, though is slightly envious of those who have strong opinions in this direction. Less “designing better futures“, more buying the right ones. Even if Baruch had a prediliction to think about policy he doesn’t have time to think about more than what he writes about already; he has a day job, and a very intense one, which soaks up what mental energy he can muster these days.

But buying better futures are not what the best blogs in this space are about (and not what Nick Gogerty’s blog is either). Posts about the latest chart formation in the S&P500 are not memorable. They help no-one. Blogs about how best to trade can be interesting, but remain narrow and mercenary. So in the end are posts about how many iPads Apple will sell, the stock-in-trade of UB recently. Myself and Bento are just not that qualified to do much else and don’t have the time to post as often as we want. But there are other bloggers who are and who can. At its best, the econo-blogosphere can be the last haven of truly independent, non-captured, and crucially, informed, commentary able to affect policy and opinion makers positively. It used to do just that. It may not help in the end but let someone at least try.

Get your game back on, people. Get some fire in the belly again. A crisis is a terrible thing to waste, and it looks like we are on the verge of wasting ours.

* the irony is of course, is that the millions in banker wodge financing the lobbyists is at least partly the hot money doled out by the Fed to banks in that extraordinary money machine called ” quantitative easing”: Fed buys up at full whack the treasuries it issues to banks at a discount, financed by cheap rates set by the Fed itself. Said banks, busting out with Fed-invented cash, or more properly, “trading profits”, refuse to lend it to small businesses like they’re supposed to in the textbooks and support the economy. No, they plow it into awarding themselves big bonuses and, most pricelessly, pay lobbyists to pay off politicians to subvert both good sense and a public opinion which is as viscerally opposed to big banking as it is ignorant and pliant, and make sure the status quo ante crisum is restored. An edifying spectacle.

Google: Scientist

Baruch,

Symbolism is never lost on the Chinese, who are the masters of signaling, and thus there was some great poignancy to Google’s A new approach to China being posted to the blogspot.com domain, which is blocked in its entirety by China’s censorious government. This proved quite a sassy way to illustrate a point, before even starting on the merits of the case. Those outside China didn’t even notice. Everyone inside China, including the officials, had to turn on their VPN to read it.

Now that the deed is done so publicly, I don’t imagine either side will back down, and nobody expects Google.cn’s redacted search service to last much longer, with perhaps a further punitive ban on google.com for the sheer audacity of this insubordination. But already today the blogosphere erupted in competing narratives explaining Google’s autodefenestration from Chinese search, and not all were wholly credulous of Google’s stated motives.

Among the cynics, the arguments ran thus:

- Google is misrepresenting its decision: It was a face-saving, kudos-generating way to exit a failing business (though without explaining why profitably capturing 31% of the search market in China should prompt shutting down).

- Google is making a mistake: No business in their right mind would purposely anger the masters of such a lucrative market, so this has to be a stupid tactical mistake. (The stated presumption here is that Google cannot be ethical, or it would not have entered China in the first place, so this fiasco must be a very bad business decision merely masquerading as a moral decision.)

Among the partisans:

- Google was pressured into it by Hillary Clinton, thinks Rao Jin, the founder of the China’s patriotic Anti-CNN forum. (I suspect a failure of the imagination on the part of Rao — clearly, he is projecting onto the US how things are done in China.)

And tomorrow, expect the official mouthpieces’ take, which I predict will involve far more references to the peddling of pornography than to the free market of ideas.

I, Bento, take Google’s explanation at face value, however. And I intend to restate the narrative in terms that will be familiar to long-time readers of Ultimi Barbarorum: All along, Google’s approach to China has been that of the scientist: There was a testable hypothesis, an experiment, and a conclusion based on that experiment. And today, we saw the publication of the results — the hypothesis proved false.

Specifically, the hypothesis, as formulated by Google during 2005: The internet in China will become freer in the coming years, and Google’s presence in China will help strengthen this process. Many believed and hoped this might be the case — the Olympics were approaching, China was opening up, officials exuded reasonableness.

The experiment, initiated in January 2006: Enter the Chinese search market, try to improve the system from within by collaborating with the regime, and see if China’s internet gains freedoms over time.

The evidence: Over the past few years, a progressively stricter program of shutting down those Chinese sites that do not comply with demands for censorship and surveillance. The progressive blocking of all popular foreign sites that allow uncensored anonymous communication, including several Google properties: Twitter, Facebook, YouTube, Blogger, WordPress, IMDB, Google Docs, URL-shortening services… And, what Google cites as the final straw, recent industrial-strength malware attacks aimed at Gmail-using Chinese dissidents.

The conclusion: Google’s collaboration was not making things better; things were getting worse. They admit they were wrong! There may have been a financial return on its China investment, but the civic return proved disappointing.

Faced with this realization, Google could have done nothing. But that way lies death by a thousand cuts as web property after web property gets axed. How soon before Gmail gets blocked? Google Maps? Earth? Picasa? Google Reader? Instead, Google cleanly terminated the experiment: There will be no more collaboration with the regime. Now China must throw them out if it wants to save face domestically — albeit at the price of losing face internationally.

As Spinozists, this is a proud day for us. Google has posted that placard declaring China’s government Ultimi Barbarorum in a public place. Gone for them is the queasiness of having to placate a regime that believes calling for free elections deserves 11 years in jail for subverting party state power. I’m betting it’s a relief.

A postscript: I was surprised that several Shanghai-based European VCs and businessmen I follow on Twitter were among the cynics, berating Google for not conforming to Chinese/Asian business practices based on saving face, consensus and relationship-building, instead reverting to an “American” ultimatum. But these views come from individuals who have already made their peace with China’s political system, and whose business models and reputation do not depend on the unfettered flow of information. Perhaps some of them are unwittingly using the occasion to signal their own reliability as partners in China: “Look at us — we’d never consider doing what Google just did.” Google may have burned its financial bridges, but they are burning their moral bridges, making them the Stupid Cartesians of this sorry episode, Baruch.

More on the trading tax

Fellow collegiants Jay and the incomparable Cassandra carp in the comments of the previous post about, well, many things, but mainly about Baruch’s distrust of a trading tax. Their key points in favour of the tax are, I think:

  1. the financial sector is too big and needs to be shrunk and simplified, which is also Krugman’s key idea. A trading tax would be a step in the right direction
  2. there is a way to distinguish, mostly to do with timeframe, between “speculation” and “investment”. Generally two legs, sorry, speculation is Bad, leveraged speculation in highly liquid markets even worse and responsible for lots of the financial crisis. However, “informed and active” investment is Good; a trading tax would restrain one and leave the other unrestrained.

 If I’ve misunderstood something or left something out, let me know.

Firstly, I am very interested as to how we can possibly know how big the financial sector should be. Jay and Cassandra might answer “I don’t know exactly, but I just know it’s too big”. They might argue we expect too much of them; the sizing of any particularly important industry should be above anyone’s pay grade, let alone the responsibility of a couple of commenters on an obscure 3rd rate econo-blog.

Yes, well but that’s the point. We’ve largely done away with the type of industrial planning that pulled western economies out of the devastation of WW2, the period of MITI in Italy, the Marshall Plan, the last time we had an economic regime where people actually decided how big certain industrial sectors should be. That type of dirigisme worked in conditions of relative simplicity, where there were fewer moving parts to an economy, trade was restricted to controllable flows between large trading blocs, and exchange rates were stable. For most of the postwar period the financial sector of most economies was small, and mainly boring. In the UK, for example,  it was the preserve of a class of people drawn from the chinless children of an addled aristocracy. They really did wear bowler hats. Their tasks were simple enough for them to perform even after polishing off a litre of claret every lunchtime and leaving the office at 4pm.

I would argue the explosion in financial innovation and the size of the financial sector coincided with the increase in the overall complexity of the global economy from the early1980s on. Bretton Woods had broken down; there were extreme fluctuations in interest rates and costs of capital; the rise of Japan and other emerging markets were destabilising settled industries in Europe and the US; new technologies were creating new working practices and business models.  I am not saying a supersized financial system was the cause of this increase in dynamism and complexity. But what if it was a response?

Looking at where we are since 2000, we have a global economy which has made a step change again in complexity and dynamism.  Things have globalised to the extent that concepts of imports and exports have lost their meaning. Our economic system is optimised, primed to work at an extremely high level of just-in-time delivery. New business models pop into existence overnight, and destroy old ones — they demand and create capital and wealth at an unprecedented rate. And it’s largely great for everyone; most of us are richer. Literally billions of people have seen their living standards improve this decade. It’s been an exciting time to be alive.

This is an unpopular thought, but here goes: what if the current financial system is actually rightsized for our economy? Sized specifically to provide  the greater degree of economic dynamism we have come to expect, and on a much more massive geographic scale? Might there not be a price to pay in shrinking it?

Now let’s try look at the second debating point of my commenters and distinguish between “speculation” and “investment.” I still don’t understand the difference. But I don’t think anyone does; I am not sure there is a qualitative difference. Cassandra introduces the concept of (allocative) “efficiency” in the sense (correct me if I am wrong) that the hardworking “investor” with his longer-term timeframe performs a useful societal function in allocating capital to where it is needed. Short term specs, on this reading, do not.

I think this is wrong; speculative traders probably have as much or more allocative efficiency as the investment-minded ones. They have more money, for one thing, but more importantly even the highest frequency High Frequency Trader is actually tracking the portfolio decisions made by actual investors. Even Raj, at the height of his powers, was effectively allocating capital to companies which were showing better earnings. He just had the earnings release a bit before everyone else. Most short term specs, whether technical, quant or flow-driven, are really piggy-backing on investors; they basically buy the same stocks and amplify their decisions. Qualitatively, as I say, there’s no real difference, except they are either lazier or smarter than fundamentalists like me. Probably both; I bet they get home before 7pm. Is there a difference in holding period? Generally yes. But today I entered and exited a position in a tech stock in the space of 40 minutes. In fact it was a mistake. But I don’t feel bad about it. Do you think I should?

Cassie thinks it was the leveraged specs who blew us up in the crisis. No way. It was the leveraged investors. Those guys buying subprime weren’t in it for the quick buck; they were going to hold them for as long as they could borrow overnight at 5% and earn 7% on the bonds, ie as long as the then-current interest rate regime was going to last. Holding periods were measured in years. In the end were barely able to trade the stuff. That was the problem. As Jay puts it, “in less liquid markets, shareholders act more like owners” — they acted like owners, all right, and look where it got them, and us.

Look, a smallish trading tax may not make all that much of a difference, really. Financial markets will survive, and a tax will likely end up making a good few investment bankers richer than they would have been, when they come up with a way of avoiding it. There’s actually a trading tax in place in the UK already. It’s called Stamp Duty. I don’t know how much it is because I have never paid it on any of my UK trades, we use something called CFDs to avoid it. Everyone does this except low volume retail investors: Stamp Duty has thus merely become another way the little guy gets screwed. I am not sure this was the intention of its inventors.

But if you think discouraging speculation in liquid equity or forex markets is going to somehow prevent another crisis, think again. The root causes of our difficulties lay in a combination of too much easy money feeding a boom in illiquid debt securities, held for investment. A trading tax would do, and would have done, nothing to prevent any of those conditions from prevailing again.

Compromising my values every day, for you.

Right now active investors and speculators are about as popular as genital herpes. This is unfortunate because I, Baruch, am one of them.

Examples of this anti-speculator animus are everywhere. Paul Krugman has long had in mind the creation of a special level of hell for “Masters of the Universe”, as he calls us, not kindly, in his excellent Return of Depression Economics. He thinks I’m “socially useless”, if not dangerous, and wants to have a special tax levied on me. Alice Schroeder, author of the latest Warren Buffett biography (how clever of her to realise that another biography of Warren Buffet was what the world needed!), has a very maximalist interpretation of securities law. She believes it’s impossible “to make a living on Wall Street without compromising your values,” and goes so far to suggest that when it comes to investing, “It’s hard to make a living legally.” Felix Salmon, sworn enemy of active investing, links to a largely incomprehensible blogpost from profs Fama and French which suggests investing in mutual funds is like buying an index fund but you pay more fees, ie it is a bad idea and thus “alpha-peddlers,” people like me, are snake oil salesmen. AllAboutAlpha (HT Abnormal) put it best last month in an apposite post about the emergence “of a very quiet yet growing subset of individuals who believe that alpha still exists, but that getting it isn’t, dare they say, legal.”

Summing it all up, the charge sheet goes as follows: 

  • institutional investors like me are unable to deliver things we claim we are able to deliver, viz outperformance, alpha, whatever you want to call it.
  • As such my activities make no contribution to society and perform no useful function. In fact we are positively dangerous, and our widespread use of illegal information makes us unethical to boot.
  • Society would benefit much more if retirement savings were invested in index funds, which contain all the upside of equity investing but at lower cost, and meanwhile the rest of us who foolishly insist on trading for a living should be taxed. 

A lot of this stems from the traditional malice and envy of those who “review”  for those who “do”. We can’t do much about that. But there are intellectual assumptions behind some of it which are worthwhile tackling. In my opinion it all boils down to the hoary chestnut of the strength, or weakness, of the Efficient Market Hypothesis. The critics above share a belief in a strong form of EMH, which precludes investors from making returns which persist, and drives the less scrupulous to cheat in order to fulful their promises. Alice Schroeder puts it like this:

There is only so much alpha — that excess return above a baseline average — to be had in an efficient market. The incentive to create some artificial alpha one way or another is very high. Those who bend the rules successfully post good numbers, which adds to pressure on other Wall Streeters to push the gray boundaries of legal information flow.

What I do NOT propose to do here is get into the statistical nitty gritty of whether a strong or weak EMH is provable or improvable by positive hedge- or mutual fund returns, or their absence. I don’t quite know how to do it, and it’s deathly boring anyway. What we can do instead is weigh the intellectual coherence of the charge sheet. Is a financial system re-engineered to discourage speculation a good thing? Would it work? What would it be like?

This is what Baruch thinks: these objections to active investing are not at all coherent: firstly, we really don’t want a truly efficient market — it would be a disaster. Secondly, any restraint on speculation would endanger proper investment. The two are inextricably intertwined. Thirdly, index investing is not a truly scaleable strategy; if all of us do it, it will stop working. Let’s go through each of these points in turn.

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$1.3 million lost in blatant but failed attempt at insider trading?

The blogosphere made the catch! The Interweb protects the rest of us from evil doers! The world is ablaze with the news that prior to the 3Com buyout announced by HP last week, there was an unusual amount of volume in the $5 november call in 3Com. We’re all pretty sensitised to insider trading at the moment, and so this looks as clear cut and beautiful a case of  evil-doers caught with their hands in the till as we are likely to see in our time on earth. As Tyler Durden puts it:

This is so blatant it is sufficiently stupid that even the SEC will presumably catch the perpetrator. Here’s to hoping the trader ends up being Galleon’s Raj Raj buying options from his E-Trade account while on bail. Of course, we fully expect any prosecution case against the perpetrator to fall apart at the seams courtesy of a completely inept legal team at the SEC and the Justice Department.

Oh really? Before the Zero Hedge folks get the pitchforks out, let’s stop and think a bit. Let us be splitters, and not lumpers, and we might see that would be quite reasonable for the SEC and DoJ not to prosecute anyone at all. Using the principle of Occam’s Razor, they may well tend to conclude that no insider trading took place. At least not in the options, the underlying or common may be a different matter.

Let’s get technical here. In the case of the unusual volume in the 3Com options, you should know that incredibly unusual volumes in options is not terribly unusual, if you follow me. It is in fact the case that the volume of a particular option resides, as Taleb would have it, in Extremistan. It is subject to many many days of low and limited trading, and very few days of extremely high volume, orders of magnitude above the norm, where most of the total volume traded in the life of the option takes place.  This occurs most notably in the final month of the option’s life. This is so because people are more likely to buy a particular option when its intrinsic value (the portion of the option price described by the difference of the strike and underlying prices and its volatility) is highest in proportion to its time value and its total value. This is when you get the most “bang for your buck”, as Baruch puts it — roughly 2 weeks before expiry, the option is in its prime, near its most efficient for hedging and speculative purposes.

That’s what people use options for, mostly. Hedging, and speculating. Options are excellent as a way of profiting moderately, or reducing losses, in conditions of risk and uncertainty. As a way of playing a dead cert, however, options are pretty crap. Had someone concrete knowledge of the 3Com deal, it would be far more efficient to buy the stock. The most important of the “Greeks”, as options dudes call the panoply of statistics surrounding options, is “delta”, the rate of change in the value of the option relative to the value of the shares (it’s a function of volatility, time to expiry, a whole lot of stuff, don’t trouble your head), and this is always less than one. 3Com options buyers made far less money on the takeover by buying options than they would if they had bought the stock.

Assume the 4,000 Novs and the same in Dec calls that day came from a single buyer. S/he bought an economic interest in 800,000 COMS underlying. Purchased at 65c and 85c, both calls popped post the announcement to $2.50. Hooray, a profit of $1.4m. But trading the underlying, buying at $5.611 would have given $1.52m profit. The other thing favouring the underlying as the vessel for insider speculation was that it was so much more liquid than the options. Buying 800,000 COMS would have been a drop in the lake of the volume that day, which saw 22m shares change hands. It would also have been much, much less conspicuous, and we wouldn’t even have a story. These were pretty stupid inside traders, indeed, who not just left money on the table by playing the options, but drew extra attention to themselves by doing so.

Though of course, if you want to insist on the inside trading thesis, you can always posit insiders with limited funds who couldn’t afford 800k underlying shares. So the DoJ in its inquiries should be able to exclude institutional investors. Or at least competent ones. But come on; is it the simplest explanation? Or is it actually a stretch?

Perhaps it was insider trading, but we have to posit incompetent and poor insiders for the thesis to work, and while possible this seems less likely than other explanations. A less complex interpretation for the COMS trade is that shorts, not long insiders betting on a takeover, got spooked and decided to hedge. Over 10m shares of COMS were shorted at the end of October, a proportion which might have remained stable into the takeover. Rumours fly about all the time, and 3Com has been known to be a takeover target since like forever. A 20% to 50% gap move in a big short can seriously spoil your day, if not your year, and a call position is an excellent way to hedge, to take the sting out, to make an existential 50% loss into, say, a merely unpleasant 10% one. When COMS has cancelled a roadshow, you’re seeing weirdly high volumes and a breakout, it’s actually pretty prudent for a short to hedge a bit with calls against a takeover.  

This sort of trade, moreover, happens all the time. Just this Friday, PALM November $12.50 option volume went through the roof; never mind a measly 4,000 contracts, they traded 21,000 on the day. The occasion was the the ridiculous suggestion, no doubt assiduously spread by inscrupulous holders eager to get out with some honour, that Nokia would be taking them over that weekend. The volume can probably be explained by the fact that PALM is probably the most shorted tech stock around at the moment, and more likely than not it was this lot, not numpty spanners who actually believed this crap, who bought most of the calls to cover their arses just in case. It would have been evidence of insider trading, of course, had there been an actual takeover at the end of it, and no doubt we would all be tut-tutting about the state of the markets today and how it’s all stacked against the little guy.

As it is, there wasn’t. At least there hasn’t been yet. And the owners of the options, who bought at 65c (they last traded at 23c) have until friday for the takeover to happen, after which the options will expire worthless with PALM at its current price. That will be $1.3m down the tubes. If that was money for speculation, it would have been painful for all but the biggest fund. If it was merely shorts paying up for insurance against getting their faces ripped off it would be more than bearable. You tend not, after all, really want your hedge to be making you money.

“To speculate,” the prophet said, “is human. But to hedge is divine.” The game is not just stacked against the little guy, it’s stacked against everyone, which is why some cheat. At least the little guy probably has a day job. It’s not wrong to be aware of what is probably widespread insider trading in stockmarkets today. But it’s probably very important to aim for the real evil-doers, the ones who pay executives to “get the quarter”, who know exactly what the company is going to print to the decimal point, and who have covered the tracks of their entry in a way specifically designed not to be noticed. We should get these guys, they suck, and Baruch can only applaud the FBI for the way they have handled the Galleon case. But we do need to stop and think before we throw premature accusations that may get innocent hedgers into hot water and don’t help anyone to make the game fairer.

Inside Men

Crikey. Looks like they’re going after Stevie Cohen now. For context, SAC Capital is the leading hedge fund of our time. They get to charge not 1 and 20, not 2 and 20, but 3 and FIFTY to their punters. And like La Gavroche, they get to decide who gets in; most of the funds are closed, with waiting lists up the wazoo. They’ve done this through nothing but creating consistent, (suspiciously?) persistent, 20% plus returns a year for god knows how long. SAC is the “smart money” you would follow if you knew where it was going; Baruch has known traders do that, no questions asked. And why? Because you just reason that they know something; they always do. How ominous that sounds now.

If SAC goes down like Galleon did it’s a much much bigger deal. I don’t mean the trading impact on the market, although there might be some — SAC is a rapid-fire trading house and will likely be positioned in mostly highly liquid securities. What I mean by a bigger deal is in an Ivan Boesky sort of way, a Drexel Burnham Lambert, a Defining Moment of Wall Street Greed sort of thing. A number of awful mini-series will be made about it. It may even turn out to be worse than that.

It’s clear too, the other half of the vast conspiracy (should it be proven to exist, of course) lies among technology stock executives, at least among those high enough up the chain to know the numbers. So far, at least, executives at IBM, Intel, 3Com, Atheros, and Polycom are supposed to involved. This is a highly representative list, across many tech subsectors and market caps. It’s not unreasonable to think staff at other companies are going to be indicted. Galleon’s original investors seem to have been tech executives who used to talk to Raj when he was a sell-side analyst, ie his sources, his informal “channel checkers”. Even if no brown envelopes changed hands initially, secretly advising a fund you have invested in p.a. on sensitive stuff doesn’t seem a stretch on the part of the executives, especially if it took place before RegFD. The relationships may have then become formalised, secrets in exchange for cash — is it unreasonable to imagine that the original conflict of interest sowed the seeds of the greater, and more obvious crime later on. If I was one of the Feds working the case I would view identifiying the early and later investors in Galleon as an avenue of enquiry rich, shall we say, in possibility.

Now it’s not just Galleon involved, but a horde of satellite hedgies with obscure names, and some of the managers who have started to cooperate with the authorities seem to have worked at SAC. “People familiar with the matter” (ie most likely the prosecutors themselves) have told the WSJ that SAC are the ones they’re gunning for. Given the size of the target, the prosecutor who can pull off this one is, on past form, a dead cert to be mayor of NYC, or at least state governor, and eventually will have the chance to become a cross-dressing presidential candidate.

If indictments are really going to be sent out, a number of half-formed thoughts spring to Baruch’s mind:

  1. this is grist to the mill of the “you can’t make money in the stock market crowd”, the Felix Salmons of this world* who would have us all invest in index funds and ETFs. This is terrible, not just for people like me who depend on belief that a small number of gifted investors are capable of consistent, though not necessarily persistent, returns. No, it also, reductio ad absurdiwhatever, will make the stockmarket less liable to make any distinctions between companies whether they be good ones or bad ones — the very life force of capitalism itself
  2. highly successful “fundamentalist” hedge funds may now have to spend as much time excusing suspiciously excellent performance, just as more unfortunate ones have had to traditionally spend time explaining away bad returns. In many cases this may be difficult, as the successful ones no doubt touted their “informational edge” as a way of getting the investors in in the first place.
  3. because of this I can’t decide whether this is good for us honest fundamental investors, or bad. At worst, the boundaries of what we consider ethically and legally acceptable may stray. What we could call the “brown envelope” investment strategies are clearly not kosher, but what about ones where legitmate “homework” brings about the same result? How exactly is a sell-side channel check, communicated to a limited number of paying clients, conceptually different? Insider trading as a concept does not have hard edges, and innocents may get caught up in the net, or much worse, be encouraged to stop doing any digging at all. Maybe investors will conclude that all the fundamental investment strategies are at risk, and eschew the class altogether in a “kill them all, god will know his own” sort of way. At best, however, the money invested in dodgy funds may find a home with more honest practitioners, and, much more to be hoped for, fund investors themselves may reset unrealistic expectations for consistency of returns. Larger drawdowns will become more acceptable, as will greater volatility in monthly and quarterly track records. In other words, expectations will become more in line with what the real world actually doles out.

* of course, Felix Salmon has many other opinions, some of which are even correct.