Tagged: hedges

Cans and Roads

The problem with kicking the can down the road is what happens when you reach a hill.

Speaking of hills, Taos wasn’t what we’d expected.  Galleries cluster the square, yes.  We loved our circuitous bike ride along the foothills to Arroyo Seco. El Meze boasts views, an iron-chef James Beard winner and delectable fare. The Rio Grande Gorge nearby inspires awe.  But you won’t find posh on La Placita at Paseo del Pueblo Sur. Julia Roberts bought Don Rumsfeld’s 40-acre ranch here to escape Rodeo Drive, not to replace it. Taos is backwoods, weedy, agrarian, a bit Baja. Signature dish? Fry bread at Ben and Debbie’s Tiwa Kitchen down the dusty street from Taos Pueblo, a Native monument.

Do you know what a whole life insurance policy is? It’s money for death that first builds cash value.  You might suppose there’s little connection to either Taos or investor relations. Conventional wisdom taught folks to “buy term and invest the difference.” Why blend your hedge with your investment? Insurance by definition is the price you pay for the unexpected, and investing used to be the opposite.

At Taos Pueblo, for a thousand years the people bested marauders with adobe walls and wooden ladders. The apartment-like construction permitted entry through holes in ceilings doubling as doors. If enemies breached walls, occupants pulled ladders and the complex transformed into an impenetrable fortress.

Today Taos Pueblo is a reservation with a casino down the road. Doors and stairs have replaced holes and ladders and the wall once 10-15 feet high is now a short decorative reminder re-plastered annually for the tourists. Residents count today on the federal government.

Whole life insurance is effectively what’s gotten the planet into trouble. A policy is an agreement to exchange value. Say $1 million. It’s a contract costing you a sum and guaranteeing you a million dollars if you die, which also lets you leverage the amount you’re spending but with immediate impact on the contract’s value. It’s a complex derivative. AIG offered them. The contract guarantees a return, so AIG got insurance on the insurance from a reinsurer and transferred the remaining risk to brokers like Lehman Brothers, which bought mortgage-backed securities to offset promises to backstop AIG’s commitments to pay life-insurance contracts a guaranteed return.

This all works fine until you come to a hill. Take Greece. So long as the value of assets – homes, stocks, bonds, art, commodities, on it goes – rose, everybody got a guaranteed return and one out of three people could work for the government and still expect to retire at 50 with a pension. That concept came to a chaotic halt when stuff stopped rising in value. Now we wait for a conclusion or a shoe smacked into the can rolling up the rising road.

For most of a thousand years Taos Pueblo ruled its domain and relied on nobody.  Today you take Camino del Pueblo north from Taos Plaza until it dead-ends into a dirt parking lot, where you pay a fee to visit.

What were they doing for a millennium that worked so much better? One could say, “No, Europeans showed up. That’s what stopped it.” Sure. The lesson that you’re better off relying on nobody stands, even if that means you don’t have doors and instead have holes in ceilings, and ladders. Is anybody paying attention?

Back to IR. Your shares today are a whole-life insurance policy.  They’re an asset with associated costs and capacity for leverage via indexes and ETFs, options and futures. All of it is interconnected.  Your story becomes secondary to liabilities and yield.  I’m sorry to tell you so but it’s a fact.  It must be part of what you explain to management or you’ll be leaving out the linchpin of contemporary capital markets.

History is predictive analytics.  The fundamental flaw in our global model is simple. You cannot guarantee a future without hills and if your model depends on kicking cans down roads, sooner or later the can will roll back to you.

The solution?  Simplicity.  Occasional inconvenience. Something a bit Baja. You may have to crawl through a hole in the ceiling. Cutting a door in the wall makes life easier but supposes risk is gone permanently.

We’d warned in May that June might be the roughest month since last autumn in what is our ongoing Great Risk Asset Revaluation. It was, though it took longer than we thought.  We’re not through this turbulence. We’ve reached a hill, of some sort.

Taos Pueblo still stands and its people are delightful and resilient as are humans generally regardless of whole-life insurance policies and risk-transfer. But tomorrow comes, and convenience costs. That’s today’s capital-markets lesson.

Wag the Dog

Today a new era begins.

One day in May 1792, 24 brokers gathered beneath a buttonwood tree in lower New York City and agreed to confederate in conducting their stock-in-trade. Thus began the New York Stock Exchange.

Today, the NYSE is slated to cease trading publicly. The InterContinental Exchange – The ICE – cleared final regulatory hurdles and closed the transaction.

It’s a study, an archetype, of the monumental change these last 15 upending years in equities, that The ICE is a derivatives market that didn’t exist when the Order Handling Rules in 1997 fundamentally shifted market orientation from investing to intermediation.

You’ve heard the cliché about the tail wagging the dog? Derivatives depend for existence on some underlying thing, an asset. Where derivatives have exploded in securities markets everywhere, equity assets have shrunk, not in value but in number. Keep this thought in mind. We’ll come to its significance.

According to SIFMA, the trade association for US capital markets, interest-rate derivatives alone reflect about $600 trillion of notional value. Compare to assets from US investment companies directed at US equities, according to consultancy Towers Watson and the Investment Company Institute: Roughly $11.4 trillion from a total $34.2 trillion under management. Dwarfed.

Sure, other assets in US equities originate internationally. But there’s been a colossal shift since 1972 (an ironic numerical anagram), when derivatives began to percolate globally as first the dollar and then the raft of global currencies departed from mooring gold, creating value uncertainty that had to be hedged in securities markets.

The pace gained steam in the 1990s and in equities it coincided with a reversal in the number of public companies in the National Market System. That figure peaked near 8,000 in 1998, data from Wilshire Associates shows. (more…)

We were in San Francisco Sunday escaping the heat parching most of the country. Cool heads are better than hot heads, we thought. It was nice to need a sweater.

Speaking of needing things, there’s a flaw in consensus estimates. Consensus by definition means it’s the general view. But the general view reflected by estimates of earnings, revenues or cash flows comprises less than 15% of total market volume.

Across the market, we find that about 12.5% of substantive volume is what we’d call rational – driven by thoughtful investment derived from fundamentals. How can this be? Great swaths of trading today are driven by relative value – the current value of this basket of things versus that basket of things.

Somewhere around 30% of volume is this kind of trading that we consider program trading. It’s driven by market factors and relative value. After all, currencies that denominate securities have only relative and not intrinsic value. Should we not expect trading instruments to behave the same?

What’s more, some 65% of total market volume on average is just air created by the maker/taker model prevailing across global exchanges, in which we’ve all been fed this line of hooey that a massively mediated market is better for buyers and sellers than one with few intermediaries. When in the history of human commerce has it been more efficient to cut the middle man in rather than out? (more…)