Tagged: risk

Supine Risk

We’re in New York this week while companies gather in Dallas for the annual NAREIT conference, the association for real estate investment trusts.

Real estate is about 3% of the S&P 500. By comparison, Technology is 23%, the largest by a wide margin over healthcare and financials (a combined 27%).  Yet large REIT Exchange Traded Funds hold more assets than big Tech ETFs, with the top ten for each managing $54 billion and $46 billion respectively.

The implication is disproportionate influence in real estate from passive investment. With market sentiment the weakest in more than a year by our measures, I’m prompted to reflect on something we’ve discussed before: Risk in passive investment.

One might suppose that investments following models are less risky than portfolios built by selecting stocks on fundamental factors. Singling out businesses leaves one open to wrong decisions while baskets diffuse risk. Right? Look at Vanguard’s success.

Yes. But missing in these assumptions is what happens when concentrated assets are bought and sold. The biggest real estate funds are mainly at Vanguard, Blackrock, State Street and Schwab. It’s probably true across the whole market.

Behind ETFs, stocks are concentrated too. We’ve described how the top thousand stocks are more than 90% of market volume, capitalization and analyst coverage. Just 8% of assets are in the Russell 2000, the bottom two tiers of the Russell 3000. And there are barely more than 3,300 companies in the Wilshire 5000 now.

Lesson: Everything is big. One reason may be that money buys without selling. Inflows are topping outflows (hint: That has now stopped for the first time in over a year), so indexes aren’t paying out capital gains, skewing returns, as Jason Zweig wrote in the Wall Street Journal Nov 10.

Mr. Zweig highlights the PNC S&P 500 Index Fund, which is distributing 22% of assets as a taxable gain because people have been selling it.  The fund has performed about a third of a percent behind peers. Add in capital gains and the sliver becomes a maw.

Mr. Zweig notes that some big funds including the Vanguard 500 Index and the State Street Institutional S&P 500 Index Fund haven’t paid out capital gains in more than 15 years. If investors aren’t cashing out, assets aren’t sold, capital gains aren’t generated, and results don’t reflect underlying tax liability.

To me there’s a bigger passive risk still. With more money chasing the goods than selling them, things perpetually rise, turning investor-relations professionals and investors alike into winners, but begging the question: What happens when it stops?

I’ve always liked Stein’s Law as a bellwether for reality. If something cannot last forever, said Herb Stein, father of famous son Ben, it will stop. Since it cannot be true that there will always be buyers without sellers, the prudent should size up what happens when giant, concentrated owners shift from buying to selling.

To whom do they sell?

And how can we have buyers without sellers?  Mr. Zweig talks about that too, indirectly. We’ve written directly about it (and I’ve discussed it with Mr. Zweig).  Indexes and ETFs may substitute actual shareholdings with something else, like derivatives. If you can’t find an asset to buy, you buy a right to the asset. This idea torpedoed the mortgage market. You’d think we’d learn.

There’s a rich irony to me in equities now.  During the financial crisis, regulators bemoaned the long and risky shadows cast by giant banks too big to fail because failure would flatten swaths of the global economy.

That was just banks. Lenders.

What we’ve got now is the same thing in the equity market, but risk has transmitted to the assets we all depend on – not just the loans that leverage dependency.

It’s the most profound reason for future policymakers (Jay Powell and Steven Mnuchin) to avoid the mistakes made by the Bernanke Generation of central bankers, who depressed interest rates to zero out of frantic and preternatural fear of failure.

The absence of reasonable interest rates devalues money and pushes it into assets at such a profound rate that for very long stretches the only thing occurring is buying. Result: Everything is giant, and concentrated – the exact opposite of the way one diffuses risk.

When it stops there are no buyers left.

How to get out of a problem of this magnitude?  Quietly. If enough people tiptoe away, there will be buyers when everything is properly priced again.  The hard part is knowing when, because passive risk reposes supine.

Culmination

Outcomes are culminations, not events.

Denver bid farewell this week to retiring Broncos quarterback Peyton Manning who for eighteen years accumulated the byproducts of focus, discipline and work, twice culminating in Super Bowl victories.

The idea that outcomes are culminations translates to the stock market. What happens today in your stock-trading is a product of things preceding today’s culmination just as our lives are accumulations of decisions and consequences.

Rewind to Feb 11, 2016. The S&P 500 hit a 52-week low of 1829. Recession fears were rippling globally. European banks were imploding, with some pundits predicting another 2008 crisis. China was lowering growth views and weakening its currency to pad the landing (word since is some 5-6 million workers will be laid off through 2017).

In apparent response, the US stock market soared, recovering to November levels. If the market is a proxy for the economy, it’s a heckler hurling eggs. Wiping away yolk, pundits said markets expecting monetary tightening from the Federal Reserve saw stasis instead. Recession fears were overblown and an overly reactive market rebounded.

But headlines don’t buy or sell stocks, people and machines do.  Markets move on money. This is what we’ve learned from more than a decade of market lab work, repeating behavioral measurements with software, servers, algorithms and models.

Follow the money.  The most widely traded equity in the world, SPY, is a derivative. It’s an Exchange-Traded Fund (ETF) tracking the S&P 500.  Nearly 50% of all options volume ties to it.  In 2016 so far almost every trading day at least 12 of the 25 most actively traded stocks were ETFs.

Why do we say ETFs are derivatives? Because derivatives extend access to assets, exactly the thing ETFs do. They’re securities trading on underlying stocks without owning them. The sponsor owns assets, yes. But ETF investors hold only a proxy.

ETFs depend on arbitrage. Rules the SEC approved for ETFs effectively sanction use of information the rest of the market doesn’t know about demand by the big brokers who produce ETF shares for trading.  These brokers are continually shorting index components and derivatives or ETF shares to close the gaps that form between the value of the ETF and what it represents (stocks, sectors, commodities, bonds, indices).

In the stock market, the price-setters are primarily short-term traders (high-frequency firms) arbitraging small price-divergences in many things simultaneously. ETFs are stocks that provide exposure to other stocks, sectors, commodities, bonds and indices. For arbitragers, they’re a massive additional layer of arbitrage permutations:  How might this financial ETF vary with that energy futures contract, and this basket of energy stocks?

What develops in this market is a disregard for fundamental factors. Prices are mathematical facts. Spreads drive directional-change. The market’s purpose devolves from economics to how to price a stock, sector, commodity, bond, futures contract, option or index relative to things associated with it or its value at a point ranging from fractions of seconds to next month before a derivatives contract expires.

It’s not investment but arbitrage of such scale and size that few recognize it. Yesterday, the most actively traded stock was the VelocityShares 3x Long Crude ETN linked to the S&P GSCI Crude Oil Index Excess Return (UWTI).  Yes, that its name! It’s an exchange-traded product backed by Goldman Sachs, and it dropped 13.3%. Offsetting, the eighth most active stock was DUST, the Direxion Daily Gold Miners Index Bear 3x Shares, which rose 13.7%.

Neither DUST nor UWTI owns tangible assets. Their returns depend on derivative contracts held by banks or other counterparties. Now step back. Look at stocks. They are moving the same way but over longer periods. Market moves are a culmination of whichever directional trade is winning at the moment, plus all the tiny little arbitrage trades over ETFs, stocks, commodities, bonds and indices, tallied up.

There are two links back to fundamentals. First, banks back this market. Some of them are losing badly and this is what European bank trouble last month signaled. And this IS a consequence of Fed policy.  By artificially manipulating the cost of capital, the Fed shifted money from scrutinizing economics to chasing arbitrage opportunities.

When arbitrage has exhausted returns, the market will change direction again. It’s coming soon.  The bad news is the market has not yet considered economic threats and is ill-equipped to do so.

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.

Risk

We figured if The President goes there it must be nice.

Reality often dashes great expectations but not so with Martha’s Vineyard where we marked our wedding anniversary. From Aquinnah’s white cliffs to windy Katama Beach, through Oak Bluffs (on bikes) to the shingled elegance of Edgartown, the island off Cape Cod is a winsome retreat.

Speaking of retreat, my dad, a Korean Police Action era (the US Congress last declared war in 1943, on Romania. Seriously.) veteran, told me his military commanders never used the word retreat, choosing instead “advance to the rear!”

Is the stock market poised for an advance to the rear? Gains yesterday notwithstanding, our measures of market sentiment reflected in the ten-point ModernIR Behavioral Index dipped to negative this week for the first time since mid-August. Risk is a chrysalis formed in shadows, studied by some with interest but generally underappreciated.

It happened in 2006 in housing, when trader John Paulson recognized it and put on his famous and very big short. Most missed the chrysalis hanging rather elegantly in the mushrooming rafters of the hot residential sector.

It happened in the 17th century Dutch tulip bubble, an archetype for manic markets.  Yet then tulips and buyers didn’t suddenly explode but just the money behind both, as ships from the New World laden with silver and gold flooded Flanders mints with material for coin. Inflation is always and everywhere a monetary phenomenon.

It’s hard to say if mania is here hanging pupa-esque on the cornices of the capital markets. Most say no though wariness abounds. Mergers are brisk and venture capital has again propagated a Silicon Valley awash in money-losing firms with eye-popping values. Corporate buybacks will surpass $1 trillion in total for 2013-2014, capital raking out shares from markets like leaves falling from turning September trees. (more…)

Missing Volume

I’ve made South Dakota jokes – “fly-over state,” “waste of dirt that could have been used making Colorado larger,” etc.  Not again.

It’s but six hours by car from Denver and we love road trips, so we put a junket to Mount Rushmore on the calendar. Turns out there’s more to the “under God people rule” state than chiseled presidents. In Custer State Park (where never is heard a discouraging Ranger word) this fella ambled by while his brethren were at home on the range below Harney Peak and picturesque Sylvan Lake. Loved it. We’ll go back.

Speaking of gone, wither volumes? And should you worry?

A client yesterday asked about splitting the stock. Share volume is tepid, off nearly 75% since 2009, though dollar-volume (more important to us) is down less, about 40%. Should they do something to stimulate it, they wondered?

Weak volumes would seem cause for concern. It suggests a lack of consuming. It’s happening more on the NYSE than the NASDAQ.   In 2009, the NYSE averaged 2.6 billion shares daily, about $82 billion of dollar-flow. In 2014 so far, it’s 1.02 billion shares, about $40 billion daily.  The NASDAQ in 2009 saw about 2.5 billion shares and $60 billion daily compared to 2.0 billion shares and about $73 billion in 2014.

The big companies are concentrated on the NYSE, which has about 70% of total market cap.  Money is trading smaller companies, but not owning them, evidenced this year at least by sustained volumes for small-caps but weakness in the Russell 2000, down almost 2% this year with the S&P 500 up 7.5%.  Plus, shorting – renting – is rampant, with 44% of daily market volume the past 20 days, nearly half of trades, from borrowed shares.

Check the Pink Sheets and it’s stark. Volume is averaging about 14 billion shares daily in penny stocks in 2014, compared to about 2.3 billion shares daily in 2009.  Dollar volumes are small but have doubled in that time to $1 billion daily. KCG Holdings as a market-maker does over a 1.2 billion shares a day by itself in penny stocks.

And derivatives volumes have jumped since 2009. Global futures and options trading according to the Futures Industry Association totaled 21.6 billion contracts in 2013, up from 17.7 billion in 2009. More telling is where. In 2009, equity and equity-index derivatives volume was 12 billion contracts, identical to 2013. But energy, currency and metals derivatives trading has exploded, jumping 125% to 5.3 billion contracts in 2013.

The answer to where equity volumes have gone is into trading small caps and penny stocks and derivatives tied to energy, currencies and metals. Investors are searching for short-term differentiation and safety from uncertain asset values affected by massive currency infusions from central banks.

What’s it mean to you in the IR chair? Volume doesn’t define value. Witness Berkshire Hathaway Class A units trading 250 shares daily (about $47m). What matters is who drives it. Don’t give in to arguments for “more liquidity.” You’ll help short-term money, not long-term holders. We don’t think splitting your stock today improves liquidity or appeal to the money that matters.

Speaking of rational money, it averaged 14.5% of total equity volume the past 20 days. Tepid.  Where are active investors? Watching warily, apparently. What drives equity values right now is asset-allocation – the “have to” money that buys the equity class because the model says to.

And meanwhile that money is offsetting risk with derivatives in currencies, energies and metals. Take care not to draw the wrong conclusion about the value of your shares. It’s tied to things way beyond fundamentals at the moment.

Risk-Free Return

Everybody is talking about the weather. Why doesn’t somebody do something?

This witticism on human futility is often attributed to Mark Twain but traces to Twain’s friend and collaborator Charles Dudley Warner. A century later, it’s still funny.

There’s a lot of hand-wringing going on about interest rates, which from the IR chair may seem irrelevant until you consider that your equity cost of capital cannot be calculated without knowing the risk-free rate.

That and a piece in Institutional Investor Magazine some weeks back brought to my view by alert reader Pam Murphy got me thinking about how investors are behaving – which hits closer to investor-relations than anything.

When I say hands are wrung about rates, I mean will they go up? We’ve not had normalized costs of capital since…hm, good question. Go to treasurydirect.gov and check rates for I-Bonds, the federal-government savings coupon. I-Bonds pay a combination of a fixed rate plus an inflation adjustment. Guess what the fixed rate is? 0.00%. The inflation-adjusted return May-Oct 2013 is 1.18%.EE-Bonds with no inflation adjustment yield 0.20% annually. This is a 20-year maturity instrument. Prior to 1995, these bonds averaged ten-year maturities and never paid less than 4% annually, often over 7%. If the I-Bond pegs inflation at 1.18% every six months, translating to 2.36% annually, is the risk-free rate of return a -2.16%? (more…)

We were on the bikes at dawn in Denver where on the oval at Washington Park it was 45 degrees as the sun rose.  That’ll wake you up!

Speaking of waking up, did you read Sebastian Mallaby’s article in the weekend Wall Street Journal called “Learning to Love Hedge Funds?” Going back to the first hedge fund in 1949, run by Alfred Jones, Mallaby contends that hedge funds represent the optimal risk-management model.  Government tries to prevent bad things from happening. Hedge funds, where owners put their money at risk and earn returns when profits are produced, view risk as a pathway to opportunity, but one marked by prudent insurance, or hedges, against downside.  Jones produced cumulative returns of 5,000% from 1949-1968, Mallaby notes. (more…)