Monday, October 15, 2007

Veryan Allen: Bernanke puts and Minsky moments


Those who ignore history are condemned to repeat it but those who rely on history are condemned to blow up. Similarly those who believe in the ability of conventional economics or mathematics to model the emotional, non-random and illogical processes underlying financial markets are headed for problems. Also insufficient penalties for excessive risk taking often lead to bigger trouble later. Even if stock markets round the world continue to rally investors would be well advised to have lots of shorts, plenty of puts and a substantial weighting in other truly UNCORRELATED sources of return. It's called hedging or managing your portfolio risk in case you turn out to be wrong.

Recently I was trying to show some investors how speculative bubbles form, why intelligent does not mean rational and that market prices often exceed intrinsic value. I auctioned a $100 note, offering it to the highest bidder with the BINDING covenant that the 2nd and 3rd highest bidders must also pay. Sure enough $5, then $10 bids started things off but it was not long before the bids went far ABOVE the $200 level. This despite all those present being financial professionals with an alphabet soup of qualifications after their names and knowing, with certainty, that the value of the asset being auctioned was just $100. The actions of the people who bid $90 and $95 when someone else bids $100 are fascinating. After all, they are facing a certain large loss or they can...

Many investors right now are scared of being that second or third bidder. The incentives on offer mean the cost of NOT being the winning bid can be high. Some who invested in subprime CDOs probably knew they were overpaying but bought anyway due to the risk of underperforming their "peers". Buying China now at 6,000, India at 19,000 or USA at 14,000 might look "cheap" compared to the possibility of having to pay even more later, missing the rally or even worse having clients redeem from you to go into the fund that paid even higher. On another tack, take the recent ABN-Amro takeover saga. RBS won and Barclays stuck to its financial benchmarks but it was also the losing bidder. Barclays may have been correct to stay with its metrics but the cost of being second and emerging with nothing may be higher than management realise.

With so many fund manager searches decided on the basis of recent league table performance, the expense of not being the highest bidder can be significant. As well as stock and bond markets, auctions dominate asset sales ranging from private equity deals to distressed debt and it can often seem safer to be the winning bidder than an also ran. You have to be in it to win it so therefore it pays to bid high so as to avoid the "expense" of not winning. Research, due diligence and the cost of information gathering and analysis are also borne by losing bidders. Ultimately however, as we are already seeing with LBO leveraged loan syndications or real estate speculation, some end up wishing they had never participated in the auction at all. That is why markets oscillate in cycles of euphoria and depression and why stability is inherently unstable.

Adding fuel to the fire of auction-based securities markets is the possibility of moral hazard created when the risks of overpaying are not adequately punished. The "Bernanke put" was exercised last month so apparently everything is now fine! Time to dump those "expensive" hedge funds as the 5 year old bull market just got more rocket fuel? Not quite. With the dollar so low and oil and gold at highs the probability of recession must have been considered dire to warrant an immediate cut of 50bp. But can the cure for easy money be to provide more easy money? Could we be setting up for a period of recession AND inflation? In the last stagflationary period in the late 1970s the ONLY investment products that performed were, of course, hedge funds. Long only stock AND bond funds hate such times.

The faith in the power of the authorities is probably storing up bigger problems in the future. So many Chinese stock traders have insisted to me recently that the China government won't "let" China stocks go down because of the Olympics next year. Similarly USA stocks won't go down because the Fed is the Fed, even though protecting the stock market is not its direct purpose. If only the causality of central bank and government policy on financial markets were so simple. "Don't fight the Fed" has usually proved true but does not mean the Fed or other central banks always win.

Considering that August non-farm payrolls weren't -4,000 but were actually +89,000 the "reasons" for the rate cut might now be questioned. What confidence would investors think of a fund that first said it lost 0.4% and then "revised" to +8.9%. The error in economic statistics is so high that it is a wonder so many pay attention to the initial number. Inflation, in particular, seems higher than the inflation "numbers" are showing. If anything I suspect the rate cut decision came down to the risks of doing something aggressive (50bp) versus not (25bp). In the short term it is perhaps safer to give the crowd what they want even if it could be wrong in the long term.

It is a shame Hyman Minsky didn't ever receive the Nobel Prize in Economics. But then if he had, a bunch of neoclassical, equilibrium, efficient market dreamers would have had to return theirs. The recent Minsky moment is a reminder of the permanent instability of markets. And the inevitability of bull AND bear markets overshooting. Stock markets start by climbing a wall of worry but then clamber over it usually due primarily to the fear of being the second-bidder. Later markets quickly descend a cliff of chaos. Risk appetite, like pride, is always highest before a fall.

The recent volatility nicely demonstrated the value of hedge funds particularly the opportunities created out of crisis and then recovery. Buying and holding is not optimal compared to shorting before a problem is generally realised and then buying as the crowd overreacts to those problems. Now that the Bank of England has effectively "guaranteed" the deposits at Northern Rock and UBS, Deutsche, Citigroup and other banks have warned on earnings are the credit problems really over so quickly? The implosion of several credit risk premium products and Northern Rock are examples of skilled managers being able to make money on the down AND maybe the up.

Underlying the credit situation is a bear market in many areas of real estate that is likely not going away anytime soon. Lending without awareness of risk has similarities to Japan in early 90s; unconstrained lending and optimistic default assumptions and massive loans on collateral that historically had never dropped steeply in price. There were many false dawns in the numerous credit "recoveries" but Japanese real estate just kept going down. Again overlending is like the second bidder dilemma. Getting the deal looks better than completely missing it and underperforming your competitors' loan book or sales of mortgages. Perhaps other countries have learnt from Japan or more likely they haven't.

September has historically been the worst month for stock markets so the data miners won't be happy that it turned out to be such a strong up month. The final quarter is historically the best so it will be interesting if it is this time. According to the experts there is little chance of a bear market since Ben will be there with another 50bp cut if anything bad happens. Global economies and developed stock markets are so correlated these days that Fed decisions almost amount to Central Bank of the World decisions. You have to wonder how long dollar pegged currencies like the HK$ and Middle East currencies will want to get dragged down by a subprime currency like the US$. I wouldn't want to sell my oil for dollars unless they happen to be Canadian, New Zealand or Australian notes.

The so-called hedge fund crisis didn't seem to last very long. Just a month ago there were supposed to be wholesale redemptions because of a "horrendous" August (-1.5% INCLUDING the blowups and all the non hedge funds that wrongly get included in these "indices") but now apparently everything is fine. Hedge fund inflows continue and the firms that "calculate" hedge fund redemptions admit they did their sums wrong just like governments can't seem to count new jobs accurately. The main lesson of last quarter was losing 20 or so investment products out of over 10,000 (0.2%) that purported to be hedge funds and whose assets were quickly taken over by real hedge funds and the "discovery" that some public domain alternative investment strategies are now a tad crowded and contageous.

August was a bad month for hedge funds but September was one of best months ever for hedge fund performance. Recency bias is perhaps the most pernicious disease in finance. Funny how many supposed long term investors worried about just a few weeks of hedge fund turbulence. Now with the September data point in, all is forgiven at least until the next drawdown. I find the common reaction to good hedge funds in a temporary loss to be silly. A good stock that goes down is a buying opportunity; a good hedge fund that has a rough quarter is also a buying opportunity. I wonder how many redemption notices were cancelled recently.

New strategies that are not crowded performed well. NEW quant strategies were able to make money out of OLD quant strategies. Real credit hedge funds and short sellers took advantage of the long biased credit crowd. Carbon trading, shipping freight and property derivatives have all created new alpha opportunities. Many established strategies were affected despite the previous appearance of being independent. Investors demanding transparency has led to significant strategy know-how leakage and trade crowding to less-skilled firms. Interesting how the market gets LESS efficient and MORE irrational as more "smart" money enters the field; precisely the opposite of what "should" happen. That is because the smartest money gets to arbitrage the money that isn't as smart as it thinks. There is MORE alpha available than ever before; it just requires higher skill and uncrowded methods to capture it.

The investment universe offers a universe of opportunities and the more "hedge funds" there are, the better chances for the GOOD hedge funds to make money out of them. With the hedge fund industry still so tiny at $2.5 trillion AUM, compared to the much larger future demand, the scope for new funds, new strategies and new asset classes is clearly going to continue to grow. It won't be a straight line of course but I wouldn't consider the hedge fund industry mature before $25 trillion AUM so there is clearly a lot more industry expansion. There are so many NEW ways and NEW products appearing to make money in global finance.

The second-bidder auction was first devised by Martin Shubik and later popularised by Marvin Minsky. I find games like that closer to how market participants actually behave than the wider known ideas like "Greater Fool" or Prospect Theory. In many parts of the world there are still plenty of $200 bids for $100 securities going on right now. Am I therefore bearish? Since it is entirely possible those bids could go to $300 or $400, no.

I try to ride steamrollers not collect nickels in front of them although I jump off if there is a another steamroller approaching from the other direction. So I am bullish; not on the stock or bond markets, of course, but on the ongoing availability of low risk alpha generating opportunities and the existence of fund managers with the skills to identify them. The ONLY two things to be ALWAYS long of are alpha and volatility; everything else needs to be hedged.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.