| Arete Quarterly Q114 |
Welcome
Several years ago Monster.com firmly established its brand in job hunting with a famous television ad entitled, "When I grow up" (You can watch the video on youtube). It features several snippets of kids listing their career aspirations. It starts with, "When I grow up," and follows with statements like, "I want to file all day," and "I want to have a brown nose," and "I want to be a 'yes' man."
The humorous list touched on challenges all of us face in our careers and in doing so, was an effective reminder for the audience to, according to businessinsider.com, "seek better opportunities that live up to childhood dreams."
This ad came to mind as I was reading the latest Michael Lewis book, Flash Boys: A Wall Street Revolt. Perhaps nowhere have childhood dreams become more corrupted than on Wall Street and Flash Boys delivered the message loud and clear as it relates to high frequency trading (HFT). I doubt if there are many who think Wall Street is completely innocent, but the insights from Flash Boys reveal a magnitude of bad behavior that can be shocking even to seasoned finance veterans.
Even one of the central figures in the book, Brad Katsuyama, a seasoned trader, underestimated the degree of misconduct. He had worked for Royal Bank of Canada and left to build a team to create a new stock exchange.
The new exhange was designed to ensure orders were matched fairly largely by confounding HFT efforts to cheat the system. As Lewis explains, however, “Brad’s biggest weakness, as a strategist, was his inability to imagine just how badly others might behave … He hadn’t imagined that they [big banks] would use their customers’ stock orders to actively try at their customers’ expense to sabotage an exchange created to help customers."
Interestingly, few of the key players seem to harbor any significant resentment for individual behavior; people just respond to incentives as we all do. Lewis certainly directs some harsh criticisms to individuals, but reserves the harshest admonitions for the system as a whole. As he describes, "The deep problem with the system was a kind of moral inertia. So long as it served the narrow interests of everyone inside it, no one on the inside would ever seek to change it.”
One manifestation of this credo is the fragmentation of the big picture such that exceptionally few participants ever fully understand their contribution. One example of many is, “The customer guy was better at his job - and had deniability - if he remained oblivious to whatever the prop guy [proprietary trader] was up to.” This is a significant risk to investors at all levels. The person you know, the person you trust, may just not know, or not want to know, what is going on in the big picture.
Despite the increasingly obvious flaws to the market structure, change has been resisted because so many people benefit from the arrangement. As Lewis describes, “It wasn’t easy … to try to effect some practical change without a great deal of fuss, when the change in question was, when you get right down to it, a radical overhaul of a social order.”
Even this understates the challenge, however. During one meeting, Lewis described an investor’s comments: “'It seems like there is a first mover risk for someone to behave the right way,' he said. He was right: Even banks that were behaving relatively well weren’t behaving all that well.”
While Flash Boys focuses on HFT, it is a microcosm that illuminates important realities of the broader financial industry. In doing so, it provides valuable lessons for those of us who participate in any part of the industry.
One lesson is to highlight the shocking extremes of bad behavior. Our mental models of behavior need to be re-calibrated to incorporate much more extreme behavior in the world of finance. Another lesson is to appreciate that it is exceptionally difficult to get good, complete information from a corrupted, insular system. Most of the time that can only happen from outside of the system as Katsuyama and his team have done. Best wishes to them!
Finally, one of the most telling insights of the book comes in its acknowledgements. Lewis describes, “The people who work in these firms have grown more cynical about them, and more willing to reveal their inner workings, so long as their name is not attached to these revelations.” While the Wall Street “system” is still largely in place, cracks are appearing. Perhaps some day more finance industry participants will be able to live up to childhood dreams.
Several years ago Monster.com firmly established its brand in job hunting with a famous television ad entitled, "When I grow up" (You can watch the video on youtube). It features several snippets of kids listing their career aspirations. It starts with, "When I grow up," and follows with statements like, "I want to file all day," and "I want to have a brown nose," and "I want to be a 'yes' man."
The humorous list touched on challenges all of us face in our careers and in doing so, was an effective reminder for the audience to, according to businessinsider.com, "seek better opportunities that live up to childhood dreams."
This ad came to mind as I was reading the latest Michael Lewis book, Flash Boys: A Wall Street Revolt. Perhaps nowhere have childhood dreams become more corrupted than on Wall Street and Flash Boys delivered the message loud and clear as it relates to high frequency trading (HFT). I doubt if there are many who think Wall Street is completely innocent, but the insights from Flash Boys reveal a magnitude of bad behavior that can be shocking even to seasoned finance veterans.
Even one of the central figures in the book, Brad Katsuyama, a seasoned trader, underestimated the degree of misconduct. He had worked for Royal Bank of Canada and left to build a team to create a new stock exchange.
The new exhange was designed to ensure orders were matched fairly largely by confounding HFT efforts to cheat the system. As Lewis explains, however, “Brad’s biggest weakness, as a strategist, was his inability to imagine just how badly others might behave … He hadn’t imagined that they [big banks] would use their customers’ stock orders to actively try at their customers’ expense to sabotage an exchange created to help customers."
Interestingly, few of the key players seem to harbor any significant resentment for individual behavior; people just respond to incentives as we all do. Lewis certainly directs some harsh criticisms to individuals, but reserves the harshest admonitions for the system as a whole. As he describes, "The deep problem with the system was a kind of moral inertia. So long as it served the narrow interests of everyone inside it, no one on the inside would ever seek to change it.”
One manifestation of this credo is the fragmentation of the big picture such that exceptionally few participants ever fully understand their contribution. One example of many is, “The customer guy was better at his job - and had deniability - if he remained oblivious to whatever the prop guy [proprietary trader] was up to.” This is a significant risk to investors at all levels. The person you know, the person you trust, may just not know, or not want to know, what is going on in the big picture.
Despite the increasingly obvious flaws to the market structure, change has been resisted because so many people benefit from the arrangement. As Lewis describes, “It wasn’t easy … to try to effect some practical change without a great deal of fuss, when the change in question was, when you get right down to it, a radical overhaul of a social order.”
Even this understates the challenge, however. During one meeting, Lewis described an investor’s comments: “'It seems like there is a first mover risk for someone to behave the right way,' he said. He was right: Even banks that were behaving relatively well weren’t behaving all that well.”
While Flash Boys focuses on HFT, it is a microcosm that illuminates important realities of the broader financial industry. In doing so, it provides valuable lessons for those of us who participate in any part of the industry.
One lesson is to highlight the shocking extremes of bad behavior. Our mental models of behavior need to be re-calibrated to incorporate much more extreme behavior in the world of finance. Another lesson is to appreciate that it is exceptionally difficult to get good, complete information from a corrupted, insular system. Most of the time that can only happen from outside of the system as Katsuyama and his team have done. Best wishes to them!
Finally, one of the most telling insights of the book comes in its acknowledgements. Lewis describes, “The people who work in these firms have grown more cynical about them, and more willing to reveal their inner workings, so long as their name is not attached to these revelations.” While the Wall Street “system” is still largely in place, cracks are appearing. Perhaps some day more finance industry participants will be able to live up to childhood dreams.
Market Overview
For those of us who invest on the basis of economic reality, the last few years have often been a bewildering mixture of surrealism, behavioral extremes, and outright fantasy. This isn’t to say there aren’t good companies out there or that significant progress isn’t being made in a number of industries. It is to say, however, that levels of economic activity, as measured by sustainable free cash flows, have become seriously disconnected from market valuations and as such, have provided only extremely wobbly foundations for market recovery.
The notion of disconnectedness was captured beautifully in this recent snippet on Yahoo Finance: “The market pullback has been driven by well-connected insiders, hedge funds and private investors fleeing from winning risky trades, not by serious concerns about the economy.” So let’s get this straight, we as investors should not be worried in the least that “well-connected insiders, hedge funds and private investors” are running away from the market? Is it because these folks are so poorly informed they can’t possibly have good insights?
We have mentioned catching glimpses of doubt creeping into the dominant market narrative several times over the past year or so. When tapering was first mentioned last spring, markets plunged violently before the Fed backpedaled with ameliorating language. A similar glitch occurred later in the year when the Fed committed to start tapering and yet again in January of this year when the pattern of tapering became established. The tight correlation between market selloffs and Fed statements, completely abstracted from underlying revenue growth and cash flow potential, highlight the weak rationale for continued market appreciation.
Grant Williams summed up the mentality nicely in his December 2013 letter, Things that make you go Hmmm…: “Throughout 2013, the distortions created by intervention in once-free markets have left many (myself included) scratching their heads. The interventions have worked - almost faultlessly - but for them to do so has required the suspension of one belief system (economic reality) and the adoption of another - namely, that everything will be OK because … well, just because. Can the fantasy persist into 2014? Yes. It most certainly can. Will it continue into 2014? Most likely. Will this new belief system become the new economic reality? Not a chance."
It’s not hard to pinpoint the source of this sustained suspension of economic reality. Going back to October 2009, Gillian Tett reported in the Financial Times, “when money is virtually free - or, at least, at 0.5 per cent - traders feel stupid if they don’t leverage up.” The mindset is simple: “The longer that money remains ultra-cheap, the more traders will have an incentive to gamble (particularly if they privately suspect that today’s boom will be short-lived and want to score big over the next year).” In short, cheap money incentivizes traders to keep leveraging up and riding the wave of asset appreciation. Needless to say, this activity can be quite harmful to other market participants.
Andrew Lo, a professor at MIT and an expert in complex systems, described (also in the Financial Times) what happens when unnaturally large amounts of money flow into a given strategy or asset class: “1. It reduces the strategy’s expected return owing to competition; 2. If there is expected return remaining, this portion will be a source of correlation or ‘beta’ among all investors in the strategy; and 3. If enough assets are invested in the strategy over a sufficiently short period of time, the strategy can become a ‘crowded trade’ that is illiquid and subject to large unpredictable swings in profits and losses.”
Taken together, these insights provide a very useful context from which to understand what has happened in the market and to highlight viable scenarios for future action. It can be thought of as the unstoppable force of leveraged gambling (with cheap money) starting to butt heads with the immovable object of economic reality.
We have felt the tremors of this confrontation several times now with some small but abrupt selloffs. Most recently the selloff in biotech stocks in the first quarter (and continuing through in the second quarter) is an indication that the potential for a serious collision is increasing. While biotech stocks are certainly an extreme case, they are far from the only assets that have benefited from cheap money and that may be subject to "large unpredictable swings in profits and losses."
The levitation of nearly all financial assets from cheap money also reveals interesting insights about the nature of third party investment management. Managers face the quandary of either accepting low returns that may underperform benchmarks for a period of time, or accepting higher risk in the form of valuations that become ever more disconnected from economic reality.
One large investor admitted recently in the Financial Times in regards to biotech stocks that, “There has been a period of benign neglect where we know what we own is overvalued and today there was follow through on that sentiment.” We wonder how much someone should pay a manager that continues to hold stocks he or she knows are overvalued?
There is no doubt that this period of artificially suppressed interest rates, commonly referred to as financial repression, creates a challenge for everyone trying to deploy capital productively. In trying to better understand this landscape and its implications, we can find some useful insights from the experience of Japan since the late 1990s.
In a Financial Times article about the experience of Japan’s policy for dealing with bad home loans, Gillian Tett describes, “while nobody could quantify the scale of that quasi subsidy [to banks], there was a gnawing suspicion that prices might fall in the future if (or when) more bad news emerged. The consequence was a mood of corrosive distrust and unease, which was hard to articulate or measure but which fostered a deflationary mindset.” Tett concluded, “Without clearing prices, it is hard to rebuild real trust and confidence. In the mortgage world, as elsewhere.”
Given these lessons admonishing intervention, we cannot systematically exclude more constructive public policy options from the realm of possibility. Indeed as the Fed continues to withdraw from its program of quantitative easing, it does seem to be starting a long walk back to normality.
In addition, monetary policy has been structured in a way that provides great benefits to short term trading interests with very questionable benefits to the economy or the labor market. But this need not be the case either. More directed monetary policy could conceivably assist very specific parts of the market without incurring such large risks of excess.
Although reduced intervention may start paving the way to more reasonable asset prices, it is only one possibility and could well be a low probability one at that. In the absence of asset prices that give owners a good chance of realizing attractive returns, investors must seriously consider the possibility of allocating more to saving for the time being. Attractive returns are never guaranteed and sometimes you just need to say “No”. Of course this need not be a permanent position and should be reversed as soon as attractive opportunities arise.
Finally, there is nothing easy about slogging through periods of financial repression. Extra efforts should be made to find and engage resources that can help you cut through the noise by providing an antidote to the self-serving viewpoints, conflicting claims, and half-truths that unnecessarily complicate an already difficult task.
For those of us who invest on the basis of economic reality, the last few years have often been a bewildering mixture of surrealism, behavioral extremes, and outright fantasy. This isn’t to say there aren’t good companies out there or that significant progress isn’t being made in a number of industries. It is to say, however, that levels of economic activity, as measured by sustainable free cash flows, have become seriously disconnected from market valuations and as such, have provided only extremely wobbly foundations for market recovery.
The notion of disconnectedness was captured beautifully in this recent snippet on Yahoo Finance: “The market pullback has been driven by well-connected insiders, hedge funds and private investors fleeing from winning risky trades, not by serious concerns about the economy.” So let’s get this straight, we as investors should not be worried in the least that “well-connected insiders, hedge funds and private investors” are running away from the market? Is it because these folks are so poorly informed they can’t possibly have good insights?
We have mentioned catching glimpses of doubt creeping into the dominant market narrative several times over the past year or so. When tapering was first mentioned last spring, markets plunged violently before the Fed backpedaled with ameliorating language. A similar glitch occurred later in the year when the Fed committed to start tapering and yet again in January of this year when the pattern of tapering became established. The tight correlation between market selloffs and Fed statements, completely abstracted from underlying revenue growth and cash flow potential, highlight the weak rationale for continued market appreciation.
Grant Williams summed up the mentality nicely in his December 2013 letter, Things that make you go Hmmm…: “Throughout 2013, the distortions created by intervention in once-free markets have left many (myself included) scratching their heads. The interventions have worked - almost faultlessly - but for them to do so has required the suspension of one belief system (economic reality) and the adoption of another - namely, that everything will be OK because … well, just because. Can the fantasy persist into 2014? Yes. It most certainly can. Will it continue into 2014? Most likely. Will this new belief system become the new economic reality? Not a chance."
It’s not hard to pinpoint the source of this sustained suspension of economic reality. Going back to October 2009, Gillian Tett reported in the Financial Times, “when money is virtually free - or, at least, at 0.5 per cent - traders feel stupid if they don’t leverage up.” The mindset is simple: “The longer that money remains ultra-cheap, the more traders will have an incentive to gamble (particularly if they privately suspect that today’s boom will be short-lived and want to score big over the next year).” In short, cheap money incentivizes traders to keep leveraging up and riding the wave of asset appreciation. Needless to say, this activity can be quite harmful to other market participants.
Andrew Lo, a professor at MIT and an expert in complex systems, described (also in the Financial Times) what happens when unnaturally large amounts of money flow into a given strategy or asset class: “1. It reduces the strategy’s expected return owing to competition; 2. If there is expected return remaining, this portion will be a source of correlation or ‘beta’ among all investors in the strategy; and 3. If enough assets are invested in the strategy over a sufficiently short period of time, the strategy can become a ‘crowded trade’ that is illiquid and subject to large unpredictable swings in profits and losses.”
Taken together, these insights provide a very useful context from which to understand what has happened in the market and to highlight viable scenarios for future action. It can be thought of as the unstoppable force of leveraged gambling (with cheap money) starting to butt heads with the immovable object of economic reality.
We have felt the tremors of this confrontation several times now with some small but abrupt selloffs. Most recently the selloff in biotech stocks in the first quarter (and continuing through in the second quarter) is an indication that the potential for a serious collision is increasing. While biotech stocks are certainly an extreme case, they are far from the only assets that have benefited from cheap money and that may be subject to "large unpredictable swings in profits and losses."
The levitation of nearly all financial assets from cheap money also reveals interesting insights about the nature of third party investment management. Managers face the quandary of either accepting low returns that may underperform benchmarks for a period of time, or accepting higher risk in the form of valuations that become ever more disconnected from economic reality.
One large investor admitted recently in the Financial Times in regards to biotech stocks that, “There has been a period of benign neglect where we know what we own is overvalued and today there was follow through on that sentiment.” We wonder how much someone should pay a manager that continues to hold stocks he or she knows are overvalued?
There is no doubt that this period of artificially suppressed interest rates, commonly referred to as financial repression, creates a challenge for everyone trying to deploy capital productively. In trying to better understand this landscape and its implications, we can find some useful insights from the experience of Japan since the late 1990s.
In a Financial Times article about the experience of Japan’s policy for dealing with bad home loans, Gillian Tett describes, “while nobody could quantify the scale of that quasi subsidy [to banks], there was a gnawing suspicion that prices might fall in the future if (or when) more bad news emerged. The consequence was a mood of corrosive distrust and unease, which was hard to articulate or measure but which fostered a deflationary mindset.” Tett concluded, “Without clearing prices, it is hard to rebuild real trust and confidence. In the mortgage world, as elsewhere.”
Given these lessons admonishing intervention, we cannot systematically exclude more constructive public policy options from the realm of possibility. Indeed as the Fed continues to withdraw from its program of quantitative easing, it does seem to be starting a long walk back to normality.
In addition, monetary policy has been structured in a way that provides great benefits to short term trading interests with very questionable benefits to the economy or the labor market. But this need not be the case either. More directed monetary policy could conceivably assist very specific parts of the market without incurring such large risks of excess.
Although reduced intervention may start paving the way to more reasonable asset prices, it is only one possibility and could well be a low probability one at that. In the absence of asset prices that give owners a good chance of realizing attractive returns, investors must seriously consider the possibility of allocating more to saving for the time being. Attractive returns are never guaranteed and sometimes you just need to say “No”. Of course this need not be a permanent position and should be reversed as soon as attractive opportunities arise.
Finally, there is nothing easy about slogging through periods of financial repression. Extra efforts should be made to find and engage resources that can help you cut through the noise by providing an antidote to the self-serving viewpoints, conflicting claims, and half-truths that unnecessarily complicate an already difficult task.
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