Trust, illusion, values and the death of "common sense"


The S&P 500 rallied 73.2% from the March 9th, 2008 low through the recent peak and declined 6.9% since January 19th.  This is a normal correction and similar to the 7% decline we saw last June 15th-July 10th.  If the correction extended to a 10% decline, we would not be surprised.  We would not sell stocks at this time as we expect positive returns in the S&P 500 by year end.  No, we're not going to try to trade around the short-term fall and rally. 

We're encouraged by corporate earnings, which show an astonishing rebound (up 148% compared to Q4 2008) after last year's wipeout.  US GDP growth turned in the best performance in 6 years with a year over year gain of 5.7%.  The US employment situation improved -job losses flattened and the unemployment rate fell slightly.  By no means is the US economy, or the world economy for that matter, free and clear. 

We have often described the economy as an automobile engine in which the production of goods and services are the pistons, cylinders and drive-shaft; designers, engineers and marketers are the gasoline, and the finance sector is the 5 quarts of oil that keep everything moving.  The financial crisis last year was like losing most of that oil, at which point the moving parts overheat, jam and crack.  We're back to 4 quarts in the pan with a raggedly running engine, and we don't yet know the extent of permanent damage.

On balance, we remain cautiously optimistic.  However, the average investor remains deeply pessimistic.  Investors moved money out of stock funds and stock ETF's every month from August through December last year and were net sellers of stocks despite the monster run up.  The last time investors were so pessimistic was in the years following the 1973-4 bear market, during which time the S&P 500 declined 48.0%.  Economic fundamentals actually were far worse in that era - US support of Israel during the Yom Kippur war triggered an OPEC oil embargo, which tripled energy prices in a very short time frame and caused soaring inflation.  At the same time, the US was transitioning from a manufacturing to a service based economy with corresponding disruption and high unemployment.  Stock prices did not eclipse the 1972 high until 1982.  Investors who bought stocks in that era experienced returns of 2600% over the next two decades, but many more swore never to buy stocks again.

We were reminded of that history during a recent annual review with one of our clients, the CFO of a Fortune 500 company.  We routinely ask that client how much of his annual bonus he wants to invest, and this year we were surprised by his answer: "I don't want to invest any of my bonus in stocks.  I don't trust the market anymore." Really?!?  A CFO's job responsibilities include representing his company to research analysts and working with investment bankers to market that company's bond and secondary offerings.  That person thinks stocks are too risky?  Wow!  How did we arrive at this sorry state of affairs?

Stock markets exist to allow savers to spread their capital across multiple investments in corporations, thus reducing risk while earning a respectable return to support future needs.  Corporations meanwhile have access to relatively unencumbered capital (compared, for example, to borrowing from a bank,) which enables faster growth.  At the center of the stock market are "market makers" who facilitate transfer of ownership from one saver to another by taking temporary ownership of a position.  Market makers are paid for providing their capital by taking a spread on each transaction (i.e. the price of a stock on offer is always a little higher than the bid for the same stock."  The net effect is a "positive sum game" where every participant does better working within the market than working outside.  In the US, this system functioned pretty well for over 300 years, enabling the US to grow to 25% of world GDP with only 5% of the world's population.

In the last two decades, however, technology has transformed the relationship between savers, corporations and market makers.  As Warren Buffet wrote as early as 2001, "With each passing year, the noise level in the stock market rises.  Television commentators, financial writers, analysts, and market strategists are all overtaking each other to get investors' attention.  At the same time, individual investors, immersed in chat rooms and message boards, are exchanging questionable and often misleading tips."  All these resources give average investors the illusion that they can invest for themselves.  Our opinion is the average investor is no better equipped to research their own stocks and build their own portfolios than the average Saturday night poker player is equipped to compete at the professional tables in Las Vegas.  We've been researching stocks for over 30 years and we're still amazed at the things that go wrong.

Spreads on stock transactions, which averaged 25 cents/share in the 1980's, are now a penny a share.  Many market makers have abandoned the major exchanges while an ever higher percentage of volume has shifted to "electronic crossing networks"(ECN's) where prices don't have to be disclosed and no capital exists to dampen swings in supply and demand.  What's really irritating is that certain investors, called "high frequency traders" (HFT) are authorized to connect directly to the exchange computers, fire off millions of trades a day to take advantage of order flow, and extract up to $20 billion/year in "profits."  On the one hand, these traders provide the liquidity that market makers used to offer.  On the other hand, with HFT accounting for 40-55% of daily volume, that liquidity comes at a cost to buy & hold investors, traditional mutual fund and pension managers.  HFT converts the stock market from a positive sum game, to a zero or even negative sum game.

At a certain point, someone has to make some value decisions.  Is the liquidity provided by HFT a sufficient benefit to offset its costs to overall investors?  Is unrestrained liquidity necessarily a good thing?  Just because you can buy and sell 100 shares of Intel within a 5 minute (5 second, 5 millisecond) period doesn't mean value is created.  What is the value of being able to buy the SPDR's S&P 500 EFT continuously through the trading day versus buying it at day end as the Vanguard Index 500 mutual fund?  Buying the ETF incurs a commission, buying the fund does not.  Is the $8 commission worth the extra opportunity to buy and sell, or does the continuous pricing promote over trading?

We already have observed that shorting the narrowly defined Finance sector ETF's in fall 2008 allowed hedge funds to trash bank stocks without the inconvenience of having to borrow stock.  We think the UltraPro Long and Short ETF's are particularly heinous.  With up to three times leverage on the underlying S&P 500, these "products" allow investors to completely bypass margin rules.  Hedge funds love 'em, but individual investors got their eyeballs ripped out.

What really kills investor's trust in markets is the creation of what we call "negative sum" products - an innovation where some trader profits, but others take a disproportionate loss.  John Paulson was the principal of the relatively modest "Paulson & Co" hedge fund.  Like many, he recognized the bubble in housing from 2005 on.  Unlike most, as documented in Gregory Zuckerman's The Greatest Trade Ever, he figured out a way to profit from the eventual bursting of the bubble. 

Junk mortgages written against junk properties were packaged into junk securities called collateralized debt obligations (CDO's).  Unfortunately, as no one could remember a time when mortgages were not good collateral, these securities were rated AA or AAA by the ratings agencies and sold to pension plans all over the country.  As fast as the CDO's were sold, underwriters of these securities were also selling Credit Default Swaps (CDS) on the same securities.  A CDS agreement says that in the event that the issuer (the CDO) defaults, the owner of the CDS has the right to sell (put) the bond back to the issuer at par (same price as issue price.)

Paulson didn't own the CDO's but bought mountains of CDS.  He actually went to Goldman Sachs and pleaded (colluded?) with them to issue more CDO's so he could buy more CDS.  When the bonds collapsed in value in 2007 and 2008, Paulson's company made $20 billion and he personally made $4 billion.  Good fun for all except that the pension plans, representing the hopes and dreams of millions of ordinary Americans, lost about $1 trillion.  $20 billion gain offset by a $1 trillion loss?  Sound to us like the Worst Trade of All Time!  Here's the valuequestion: can we afford to live in a system where such trades are legal?

The Death of Common Sense

We'd like to think that there's a regulatory agency or agencies that understands all of the above and has both the will and the means to reign in abuses.  Unfortunately, "common sense" understanding of how markets work was sacrificed to the ideals of "market efficiency" and deregulation.  As we have previously noted, the agencies to safeguard investors, in particular the SEC, were starved of funds and stripped of authority from the 1990's on.  The Glass-Steagall Act of 1932, which separated risk taking investment banks from deposit taking commercials banks, was repealed in 1999. The Federal Reserve took a "laissez-faire" attitude to the leveraging up of bank balance sheets, despite the experience derived from the 1998 Long Term Capital Management crisis.  By the mid 2000's US banks were as aggressively leveraged as LTCM in its heyday, with balance sheets a 100 times larger.  At such leverage levels it took only 5 days for Lehman Brothers to go from fully capitalized to bankrupt in September 2008.

We'd like to see:

  • Implementation of the Consumer Finance Protection Agency to oversee the marketing of mortgages, car loans and credit cards.  Millions of Americans are routinely gouged on interest rates and fees.  That fact that the banking industry vigorously opposes such an agency tells us how badly it's needed.  Many of our clients who are small business owners have complained to us that their credit lines have been slashed recently while their rates increased - not good for promoting economic recovery.

  • The SEC enforcing its own rules on "naked" short selling, which is to say, without first borrowing the stock.

  • A blanket ban on shorting ETF's, which have no location requirement.

  • A blanket ban on "inverse" or "bear" ETF's, which have nothing to do with the capital raising function of the stock market and exist only as speculative tools.

  • A blanket ban on leveraged ETF's, which as we have noted above, circumvent margin rules.

  • A severe curtailment on issuance of Credit Default Swaps.  Bonds are bought primarily by institutional investors.  Those managers have a fiduciary responsibility to evaluate the credit quality of the bonds they invest in independently of what the rating agencies might say.  If those investors have done their homework, there's no need to give away their shareholders' yield in CDS premiums.  Meanwhile, by reducing the pool of CDS, you also reduce the instruments by which speculators can profit from a company's distress.  This technique has been likened to buying homeowners insurance on all your neighbors' houses, then setting the town on fire.

  • Enact a "stamp tax" of a hundredth of a cent per trade.  Routine investors won't notice the pinch at all, but it sure would put some friction into HFT, perhaps shrink that activity to a reasonable percentage of daily flow.

  • Reinstate some version of the "up tick" rule and also shrink the bands for triggering stocks market circuit breakers.  At present, the market has to fall at least 10% in a day before triggering a one hour halt.  Even during the volatile period in 2008-9, the largest daily decline was only 7%.  Extend the rules to all exchanges and ECN's, not just the NYSE.

  • Continued requirement that bank bonuses be paid partially in restricted stock.  If bank employees as a company fail to regulate each other, then all should suffer together.

  • Recognition of the "Trader's Option" in compensation schemes ("Heads, I make a ton of money; tails, you lose, but I don't have to give back my bonus.")

The probability of all these concepts being implemented is low.  The benefit to average Americans is diffuse, while the profits that would be lost by those who currently benefit are high.  Lobbying in Washington is intense right now to prevent or emasculate any regulatory reform.  Luckily, all Americans have the right to weigh in.  Go to or to learn more about legislation under consideration and register your opinion.  You can communicate with your own senator or representative, or you can write to those congressmen who have influence over the current legislation.  For example, Barney Frank presides over the Financial Services Committee, while Christopher Dodd presides over Banking, Housing & Urban Affairs (at least until his retirement.) 


A quiet time for us as we took our accounts fully invested last fall.  We'll start the cycle of annual rebalancing shortly.