Here’s another article that I edited at The Balance:?Short Selling Stocks- Not for the Faint Hearted.? The original author started out conservative on the topic, and I took it up another notch.
For this article, I:
added the information about changes to the uptick rule (which did not reflect anything post-2006),
corrected a small math error,
made the example more realistic as to how margin works in this situation,
added almost all of the section on risks
totally rewrote the section on picking shorts (if you dare to do it), and,
added the famous comment by Daniel Drew.
I have shorted stock in my life at the hedge fund I worked at, hedging in arbitrage situations, and very rarely to speculate.? Shorting is a form of speculation shorts don’t create economic value.? They do us a service by pruning places that pretend to have value and don’t really have it.
In general, I don’t recommend shorting unless you have a fundamentally strong insight about a company that is not generally shared.? That happens with me occasionally in insurance where I have spoken negatively about:
Penn Treaty
Tower Group
The various companies of the Karfunkels
The mortgage and financial guaranty insurers
Oh, and the GSEs… though they weren’t regulated as insurers… not that it would have mattered.
But I rarely get those insights, and I hate to short, because timing is crucial, and the upside is capped, where the downside is theoretically unlimited.? It is really a hard area to get right.
Last note, I didn’t say it in the article, and I haven’t said it in a while, remember that being short is not the opposite of being long — it is the opposite of being leveraged long.? If you just hold stocks, bonds, and cash, no one can ever force you out of your trade.? The moment you borrow money to buy assets, or sell short, under bad conditions the margin desk can force you to liquidate positions — and it could be at the worst possible moment.? Virtually every market bottom and top has some level of forced liquidations going on of investors that took on too much risk.
So be careful, and in general don’t short stock.? If you want more here, also read The Zero Short.? Fun!
I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.
So what’s weird now?
Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
Students and middle-to-lower classes borrowing too much (autos, credit cards)
Interest rates and goods and services price inflation stay low in the face of this.
Low volatility (until now)
Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks?(smaller percentage on a big base)
Low credit spreads
No one should be surprised by the current market action.? It wasn’t an “if,” but a “when.”? I’m not saying that this is going to spiral out of control, but everyone should understand that?The Little Market that Could?was a weird situation.? Markets are not supposed to go up so steadily, which means something weird was fueling the move.
Lack of volatility gives way to a surfeit of volatility eventually.? It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.? It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.
Now, we’re not back in 2007-9.? This is different, and likely to be more mild.? The banks are in decent shape.? The dominoes are NOT set up for a major disaster.? Risky asset prices are too high, yes.? There is significant speculation in areas?Where Money Goes to Die.? So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.? Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.
Could this be “the pause that refreshes?”? Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.? The lure of free money brings out the worst in many.
You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.? That’s the grand asset-liability mismatch.? Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.? Have you considered these concepts:
Preservation of capital
Dry powder
Not finding opportunities
Momentum gives way to negative arbitrages.
Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”
Going back to where money goes to die, from the less mentioned portion on the short volatility trade:
Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.
Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default ? this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?
To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a ?failure cycle? tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.
So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.? Do you have the flexibility to buy in at better levels?? Should you even touch it if it is like a knockout option?
There are no free lunches.? Get used to that idea.? If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.
Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.? Where is debt building up?? Are there unusual derivative positions building up?? What sort of parties are chasing prices?? Who is resisting the trend?
And, when markets are falling hard, remember that they go down double-speed.? If it’s a lot faster than that, the market is more likely to bounce.? (That might be the case now.)? Slower, and it might keep going.? Fast moves tend to mean-revert, slow moves tend to persist.? Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.
And once they have sold, the panic will end, and growth will begin again when everyone is scared.
That’s the perversity of markets.? They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).
Don’t let this situation be “too bad” for you.? If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.? Preserving capital is not imprudent, even if the market bounces.
In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.? Then when markets get weird, you can smile and bear it.? The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”
Credit: Roadsidepictures from The Little Engine That Could By Watty Piper Illustrated By George & Doris Hauman c. 1954
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I wish I could have found a picture of Woodstock with a sign that said “We’re #1!”? Snoopy trails behind carrying a football, grinning and thinking “In this corner of the backyard.”
That’s how I feel regarding all of the attention that has been paid to the S&P being up every month in 2017, and every month for the last 14 months.? These have never happened before.
There’s a first time for everything, but I feel that these records are more akin to the people who do work for the sports channels scaring up odd statistical facts about players, teams, games, etc.? “Hey Bob, did you know that the Smoggers haven’t converted a 4th and 2 situation against the Robbers since 1998?”
Let me explain.? A month is around 21 trading days.? There is some variation around that, but on average, years tend to have 252 trading days.? 252 divided by 12 is 21.? You would think in a year like 2017 that it must? have spent the most time where 21-day periods had positive returns, as it did over each month.
Since 1950, 2017 would have come in fourth on that measure, behind 1954, 1958 and 1995.? Thus in one sense it was an accident that 2017 had positive returns each month versus years that had more positive returns over every 21 day period.
How about streaks of days where the 21-day trialing total return never dropped below zero (since 1950)?? By that measure, 2017 would have tied for tenth place with 2003, and beaten by the years 1958-9, 1995, 1961, 1971, 1964, 1980, 1972, 1965, and 1963.? (Note: quite a reminder of how bullish the late 1950s, 1960s and early 1970s were.? Go-go indeed.)
Let’s look at one more — total return over the whole year.? Now 2017 ranks 23rd out of 68 years with a total return of 21.8%.? That’s really good, don’t get me wrong, but it won’t deserve a mention in a book like “It Was a Very Good Year.”? That’s more than double the normal return, which means you’ll have give returns back in the future. 😉
So, how do I characterize 2017?? I call it?The Little Market that Could.? Why?? Few drawdowns, low implied volatility, and skepticism that gave way to uncritical belief.? Just as we have lost touch with the idea that government deficits and debts matter, so we have lost touch with the idea that valuation matters.
When I talk to professionals (and some amateurs) about the valuation model that I use for the market, increasingly I get pushback, suggesting that we are in a new era, and that my model might have been good for an era prior to our present technological innovations.? I simply respond by saying “The buying power has to come from somewhere.? Our stock market does not do well when risk assets are valued at 40%+ of the share of assets, and there have been significant technological shifts over my analysis period beginning in 1945, many rivaling the internet.”? (Every era idolizes its changes.? It is always a “new era.”? It is never a “new era.”)
If you are asking me about the short-term, I think the direction is up, but I am edgy about that.? Forecast ten year returns are below 3.75%/year not adjusted for inflation.? Just a guess on my part, but I think all of the people who are making money off of low volatility are feeding the calm in the short-run, while building up a whiplash in the intermediate term.
Time will tell.? It usually does, given enough time.? In the intermediate-term, it is tough to tell signal from noise.? I am at my maximum cash for my equity strategy accounts — I think that is a prudent place to be amid the high valuations that we face today.? Remember, once the surprise comes, and companies scramble to find financing, it is too late to make adjustments for market risk.
I thought this old post from RealMoney.com was lost, never to be found again.? This was the important post made on November 22, 2006 that forecast some of the troubles in the subprime residential mortgage backed securities market.? I favored the idea that there there would be a crash in residential housing prices, and the best way to play it would be to pick up the pieces after the crash, because of the difficulties of being able to be right on the timing of shorting could be problematic.? In that trade, too early would mean wrong if you had to lose out the trade because of margin issues.
With that, here is the article:
====================
I have tried to make the following topic simple, but what I am about to say is complex, because it deals with the derivative markets. It is doubly or triply complex, because this situation has many layers to unravel. I write about this for two reasons. First, since residential housing is a large part of the US economy, understanding what is going on beneath the surface of housing finance can be valuable. Second, anytime financial markets are highly levered, there is a higher probability that there could be a dislocation. When dislocations happen, it is unwise for investors to try to average down or up. Rather, the best strategy is to wait for the trend to overshoot, and take a contrary position.
There are a lot of players trotting out the bear case for residential housing and mortgages. I’m one of them, but I don’t want overstate my case, having commented a few weeks ago on derivatives in the home equity loan asset-backed securities market. This arcane-sounding market is no small potatoes; it actually comprises several billions of dollars’ worth of bets by aggressive hedge funds — the same type of big bettors who blew up so memorably earlier this year, Amaranth and Motherrock.
A shift of just 10% up or down in residential housing prices might touch off just such another cataclysm, so it’s worth understanding just how this “arcane-sounding” market works.
I said I might expand on that post, but the need for comment and explanation of this market just got more pressing: To my surprise, one of my Googlebots dragged in a Reuters article and a blog post on the topic. I’ve seen other writeups on this as well, notably in Grant’s Interest Rate Observer (a fine publication) and The Wall Street Journal.
How a Securitization Works (Basically)
It’s difficult to short residential housing directly, so a market has grown up around the asset-backed securities market, in which bulls and bears can make bets on the performance of home equity loans. How do they do this?
First, mortgage originators originate home equity loans, Alt-A loans and subprime loans. They bring these loans to Wall Street, where the originator sells the loans to an investment bank, which dumps the loans into a trust. The investment bank then sells participation interests (“certificates”) in the trust.
There are different classes of certificates that have varying degrees of credit risk. The riskier classes receive higher interest rates. Typically the originator holds the juniormost class, the equity, and funds an overcollateralization account to give some security to the next most junior class.
Principal payments get allocated to the seniormost class. Once a class gets its full share of principal paid (or cancelled), it receives no more payments. Interest gets allocated in order of seniority. If, after paying interest to all classes, there is excess interest, that excess gets allocated to the overcollateralization account, until the account is full — that is, has reached a value equal to the value of the second most junior class of trust certificates — and then the excess goes to the equity class. If there’s not enough interest to pay all classes, they get paid in order of seniority.
If there are loan losses from nonpayment of the mortgages or home equity loans, the losses get funded by the overcollateralization account. If the overcollateralization account gets exhausted, losses reduce the principal balances of the juniormost certificates — those usually held by the originator — until they get exhausted, and then the next most junior gets the losses. There’s a little more to it than this (the prospectuses are often a half-inch thick on thin paper), but this is basically how a securitization works.
From Hedging to Speculation
The top class of certificates gets rated AAA, and typically the lowest class before the equity gets rated BBB-, though sometimes junk-rated certificates get issued. Most of the speculation occurs in securities rated BBB+ to BBB-.
The second phase of this trade involves credit default swaps (CDS). A credit default swap is an agreement where one party agrees to make a payment to another party when a default takes place, in exchange for regular compensation until the agreement terminates or a default happens. This began with corporate bonds and loans, but now has expanded to mortgage- and asset-backed securities.
Unlike shorting stocks, where the amount of shorting is generally limited by the float of the common stock, there can be more credit default swaps than bonds and loans. What began as a market to allow for hedging has become a market to encourage speculation.
With CDS on corporate debt, it took eight years for the notional size (amount to pay if everyone defaulted) of the CDS market to become 4 times the size of the corporate bond market. With CDS on home equity asset-backed securities, it took less than 18 months to get to the same point.
The payment received for insuring the risk is loosely related to the credit spread on the debt that is protected. Given that the CDS can serve as a hedge for the debt, one might think that the two should be equal. There are a couple reasons that isn’t so.
First, when a default happens, the bond that is the cheapest to deliver gets delivered. That option helps to make CDS trade cheap relative to credit spreads. But a bigger factor is who wants to do the CDS trading more. Is it those who want to receive payment in a default, or those who want to pay when a default occurs?
How It Impacts Housing
With CDS on asset-backed securities, the party writing protection makes a payment when losses get allocated to the tranche in question. Most protection gets written on tranches rated BBB+ to BBB-.
This is where shorting residential housing comes into the picture. There is more interest in shorting the residential housing market through buying protection on BBB-rated home equity asset-backed securities than there are players wanting to take on that risk at the spreads offered in the asset-backed market at present. So, those who want to short the market through CDS asset-backed securities have to pay more to do the trade than those in the cash asset-backed securities market receive as a lending spread.
One final layer of complexity is that there are standardized indices (ABX) for home equity loan asset-backed securities. CDS exists not only for the individual asset-backed securities deals, but also on the ABX indices as well. Those not wanting to do the credit work on a specific deal can act on a general opinion by buying or selling protection on an ABX index as a whole. The indices go down in quality from AAA to BBB-, and aggregate similar tranches of the individual deals. Those buying protection receive pro-rata payments when losses get allocated to the tranches in their index.
So, who’s playing this game? On the side of falling housing prices and rising default rates are predominantly multi-strategy and mortgage debt hedge funds. They are paying the other side of the trade around 2.5% per year for each dollar of home equity asset-backed securities protection bought. (Deals typically last four years or so.) The market players receiving the 2.5% per year payment are typically hedge and other investment funds running collateralized debt obligations. They keep the equity piece, which further levers up their returns. They are fairly yield-hungry, so from what I’ve heard, they’re none too picky about the risks that they take down.
Who wins and who loses? This is tricky, but if residential real estate prices fall by more than 10%, the buyers of asset-backed securities protection will probably win. If less, the sellers of protection probably win. This may be a bit of a sideshow in our overly leveraged financial markets, but the bets being placed here exceed ten billion dollars of total exposure. Aggressive investors are on both sides of this trade. Only one set of them will end up happy.
But how can you win here? I believe the safest way for retail investors to make money here is to play the reaction, should a panic occur. If housing prices drop severely, and home equity loan defaults occur, and you hear of hedge fund failures resulting, don?t act immediately. Wait. Watch for momentum to bottom out, or at least slow, and then buy the equities of financially strong homebuilders and mortgage lenders, those that will certainly survive the downturn.
If housing prices rise in the short run (unlikely in my opinion), and you hear about the liquidations of bearish hedge funds, then the best way to make money is to wait. Wait and let the homebuilders and mortgage finance companies run up, and then when momentum fails, short a basket of the stocks with weak balance sheets.
Why play the bounce, rather than try to bet on the success of either side? The wait could be quite long before either side loses? Do you have enough wherewithal to stay in the trade? Most players don?t; that?s why I think that waiting for one side or the other to prevail is the right course. Because both sides are levered up, there will be an overshoot. Just be there when the momentum fails, and play the opposite side. Personally, I?ll be ready with a list of homebuilders and mortgage lenders with strong balance sheets. Though prospects are not bright today, the best will prosper once the crisis is past.
I was pleasantly surprised to be invited to contribute a chapter to this book.? I am going to encourage you to buy this book, but let me give some of the reasons not to buy this book:
Don’t buy it to give me something.? I don’t get anything from sales of this book.? Neither does Mebane Faber, who is giving all of the profits to charity.
Don’t buy it to get current ideas.? There are none here.? The weakness of the book is that the articles are dated by 9-21 months or so, BUT… that doesn’t keep the book from being relevant.
Don’t buy it if you want one consistent theme.? It’s like reading RealMoney.com, except with a broader array of authors.? There is no “house view.”
Don’t buy it for the graphics in the book.? The grayscale images in the book are good for black & white, but some are hard to read.? The graphs for my article are far better at my blog.
The book is a good one because there is something for everyone here.? Do you want quantitative finance?? There is a good selection here. Do you want good basic articles about how to think about investing?? There are a good number of those as well, particularly from well-known financial journalists, and some of the most well-regarded bloggers.? Do you want a few unusual articles that might cause you consider some asset sub-classes or techniques that you haven’t considered before?? They are here too.
The writers fall into four buckets — journalists, asset managers, pundits/authors, and those who sell information at their websites.? I will tell you that my personal favorites from this volume are Tom Tresidder, Mebane Faber, Chris Meredith, Ben Carlson (how was he the only one with two articles in the book?), Jason Hsu & John West, and Cullen Roche.
Don’t get me wrong, I like almost all of the authors in this volume, and am proud to be featured among them.? For a number of them, though, I would have picked other things they have written in 2016 that had more punch, and offered more of a difference in perspective.
Why buy this?? After you read this, you will be a smarter, more well-rounded investor.? In my calculations, that’s? pretty good — 32 articles that will take you 4 hours to read.? Got seven minutes?? Read an article; it just might help you a great deal.
Quibbles
Already stated, though if you don’t like statistics, one-third of the articles may not appeal to you.? Also, a few articles veer into political commentary (not that I would ever do that 😉 ).
Full disclosure:?I received two free copies of the book for contributing the article.? That’s all, unless someone buys the book through the link above.
If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.
I’d say this is getting boring, but it’s pretty fascinating watching the rally run. ?Now, this is the seventh time I have done this quarterly analysis. ?The first one was for December 2015. ?Over that time period, the expected annualized 10-year return went like this, quarter by quarter: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%. ?At the end of June 2017, the figure would have been 4.58%, but the rally since the end of the quarter shaves future returns down to 4.30%.
We are now in the 93rd percentile of valuations.
Wow.
This era will ultimately be remembered as a hot time in the markets, much like 1965-9, 1972, and 1997-2001.
The Internal Logic of this Model
I promised on of my readers that I would provide the equation for this model. ?Here it is:
10-year annualized total return = 32.77% – (70.11% * Percentage of total assets held in stocks for the US as a whole)
Now, the logic of this formula stems from the idea that the return on total assets varies linearly with the height of the stock market, and the return on debt (everything else aside from stocks) does not. ?After that, the formula is derived from the same formula that we use for the weighted average cost of capital [WACC]. ?Under those conditions, the total returns of the stock market can be approximated by a linear function of the weight the stocks have in the WACC formula.
Anyway, that’s one way to think of the logic behind this.
The Future?
Now, what are some of the possibilities for the future?
Above you see the nineteen scenarios for where the S&P 500 will be in 10 years, assuming a 2% dividend yield, and looking at the total returns that happen when the model forecasts returns between 3.30% and 5.30%. ?The total returns vary from 2.31%/year to 6.50%, and average out to 3.97% total returns. ?The bold line above is the 4.30% estimate.
As I have said before, this bodes ill for all collective security schemes that rely on the returns of risky assets to power the payments. ?There is no conventional way to achieve returns higher than 5%/year for the next ten years, unless you go for value and foreign markets (maybe both!).
Then again, the simple solution is just to lighten up and let cash build. ?Now if we all did that, we couldn’t. ?Who would be buying? ?But if enough of us did it such that equity valuations declined, there could be a more orderly market retreat.
The attitude of the market on a qualitative basis doesn’t seem nuts to me yet, so I am at maximum cash for ordinary conditions, but I haven’t hedged. ?When expected 10-year market returns get to 3%/year, I will likely do that, but for now I hold my stocks.
PS — the first article of this series has been translated into Chinese. ?The same website has 48 of my best articles in Chinese, which I find pretty amazing. ?Hope you smile at the cartoon version of me. 😉
Joel Tillinghast, one of the best mutual fund managers, runs the money in Fidelity’s Low-Priced Stock Fund. ?It has one of the best long-term records among stock funds over the 28 years that he has managed it.
The author gives you a recipe for how to pick good stocks, but he doesn’t give you a machine that produces them. ?In a style that is clever and discursive, he summarizes his main ideas at the beginning and end of the book, and explains the ideas in the middle of the book. ?The ideas are simple, but learning to apply them will take a lifetime.
Here are the five ideas as written in the beginning (page 3):
Make decisions rationally
Invest in what we know (did I mention Peter Lynch wrote the foreword to the book?)
Worth with honest and trustworthy managers
Avoid businesses prone to obsolescence and financial ruin, and?
Value stocks properly
At this point, some will say “You haven’t really given us anything! ?These ideas are too big to be useful!” ?I was surprised, though, to see that the same five points at the end of the book said more (page 276). ?Ready?
Be clear about your motives, and don’t allow emotions to guide your financial decisions
Recognize that some things can’t be understood and that you don’t understand others. ?Focus on those that you understand best.
Invest with people who are honest and trustworthy, and are doing something unique and valuable.
Favor businesses that will not be destroyed by changing times, commoditization, or excessive debt.
Above all, always look for investments that are worth a great deal more than you are paying for them.
That says more, and I think the reason they are different is that when you read through the five sections of the book, he unpacks his initial statements and becomes more definite.
Much of the book can be summarized under the idea of “margin of safety.” ?This is a type of value investing. ?When he analyzes value, it is like a simplified version of reverse discounted cash flows. ?He tries to figure out in a broad way what an investment might return in terms price paid for the investment and what “owner earnings,” that is, free cash flow, it will generate on a conservative basis.
One aspect of the conservatism that I found insightful is that he assumes that the terminal value of an investment is zero. (page 150) ?In my opinion, that is very smart, because that is the area where most discounted cash flow analyses go wrong. ?When the difference between the weighted average growth rate of free cash flow and the discount rate is small, the terminal value gets really big relative to the value of the cash lows prior to the terminal value. ?In short, assumptions like that say that the distant future is all that matters. ?That’s a tough assumption in a world where companies and industries can become obsolete.
Even though I described aspects of a mathematical calculation here, what I did was very much like the book. ?There are no equations; everything is described verbally, even the math. ?Note: that is a good exercise to see whether you understand what the math really means. ?(If more people on Wall Street did that, we might not have had the financial crisis. ?Just sayin’.)
One more fun thing about the book is that he goes trough his own experiences with a wide variety of controversial stocks from the past and his experiences with them. ?His conservatism kept him a great number of errors that tripped up other celebrated managers.
I learned a lot from this book, and I enjoyed the writing style as well. ?He clearly put a lot of effort into it; many people will benefit from his insights.
Quibbles
His methods are a lot like mine, and he clearly put a lot of thought into this book. ?That said, he doesn’t understand insurance companies as well as he thinks (I’m an actuary by training). ?There are a number of small errors there, but not enough to ruin a really good book.
Summary / Who Would Benefit from this Book
I highly recommend this book. ?This is a book that will benefit investors with moderate to high experience most. For those with less experience, it may help you, but some of the concepts require background knowledge. ?If you want to buy it, you can buy it here: Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing.
Full disclosure:?The publisher asked me if I wanted a free copy and I assented.
If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.
It is often a wise thing to look around and see where people are doing that is nuts. ?Often it is obvious in advance. ?In the past, the two most obvious were the dot-com bubble and the housing bubble. ?Today, we have two unrelated pockets of nuttiness, neither of which is as big: cryptocurrencies and shorting volatility.
I have often said that that lure of free money brings out the worst economic behavior in people. ?That goes double when people see others who they deem less competent than themselves seemingly making lots of money when they are not.
I’ve written about Bitcoin before. ?It has three main weaknesses:
No intrinsic value –?can?t be used of themselves to produce something else.
Cannot be used to settle all debts, public and private
Less secure than insured bank deposits
In an economic world where everything is relative in a sense — things only have value because people want them, some might argue that cryptocurrencies have value because some people want them. ?That’s fine, sort of. ?But how many people, and are there alternative uses that transcend exchange? ?Even in exchange, how legally broad is the economic net for required exchangability? ?Only legal tender satisfies that.
That there may be some scarcity value for some cryptocurrencies puts them in the same class as some Beanie Babies. ?At least the Beanie Babies have the alternative use for kids to play with, even though it ruins the collectibility. ?(We actually had a moderately rare one, but didn’t know it and our kids happily played with it. ?Isn’t that wonderful? ?How much is the happiness of a kid worth?)
I commented in my Bitcoin article that it was like Penny Stocks, and that’s even more true with all of the promoters touting their own little cryptocurrencies. ?The promoters get the benefit, and those who speculate early in the boom, and the losers are those fools who get there late.
There’s a decent public policy argument for delisting penny stocks with no real business behind them; things that are worth nothing are the easiest things to spin tales about. ?Remember that absurd is like infinity. ?If any positive value is absurd, so is the value at two, five, ten, and one hundred times that level.
The same idea applies to cryptocurrencies; a good argument could be made that they all should be made illegal. ?(Give China a little credit for starting to limit them.) ?It’s almost like we let any promoter set up his own Madoff-like scheme, and sell them to speculators. ?Remember, Madoff never raked off that much… but it was a negative-sum game. ?Those that exited early did well at the expense of those that bought in later.
Ultimately, most of the cryptocurrencies will go out at zero. ?Don’t say I didn’t warn you.
Shorting Volatility
This one is not as bad, at least if you don’t apply leverage. ?Many people don’t get volatility, both applied and actual. ?It spikes during panics, and reverts to a low level when things are calm. ?It seems to mean-revert, but the mean is unknown, and varies considerably across different time periods.
It is like the credit cycle in many ways. ?There are two ways to get killed playing credit. ?One is to speculate that defaults are going to happen and overdo going short credit during the bull phase. ?The other is to be a foolish yield-seeker going into the bear phase.
So it is for people waiting for volatility to spike — they die the death of one thousand cuts. ?Then there are those that are short volatility because it pays off when volatility is low. ?When the spike happens, many will skinned; most won’t recover what they put in.
It is tough to time the market, whether it is equity, equity volatility, or credit. ?Doesn’t matter much if you are a professional or amateur. ?That said, it is far better to play with simpler and cleaner investments, and adjust your risk posture between 0-100% equities, rather than cross-hedge with equity volatility products.
Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.
Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?
To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.
Ten years ago, things were mostly quiet. ?The crisis was staring us in the face, with a little more than a year before the effects of growing leverage and sloppy credit underwriting would hit in full. ?But when there is a boom, almost no one wants to spoil the party. ?Yes a few bears and financial writers may do so, but they get ignored by the broader media, the politicians, the regulators, the bulls, etc.
It’s not as if there weren’t some hints before this. ?There were losses from subprime mortgages at HSBC. ?New Century was bankrupt. ?Two hedge funds at Bear Stearns, filled with some of the worst exposures to CDOs and subprime lending were wiped out.
And, for those watching the subprime lending markets the losses had been rising since late 2006. ?I was following it for a firm that was considering doing the “big short” but could not figure out an effective way to do it in a way consistent with the culture and personnel of the firm. ?We had discussions with a number of investment banks, and it seemed obvious that those on the short side of the trade would eventually win. ?I even wrote an article on it at RealMoney in November 2006, but it is lost in the bowels of theStreet.com’s file system.
Some of the building blocks of the crisis were evident then:
European banks in search of any AAA-rated structured product bonds that had spreads over LIBOR. ?They were even engaged in a variety of leverage schemes including leveraged AAA CMBS, and CPDOs. ?When you don’t have to put up any capital against AAA assets, it is astounding the lengths that market players will go through to create and swallow such assets. ?The European bank yield hogs were a main facilitator of the crisis that was to come, followed by the investment banks, and bullish mortgage hedge funds. ?As Gary Gorton would later point out, real disasters happen when safe assets fail.
Regulators were unwilling to clamp down on bad underwriting, and they had the power to do so, but were unwilling, as banks could choose their regulators, and the Fed didn’t care, and may have actively inhibited scrutiny.
Not only were subprime loans low in credit quality, but they had a second embedded risk in them, as they had a reset date where the interest rate would rise dramatically, that made the loans far shorter than the houses that they financed, meaning that the loans would disproportionately default near their reset dates.
The illiquidity of the securitized Subprime Residential Mortgage ABS highlighted the slowness of pricing signals, as matrix pricing was slow to pick up the decay in value, given the sparseness of trades.
By August 2007, it was obvious that residential real estate prices were falling across the US. ?(I flagged the peak at RealMoney in October 2005, but this also is lost…)
Amid all of this, the “big short” was not a sure thing as those that entered into it had to feed the trade before it succeeded. ?For many, if the crisis had delayed one more year, many taking on the “big short” would have lost.
A variety of levered market-neutral equity hedge funds were running into trouble in August 2007 as they all pursued similar Value plus Momentum strategies, and as some fund liquidated, a self reinforcing panic ensued.
Fannie and Freddie were too levered, and could not survive a continued fall in housing prices. ?Same for AIG, and most investment banks.
Jumbo lending, Alt-A lending and traditional mortgage lending had the same problems as subprime, just in a smaller way — but there was so much more of them.
Oh, and don’t forget hidden leverage at the banks through ABCP conduits that were off balance sheet.
Dare we mention the Fed inverting the yield curve?
So by the time that BNP Paribas announced that three of their funds that bought?Subprime Residential Mortgage ABS had pricing issues, and briefly closed off redemptions, and Countrywide announced that it had to “shore up its funding,” there were many things in play that would eventually lead to the crisis that happened.
Some of us saw it in part, and hoped that things would be better. ?Fewer of us saw a lot of it, and took modest actions for protection. ?I was in that bucket; I never thought it would be as large as it turned out. ?Almost no one saw the whole thing coming, and those that did could not dream of the response of the central banks that would take much of the losses out of the pockets of savers, leaving bad lending institutions intact.
All in all, the crisis had a lot of red lights flashing in advance of its occurrence. ?Though many things have been repaired, there are a lot of people whose lives were practically ruined by their own greed, and the greed of others. ?It’s a sad story, but one that will hopefully make us more careful in the future when private leverage rises, creating an asset bubble.
But if I know mankind, the lesson will not be learned.
PS — this is what I wrote one decade ago. ?You can see what I knew at the time — a lot of the above, but could not see how bad it would be.
Investment entities, both people and institutions, often say one thing and mean another with respect to risk. ?They can keep a straight face with respect to minor market gyrations. ?But major market changes leading to the possible or actual questioning of whether they will have enough money to meet stated goals is what really matters to them.
There are six factors that go into any true risk analysis (I will handle them in order):
Net Wealth Relative to Liabilities
Time
Liquidity
Flexibility
Investment-specific Factors
Character of the Entity’s Decision-makers and their Incentives
Net Wealth Relative to Liabilities
The larger the surplus of assets over liabilities, the more relaxed and long-term focused an entity can be. ?For the individual, that attempts to measure the amount needed to meet future obligations where future investment earnings are calculated at a conservative level — my initial rule of thumb is no more than 1% above the 10-year Treasury yield.
That said, for entities with well defined liabilities, like a defined benefit pension plan, a bank, or an insurance company, using 1% above the yield curve should be a maximum for investment earnings, even for existing fixed income assets. ?Risk premiums will get taken into net wealth as they are earned. ?They should not be planned as if they are guaranteed to occur.
Time
The longer it is before payments need to be made, the more aggressive the investment posture can be. ?Now, that can swing two ways — with a larger surplus, or more time before payments need to be made, there is more freedom to tactically overweight or underweight?risky assets versus your normal investment posture.
That means that someone like Buffett is almost unconstrained, aside from paying off insurance claims and indebtedness. ?Not so for most investment entities, which often learn that their estimates of when they need the money are overestimates, and in a crisis, may need liquidity sooner than they ever thought.
Liquidity
High quality assets that can easily be turned into spendable cash helps make net wealth more secure. ?Unexpected cash outflows happen, and how do you meet those needs, particularly in a crisis? ?If you’ve got more than enough cash-like assets, the rest of the portfolio can be more aggressive. ?Remember, Buffett view cash as an option, because of what he can buy with it during a crisis. ?The question is whether the low returns from holding cash will get more than compensated for by capital gains and income on the rest of the portfolio across a full market cycle. ?Do the opportunistic purchases get made when the crisis comes? ?Do they pay off?
Also, if net new assets are coming in, aggressiveness can increase somewhat, but it matters whether the assets have promises attached to them, or are additional surplus. ?The former money must be invested coservatively, while surplus can be invested aggressively.
Flexibility
Some liabilities, or spending needs, can be deferred, at some level of cost or discomfort. ?As an example, if retirement assets are not sufficient, then maybe discretionary expenses can be reduced. ?Dreams often have to give way to reality.
Even in corporate situations, some payments can be stretched out with some increase in the cost of financing. ?One has to be careful here, because the time you are forced to conserve liquidity is often the same time that everyone else must do it as well, which means the cost of doing so could be high. ?That said, projects can be put on hold, realizing that growth will suffer; this can be a “choose your poison” type of situation, because it might cause the stock price to fall, with unpredictable second order effects.
Investment-specific Factors
Making good long term investments will enable a higher return over time, but concentration of ideas can in the short-run lead to underperformance. ?So long as you don’t need cash soon, or you have a large surplus of net assets, such a posture can be maintained over the long haul.
The same thing applies to the need for income from investments. ?investments can shoot less for income and more for capital gains if the need for spendable cash is low. ?Or, less liquid investments can be purchased if they offer a significant return for giving up the liquidity.
Character of the Entity’s Decision-makers and their Incentives
The last issue, which many take first, but I think is last, is how skilled the investors are in dealing with panic/greed situations. ?What is your subjective “risk tolerance?” ?The reason I put this last, is that if you have done your job right, and properly sized the first five factors above, there will be enough surplus and liquidity that does not easily run away in a crisis. ?When portfolios are constructed so that they are prepared for crises and manias, the subjective reactions are minimized because the call on cash during a crisis never gets great enough to force them to move.
A: “Are we adequate?”
B: “More than adequate. ?We might even be able to take advantage of the crisis…”
The only “trouble” comes when almost everyone is prepared. ?Then no significant crises come. ?That theoretical problem is very high quality, but I don’t think the nature of mankind ever changes that much.
Closing
Pay attention to the risk factors of investing relative to your spending needs (or, liabilities). ?Then you will be prepared for the inevitable storms that will come.
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