Musing on the Markets : Financial Innovation

We (Still) Don't Know What We Don't Know

Vinny Catalano, CFA — Thu, 19 Nov 2009 02:08:00 GMT

So, here we are. More than two years into what started out as a credit crisis, one plus year after the Lehman collapse and a question that pertains to the one of the central workings of the equities market cannot be answered.

At last evening's Market Technicians Association Educational Foundation seminar, the question your trusty moderator (that's me) posed to the esteemed panel with its decades of experience was in regards to volume. Specifically, the equity markets' volume as recorded each day for every stock traded. That is, the volume that accompanies the price action that results in the market capitalization of the stock market that results in the market value of every investor's portfolio.

Many market analysts have noted the low volume that has accompanied this bull rally. Some have used this fact as a reason to be more cautious, even bearish. Others have cited that low volume bull rallies have occurred in the past and this one is no different. However, in the past, the volume recorded for equity trades completed were quite accurate and reliable, being recorded on exchanges and reported accordingly. Today, the picture is not quite so clear.

With so much trading occurring in the off the exchanges hidden recesses of dark pools and structured products, I asked my very knowledgeable panel, can any investor rely on the volume figures being generated in this current market to measure the strength of the price action of a stock? The answer received was, "We don't know". Well, if this well connected, highly informed group of individuals doesn't know, you can easily assume that just about no one knows. Do you?

The importance of understanding this issue goes beyond its impact on basic market analysis tools (such as technical analysis) and cuts to the heart of a financial system that is still shrouded in opaqueness.

Transparency remains elusive. Yet, transparency (knowing what investors need to know) is vital to the restoration of a sustained confidence in a system that can be measured. When trades occur in the dark corners of dark pools and other off-exchange structured products, clarity as to what exactly is transpiring becomes the victim and investors seeking to measure the market become the equivalent of a bystander to a drive-by financial shooting.

Investment Strategy Implications

Nothing increases the risk factor of any investment more than the dangers posed by ignorance. Yet, here we are. More than two years into what started out as a credit crisis, one plus year after the Lehman collapse and we still don't have a clear idea of what exactly is transpiring in a central part of the capital markets - equities.

For those who might be tempted to dismiss such concerns I simply point to the two key impacts of changing equity prices: the wealth effect and the cost of capital. Both directly impact the real economy, in the current case in a positive way. Were it not for rising market values, the current government policies designed to rescue the US (and global) economy would be brought into doubt. And doubt, a close cousin of uncertainty, is a bad thing for a fragile economic environment.

Price without volume is an incomplete measure of the strength (or weakness) of a market move. Yet, in the current environment, price is the only metric that can be tracked with clarity. Volume, its indicator of power, cannot.

Two years and running and we still don't know what we don't know.

To further the exploration of what we don't know tomorrow I will describe how hedge fund replication products pose a potential threat to the equity markets.

Vinny Catalano, CFA, Global Investment Strategist with Blue Marble Research publishes the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio. To learn about subscribing as well as other benefits, click here.

Beyond the Sound Bite: An Interview with Todd Harrison

Vinny Catalano, CFA — Wed, 15 Jul 2009 19:55:00 GMT

My wide ranging interview with the Founder and CEO of Minyanville includes the potential of a retest of the March lows, the importance of the US dollar to asset price changes, the "age of austerity", the value in financial innovation, and the importance of being a contrarian investor.

The length of the interview is 20 minutes 15 seconds.

(Please visit the site to view this media)

Beyond the Sound Bite: An Interview with David Kotok

Vinny Catalano, CFA — Wed, 29 Apr 2009 14:46:00 GMT

My interview with the cofounder and Chief Investment Officer with Cumberland Advisors includes a cautious equity outlook made more so by the potential flu pandemic, an asset allocation mix that favors high quality bonds over equities, uncertainty re earnings outlook for 2009, and a few thoughts on financial innovation.

The length of the interview is 14 minutes 20 seconds.

(Please visit the site to view this media)

Beyond the Sound Bite is a podcast interview service of Blue Marble Research, publisher of the "Sectors and Styles Strategy Report", a weekly investment strategy perspective which includes the outperforming Model Growth Portfolio.

To learn about "Sectors and Styles Strategy Report" newsletter and other subscriber benefits, click here.

TARP Version 1 Revisited: Mark-to-Market Back in the Crosshairs

Vinny Catalano, CFA — Thu, 29 Jan 2009 00:38:00 GMT

“Senior Wall Street executives said yesterday that they had been sounded out on plans for an “aggregator bank” that would purchase toxic assets from banks. Under one of the plans discussed, toxic assets would be valued by an independent third party. Where assets are purchased at prices below their book values, the government might then inject common equity into the banks to make up for capital wiped out by the sales.”
Financial Times, January 28, 2009

On the surface, mixed signals are emanating out of the US Treasury department. Last week, Treasury Secretary Geithner stated that he was comfortable with mark-to-market accounting. Today, we learn of the above quoted plan, which is a direct assault on mark-to-market – the real villain in turning a recession into potentially a depression. What gives?

To refresh your memory, mark-to-market accounting is rooted in the failed ideology of the efficient market hypothesis, which (in its “strong” form) says that when it comes to determining the fair value of an asset the market knows best. This dogma is so entrenched in the thinking of mainstream economists and many naïve investors that even Nobel Laureates such as Paul Krugman ascribe to this fantasy of the “wisdom of the market” (see "More on the bad bank"). Moreover, there is little doubt on these pages that the primary reason why TARP Version 1 went from “price discovery” (code for attacking mark-to-market) to bank capital infusions was due to the intimidation of then Treasury Paulsen by mainstream, non behavioral finance economists.

Investment Strategy Implications

Conspiracy theorist alert: Clever guy this Mr. Geithner. Publicly advocate for free market principles (mark-to-market) while working behind the scenes to exploit it (through the aggregator bank and price discovery (courtesy the "independent third party")).

The significance of keeping mark-to-market intact is the extraordinarily positive impact it will have on bank earnings as assets held at 20 cents on the dollar are written up ("say what?" you say) thereby producing large earnings gains. Moreover, by stabilizing the valuations of “toxic assets”, write ups will thereby alleviate banks’ capital requirements, which is the primary reason why bankers are reluctant to lend. Under the bizarro logic of mark-to-market, they need the cash to remain solvent – hence no lending.

Once mark-to-market is replaced by something like mark-to-maturity (suggested by Bernanke during early days of TARP Version 1), then, miraculously, liquidity will begin to flow through the banking system to the real economy. Sounds too simple? Allow me to refresh your memory on another non real economy factor that wrecked a large amount of unnecessary havoc on the global economy – commodity speculation and the price of oil.

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What's In A Name?

Vinny Catalano, CFA — Tue, 30 Sep 2008 14:05:00 GMT

A bailout by any other name would smell just a foul. Or would it?

The Bard may have captured the essence (pun intended) of the smell test, but then again he didn’t run for elected office. Nor did he live in a media saturated, image drenched world as we do. Therefore, when Bush left it up to the political tone deaf Treasury Secretary and Fed Chairman to be the messengers of the plan to rescue the US and world economy, he violated the primary rule of any political action – control the message. And controlling the message means framing the issue properly with a title that captures the essence of the desired action and one that will help win the hearts and minds of voters and their representatives. After all, who is in favor of a bailout of any sort? Least of all one for the “New York City fatcats (who) expect Joe Sixpack to buck up and pay for all of this nonsense*”?

To some, what you call something may appear to be trivial. However, behavioral scientists (and common sense) will tell you that many decisions made in life (including investing matters) are not done in a dispassionate, rational manner but by using mental shorthand tools (heuristics). And part and parcel of that process is how you frame the issue (framing). Therefore, if you let something get framed as a “bailout”, that’s what it will be perceived as.

So, as many members of the House rethink their profiles in cowardice by putting re-election before country, perhaps the administration and congressional leaders might consider a better process of explaining more clearly to the American public and their highly re-election conscious representatives what it is at stake.

The “Rescue America from a Depression” bill may not be the best smelling sausage to come out of Washington, but the stench of a deep recession will smell a heck of lot worse.

*Rep. Ted Poe (R), Texas

Unacceptable

Vinny Catalano, CFA — Tue, 23 Sep 2008 12:01:00 GMT

As the world listens to Messrs. Paulson and Bernanke argue for support of their three-page $700 billion manifesto, I wish to focus your attention on a central aspect of the credit crisis – the scale and scope of the credit derivatives octopus.

To illustrate, consider this: If scientists can “identify all the approximately 20,000-25,000 genes in human DNA”, and “determine the sequences of the 3 billion chemical base pairs that make up human DNA,” then why can’t the financial scientists identify the extent of the credit derivatives market?

This is a national, if not global, emergency. In such an emergency, is it acceptable to say, “We don’t know what we don’t know?” Or, “It’s too hard to figure out.” Nonsense. If this emergency were a war, would it be acceptable to say, “We can’t build that tank or missile because we don’t know where the steel is”? Of course not. So, why is it acceptable to say we don’t know the extent of the credit derivatives octopus?

Perhaps certain US government officials do know but they are just not saying so. Perhaps those certain US government officials reside in the US Treasury and Federal Reserve Bank. If so, then their actions these past anxiety-riddled months are about as inept as could be possible as a more comprehensive plan of action should have been constructed (from such knowledge) rather than the firemen Hank and Ben put out the latest financial wildfire this weekend, right now routine we have been treated to.

Investment Strategy Implications Along with the insane decisions to implement FAS 157 and eliminate the uptick rule, the outrageous neglect on the part of those charged with oversight of the entire financial services industry, and the fundamental rationale supporting each (efficient markets and laissez-faire), you can add the unacceptable argument that it’s just too hard to figure out the credit derivatives octopus.

In the process, the world’s markets and economies are now forced to experience a disorderly unwinding of the credit bubble – a disorderly unwinding that could have been mitigated had certain action steps, and the rationales supporting them, been avoided.

Sadly, today’s testimony will almost certainly contain a lot of shoulder shrugging “we don’t know what we don’t know, it’s too hard to figure out” statements. Unacceptable.

One Year and Counting

Vinny Catalano, CFA — Tue, 12 Aug 2008 08:01:00 GMT

commentary from this week's "Sectors and Styles Strategy Report:

“Of all the newfangled financial creations that have caused problems this past year, arguably the most nerve-wracking are derivatives traded over-the-counter…” Economist August 8, 2008

And the beat goes on.

On several occasions over the past year, hopes rose that the credit crisis was about to abate only to be dashed by yet another set of surprisingly large bank write-downs. Surprising to some but not on these pages. The risks from the credit crisis are far broader than originally thought and only now becoming grudgingly clear. And there is truly no end in sight.

Up and out is my way of characterizing what Nouriel Roubini has accurately described as the full scope of the financial Frankensteins created over the past decade. UP in the form of write-downs moving up the quality spectrum within an asset group. And OUT to other financial instruments created by the wizards of Wall Street.

Exacerbating the situation is the accounting rule change instituted last November, FAS 157, in which assets impacted by diminished demand produce lower values requiring mark-to-market write-downs thereby requiring new capital to meet banking related capital requirements leading to further pressure across the entire banking system. A vicious circle.

The equity markets are beset with multiple layers of issues – some, such as inflation, likely to not be an issue for much longer. However, fears of a global economic slowdown are now more real than ever, particularly when we get to 2009 and corporate default rates begin to rise as noted in the following chart* from last week’s NYSSA Market Forecast event (courtesy high yield expert Marty Fridson):

Moreover, according to Marty, the peak isn’t projected until 2010 at an 11% rate. This is the origin/catalyst of the $250 billion (net) credit default swap pain noted by PIMCO’s Bill Gross back in January of this year. So, if you want to see how banking losses get into the $1 to 2 trillion range, this is one contributing component.

Investment Strategy Implications

Last week’s so-called “Olympian rally” in equities must be taken with a huge grain of salt. As noted in several areas of this report*, the contradictory nature of the recent market rally is hardly the stuff of sustainability. Highly fragmented market action with little to no sustained and coordinated leadership provides no real investment comfort beyond riding the bear rally from its undervalued levels.

Until there is more market structure, an overall market neutral approach is advisable to take. Scalping any “lunch money” is also a good short-term course of action for a modest amount of money. Given the looming danger of a no-end-in-sight credit crisis and a 2009 that may stress test more than the banking system, the deleveraging process on multiple levels (banking, US consumer) warrants an above average level of caution.

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No End In Sight meets Mr. Alpha and Regression to the Mean

Vinny Catalano, CFA — Thu, 31 Jul 2008 11:08:00 GMT

“U.S. bank stocks may be staging another suckers' rally.” Reuters, July 31, 2008

From time immemorial the four most dangerous words in the investment language has been “This time is different”. Today, however, a new phrase seems destined to join the dreaded phrase group – “No end in sight”.

If an investor assumes that the IMF is correct, then the bank loss write-downs could reach $945 billion. If hedge fund investor extraordinaire John Paulson is correct, the number increases to $1.3 trillion. If Bridgewater Associates is correct, the number rises further to $1.6 trillion. And the top end of Nouriel Roubini’s disaster scenario range is a cool $2 trillion.

At under $500 billion in losses taken thus far, “no end in sight” is an apt phrase.

But, to quote the Joker, “Why so serious?”

Investment Strategy Implications While the relief certain investors may feel due to Merrill’s actions may be premature, investment strategy considerations drive the current portfolio decision-making process. For, if an investor has been fortunate enough to have produced alpha thus far this year – for example, portfolio and investment strategy decisions made in the Model Growth Portfolio (MGP) have yielded over 300 basis points of alpha thus far this year – then the real risk may not be the next plunge in equities (that’s coming) but the danger in not exploiting the near-term momentum game courtesy hedge fund momentum players and thereby losing valuable alpha in any short-term bear market rally.

Therefore, the appropriate current investment strategy appears to be largely a market neutral one. With an undervalued market and no sustainable and exploitable trends or themes at work, being fully invested – yet with no particular tilt from a sector perspective* – seems most appropriate. It’s only from a style and size perspective that a modest tilt toward the Smids and growth (as opposed to value) remains advisable**.

So, when Warren Buffett declares that the financial crisis due to “financial weapons of mass destruction” is “far from over”, investors should heed the warning. For those who are paid to exploit near term market moves, however, an undervalued market dominated by hedge fund momentum players is too hard to ignore and an investor stands to lose a considerable amount of hard won alpha***.

No end in sight is real. However, regression to the mean in an undervalued market may take precedence for the time being.

*The MGP is strongly underweight Energy. This will change shortly pending their 2Q08 earnings reports, the potential of negative political influences therefrom, and technical analysis considerations.

**This, however, would change should the recent weak relative performance of the Smid growth styles continue.

***If wrong, then the absolute performance will suffer, no doubt, but the alpha remains largely unchanged.

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Wildfires

Vinny Catalano, CFA — Thu, 17 Jul 2008 10:45:00 GMT

It hardly instills deep confidence in our government officials when, after nearly a year, its prime modus operandi is to react to the latest financial crisis with yet another 11th hour solution. This is one of the longer term implications of the bailout plan for Fannie and Freddie.

For all the near term good that could be construed from the latest financial wildfire containment, it is hard to understand why after nearly a year Messrs. Paulson and Bernanke are still in a reactive mode. Given all the resources at their disposal and all the warnings that are plain for everyone to see, it is most disturbing to hear the hurried pitch for unlimited back stop funds for the two GSEs.

Investment Strategy Implications The Nouriel Roubini scenario where the write-down contagion spreads both up (the quality spectrum, which in the case of mortgages involves Alt-A’s, near prime, and prime) and out (to other categories, such as credit cards, auto loans, and corporate debt) is the nightmare scenario that is threatened by the reactionary mode of government. The economic dangers that $1 trillion (on up) in banking losses would produce cannot be fully measured. But what can be assumed with a fair degree of certainty is that the deleveraging process that such a credit creation contraction would generate will exacerbate an already fragile global economic and financial situation, if not tip the global economy into a depression.

Getting ahead of the curve, being proactive with a well thought out plan would go a long way toward instilling far more overall confidence in financial institutions and, thereby, likely result in stable if not higher asset values (not to mention a better level of consumer confidence).

Putting out wildfires is necessary and helpful but hardly sensible forest management.

Smokey the Bear would not be proud.

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Where's John Maynard Keynes When You Need Him?

Vinny Catalano, CFA — Thu, 10 Jul 2008 08:19:00 GMT

This morning’s testimony before Congress affords US Treasury Secretary Paulson and Fed Chairman Bernanke yet another opportunity to allay the fears of all parties interested in the health and wellbeing of the world’s economies and markets. Unfortunately, however, what is likely to be heard is more dogmatic drivel regarding the magic of the markets as the elixir that cures all ills.

Words such as “market discipline” will almost certainly be uttered by Messrs. Paulson and Bernanke today, as they cling to an ideology, “market fundamentalism” (laissez-faire or neo liberalism, if you prefer), whose time has passed. For with their adherence to “market discipline” comes the front line, the first wave of economic chaos in the form of a rolling destruction of major chunks of the financial services industry (not wholly undeserved) and the multi-dimensional feedback loop that the resulting deleveraging and radical shrinkage of the credit creation process will produce on the US (and ultimately world) economy.

Perhaps one might wonder if those on the other side of today's testimony table might provide some philosophical leadership in this highly charged political year. Guess again.

The Republicans find themselves locked in a defensive mode attempting to preserve their market fundamentalism ideology. (Supply side voodoo economics still rules this roost.) And where they are proactive is in areas that are tied to the ole timey magic of the “invisible hand” such as oil crisis = more land for drilling. No real solutions. No real comprehensive energy policy. More of the same animal spirits, magic-of-the-markets thinking.

As for the Democrats, their agenda is fairly obvious – look busy! As they appear to “fight” for the US consumer against the dark forces of cowboy capitalism and market fundamentalism their real end game is more power via a landslide victory this fall. Until then, why take more than band-aid economic action that will result in any form of a rebounding US economy when the more advantageous political objective is to pin the McCain tail on the Bush donkey?

Investment Strategy Implications

Cowboy capitalism expressed in the financial markets is market fundamentalism. They are rooted in the same philosophical thinking that has wrecked havoc on the world’s economies and markets via fat tail economic and financial crises that mega trends such as globalization, technological innovation, and financial innovation have only exacerbated.

What is needed, and getting more desperately so with each passing month, is new thinking and a new intellectual philosophy regarding government, the economy, and the markets. A good start would be a clear recognition that the philosophical underpinnings of the past two decades, the market ideology known as market fundamentalism and its economic counterpart, cowboy capitalism (replete with trickle down economics and ever resetting stock options for corporate executives), has produced radicalized results for the interconnected world economy and markets. What is needed is fresh thinking and a willingness to transform a broken system rooted in a defunct ideology. But that is not what you and I will hear today. What you will hear is regulation and half measures. But neither is a real, sustainable solution. Therefore, the only remaining question is what will it take for transformative action that will produce less radical economic and financial results? The answer might lie in a global recession to rival the one some 70 years ago. Then we may see who emerges as this century’s John Maynard Keynes.

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