The Float

Asset Pricing and Market Transparency

In this morning's Wall Street Journal, Susan Pulliam, Randall Smith, and Michael Siconolfi describe the many challenges created by the rise of securities that trade infrequently and/or through channels other than traditional exchanges. There's a lot of excellent material in this story (and its graphics, three of which we've reproduced here). One highlight is this opening example:

The hazards of this new age of uncertainty became clear at Dillon Read in March, when rising defaults by homeowners were hammering the value of mortgage securities. John Niblo, a hedge-fund manager at the firm, acted fast. He twice slashed his fund's valuation of securities tied to "subprime" mortgages, knocking them down by about 20%, or nearly $100 million, say traders familiar with the matter.

UBS later shut down the in-house hedge fund, and Mr. Niblo was let go in August. Last week, UBS announced a $3.7 billion write-down on $23 billion of securities with mortgage exposure, including securities from the shuttered fund.

But managers at UBS AG, Dillon Read's parent company, were irate. The Swiss banking giant was carrying similar securities on its books at a far higher price, the traders say. In conference calls, the UBS managers grilled Mr. Niblo on his move. "I'm marking to where I could reasonably sell them," Mr. Niblo responded during one call, according to the traders familiar with the conversations.

We aren't sure how practical Warren Buffett's suggestion is here, but you have to appreciate the clarity with which the man speaks:

Billionaire investor Warren Buffett advocates more transparency in pricing. "Some marks can be pretty imaginative," he says. "They call it 'marking to market,' but it's really marking to myth." He says that before funds publish financial statements, they should sell 5% of hard-to-value positions to gauge values.

In Wall Street's brave new world of quant funds, structured finance, CDOs, Level 3 accounting, super-generous compensation structures, and all the rest, accurate marks may be more difficult to come by, but they're more important than ever.

 

Source

Susan Pulliam, Randall Smith, and Michael Siconolfi, "U.S. Investors Face An Age of Murky Pricing," Wall Street Journal, October 12, 2007 (subscription required)

A Short Note on Liquidity

With so much talk of liquidity sloshing around these days, it's important to take a step back and think about what the term means.

Let's start with a simple definition: A liquid market is one in which participants can readily buy or sell an asset without significantly affecting that asset's price.

Note that there are two key elements in that definition. First, liquidity implies a ready market for both buyers and sellers. Second, it implies a market in which the act of buying an asset doesn't push its price meaningfully higher and the act of selling doesn't push its price significantly lower.

This is by now a relatively familiar story to many market observers, but much of the recent turmoil in the credit markets affected relatively illiquid (i.e., difficult-to-trade) debt securities such as pools of subprime mortgages. As the market value of those securities fell over the Summer, some money managers, facing margin calls and various risk-management obligations, were forced to dump what they could sell (i.e., liquid stocks) rather than what they wanted to sell (i.e,. illiquid debt securities). That's how weakness in one asset class, exacerbated by illiquidity, spilled over into the stock market in July and August.

Since the Fed's August 17th discount rate cut, a certain giddiness has pushed the broad averages back above their July highs and taken the market's leading momentum stocks higher still. Our sense is that much of the recent enthusiasm for risky assets (e.g., emerging markets and high-multiple growth stocks) has been driven by a belief that the Fed and other central banks have injected substantial "liquidity" into the global financial system.

All of which leads us to an interesting debate: Has the Fed injected "liquidity" into the system? On one side, arguing in the negative, is John Hussman. On the other side (sort of) is Barry Ritholtz, who takes a broad view of rapid growth in the aggregate money supply.

We think there's logic in both arguments, as there clearly is a tremendous amount of cash racing around the world even as the Fed hasn't increased U.S. bank reserves. What we're left with, then, is the inescapable conclusion that in a world of truly abundant paper currency, liquidity is basically a state of mind. It's largely a psychological phenomenon (though not exclusively, as central bank policy affects investors' economic calculations by making leverage more or less attractive, and if there's a single defining characteristic of global financial markets, it's leverage).

Liquidity turns on the willingness of buyers to exchange (often leveraged) cash for assets, and of sellers to exchange (often leveraged) assets for cash. So when Hussman writes that "the Fed certainly has a psychological effect on investors," he's pretty much said it all.

There's plenty of technical detail behind this, but the essence of the idea is ridiculously simple: It's investors' risk appetites that sublimate central bank policy into financial market liquidity.

Friday Reading

After yesterday's intraday reversal in the broad averages, the any-news-is-good-news vibe might take a little breather here...or it might not!

• James Montier on some new research from Fama and French on the importance of dividends in long-term stock returns.
• State sales tax collections? Not so hot these days.
• Tim Price riffs on the ongoing reprise of "irrational exuberance."
• At FT's Alphaville, Sam Jones has a couple interesting posts on the rise of sovereign wealth funds (on the projected trajectory of SWF assets and asset allocation and the implications of SWFs for the U.S. dollar).
• At Goldman, those pesky Level 3 assets appear to have ticked up a bit in Q3.

UPDATE: Speaking of any-news-is-good-news, check this out: A half-funny, half-true manifesto for our times.

Is Style Drift a Virtue?

Last week we ran across an interesting Forbes story on the positive utility of mutual fund style drift in which Joshua Lipton argues that relatively unconstrained money managers tend to outperform their boxed-in competitors--and thus that investors should actually welcome style drift rather than fight it. This mildly contrarian take leads us back to an argument we've made repeatedly (in April and July, for instance).

We think investors' and advisors' determination to fit mutual funds into "style boxes" imposes unhelpful constraints on money managers and--more importantly--reflects a fundamental misconception of prudent return-seeking in a risk-management (and expense-management) framework.

Here's our view, as we wrote it on July 9th:

[I]nvestors should attain broad, diversified exposure to a wide range of asset classes using inexpensive index funds...then supplement that core strategy with an active management discipline that's agile (not bloated), relatively concentrated (not excessively diversified), eclectic (not style-constrained), and absolute-return-minded (not benchmark-hugging).

This is a simple formula, but too often investors get stuck with mutual funds that offer a mediocre mash-up of benchmark-tracking and active management that's too expensive to deliver efficient asset-class exposure and too big and diversified to deliver successful active management. It frustrates us to see investors pay up for active management and receive less than the index-caliber performance they could have enjoyed for a fraction of the cost.

So style drift may be a virtue, but only in the right context. Investors should keep their style-box investments pure and simple with index funds, then let their active manager(s) roam the financial markets as needed. That's a formula for lower total costs, increased investor confidence, and better long-term outcomes.

Source

Joshua Lipton, "Drifting Into Better Returns," Forbes.com, October 5, 2007

Global Equities and Target-Date Funds

Interesting story from Jonathan Burton in yesterday's Wall Street Journal on the weight of international equities in so-called "target-date" or "lifecycle" mutual funds (which, to be precise, are funds of funds).

Burton notes that the leading fund companies vary in their weightings of non-U.S. stocks, which is both understandable (because there's no unassailably "right" answer) and desirable (because it allows investors to choose among different approaches, though of course avoiding such choices is part of the appeal of these one-stop funds).

In general, we agree with Burton's suggestion that some funds of funds are significantly underweight international and emerging market stocks. Given their recent outperformance, it's important not to get too carried away with these asset classes, but for long-term investors there are plenty of good reasons to ratchet up the global exposure a bit.

For several reasons--weak asset allocations, too-frequent and/or calendar-driven rebalancing, the inclusion of mediocre funds in an otherwise useful vehicle (in part because those underperformers are hard to sell on their own), an extra layer of fees in some cases--we aren't especially fond of the target-date fund-of-fund model in the first place. But where they make sense (or where they're unavoidable, as in some 401(k) plans), investors would be well-served by meaningful allocations to non-U.S. equities (and debt, for that matter).

Related: A recent column from S&P at BusinessWeek.com on the potential trajectory of those still-searing emerging markets. After a multi-year run like the one on display in the adjacent chart (emerging markets in red, S&P 500 in blue), prudent investors will be prepared for near-term corrections in the asset class.

Whatever the near-term risks, S&P argues the longer-term emerging markets picture remains decidedly bullish:

Standard & Poor's Equity Research believes favorable EM demographic trends, increased industrialization and urbanization, and growing consumption of finished goods and services are responsible for the shift in global growth leadership. We expect these trends to continue for decades to come.

If that's the vision--and we think it's a plausible one--S&P's conclusion that emerging markets should constitute only 5% of a 60%-equity portfolio held by a long-term investor (i.e., 8.3% of the equity component) strikes us as mildly anemic.

As we noted above, there's no single answer to the question of "how much is enough" in any asset class, let alone one as potentially volatile as emerging markets. Part of the question turns on the relative emphasis one places on return-seeking and risk management in the portfolio construction process.

At this point, retail investors' demonstrated preference for international mutual funds feels a little like good old fashioned performance-chasing, but many Americans have become more comfortable with investing outside the U.S. Investors' true test will come when the "bull market in everything" no longer holds.

Source

Jonathan Burton, "Target-Date Funds: Not Foreign Enough?" Wall Street Journal, October 9, 2007 (subscription required)

Alec Young, "Emerging Markets: The Trend is Your Friend," BusinessWeek.com, October 9, 2007

Wednesday Reading

Fall is in the air as investors behold the Rorschach test that is the Federal Reserve...

• Minyanville's Todd Harrison riffs on the four pillars of the current market: Technicals, psychology, fundamentals, and big structural trends.
• Tim Iacono deconstructs recent non-farm payroll reports...and finds the composition of recent gains less than inspiring.
• Fedspeak: Bill Poole and Janet Yellen held forth yesterday.
• James Picerno considers the widening gap between core and headline PCE inflation numbers.
• Slate's Daniel Gross wonders what investors are thinking when they bid up investment banks after those banks' big write-downs...and Portfolio's Felix Salmon has an answer.
• Not necessarily riveting, but important: The minutes of the September 18th Fed meeting. The most compelling material begins about two-thirds of the way down the page. To their credit, members of the FOMC appear to grasp the limits of their foresight, as this passage reveals:

Given the heightened uncertainty about the economic outlook, the Committee decided to refrain from providing an explicit assessment of the balance of risks, as such a characterization could give the mistaken impression that the Committee was more certain about the economic outlook than was in fact the case.

This admission--that Fed policymaking is closer to Charles Lindblom's "science of muddling through" than any idealized notion of Platonic guardianship--may be mildly disconcerting to some, but it strikes us as refreshingly honest. After all, as these minutes explicitly acknowledge, the Fed shifted abruptly from inflation-watch in early August to borderline-emergency-easing since then. Social scientists refer to the earnest-but-imperfect decision-making on display at the Fed as a form of "bounded rationality," which recognizes the limitations of the information available to decision-makers and those decision-makers' ability to process that information.

Into Earnings Season

When Alcoa reports its Q3 earnings after the bell today, investors will begin to get relatively concrete evidence of the fallout from this summer's credit lockup and the deepening housing slump.*

In thinking about the relationship between earnings and stock prices, we see a relatively favorable short-term context and a more uncertain long-term environment.

In the short term, analysts have taken Q3 earnings estimates down to near-zero for the S&P 500. Assuming current prices have adjusted to those reduced estimates--and that risk appetites remain relatively robust and multiples relatively steady--it's easy to envision companies pull of yet another round of "beat-the-number," which would, at the least, provide a near-term floor for stock prices.

In the longer term, however, we see some headwinds for equities. With profit margins and the corporate share of GDP at historically high levels, it's difficult to see major, sustained moves higher in the broad market without meaningful multiple expansion. And it's difficult to imagine robust multiple expansion in an environment of mean-reverting profit margins.

None of this is to say that stock prices are poised for sudden irreversible downturns or a grinding bear market. With valuations a bit rich but nowhere near the zany levels of 2000, the more likely scenario is a continuation of the secular contraction in earnings multiples--and long-term plateau for the broad market averages--that began more than seven years ago.

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*We say relatively concrete because we're living through another period of creative accounting that makes it difficult to get a firm handle on some corporate balance sheets.

Sources

Laura Mandaro, "Alcoa To Set Off Earnings Season With Modest Growth," Dow Jones Newswire, October 7, 2007

Stoneridge

Important stuff at the U.S. Supreme Court today. From Fortune's Roger Parloff:

On Tuesday morning the U.S. Supreme Court will hear oral arguments in what has been widely described as both the most important business case of the term and the most important securities case of the decade.

The case, known as Stoneridge Investment Partners v. Scientific-Atlanta, will determine how easy or difficult it will be for plaintiffs lawyers bringing class actions for alleged securities fraud to sue third-parties in addition to the corporation that issued the stock in question. The third parties most frequently targeted are accounting firms, law firms, investment banks, and vendors who did business with the issuer.

Parloff's blog-style summary of the case and its implications is worth reading in full, as is Greg Stohr's account at Bloomberg.

What's a Little Rounding Error Between Friends?

We've written repeatedly on the potential problems inherent in "mark-to-model" valuation (here and here, for instance). To some extent, of course, marking to a model is inevitable when money managers who hold illiquid positions have to valuae those positions on a regular basis (e.g., monthly, as in the case of many hedge funds). Problems arise when agents' incentives (e.g., hedge fund fee structures) bump up against principals' interests (e.g., investors' interest in accurate valuation of the securities held in their names).

Enter Nicolas P.B. Bollen and Veronika K. Pool, two finance scholars who culled an enormous database of monthly hedge fund returns to search for evidence of systematic valuation errors. They think they've found that evidence, and--surprise--it tilts in favor of your friendly neighborhood hedge fund manager. From a Wall Street Journal report by David Reilly and Gregory Zuckerman:

New academic research suggests that some hedge-fund managers may cherry-pick flattering prices when valuing securities that don't actively trade in an effort to improve the performance of their funds.

Investors should take heed because this massaging can help make the difference between a winning or losing month, the research found. For hedge-fund managers, such statistics on the number of winning and losing months have grown increasingly significant as the number of hedge funds has exploded -- to more than 7,500 -- and managers vie to attract and retain investor capital.

...

The academic research found a significant difference in the number of funds reporting a slight gain compared with a slight loss in any given month. That difference was most pronounced for funds that trade illiquid securities; it didn't show up in funds that primarily trade stocks or futures contracts, which have active markets and easily obtained prices. This suggests that some funds could be fudging results.

...

Fund managers can have a lot of leeway in determining whether such securities have lost or gained money. As long as they remain consistent, they can, for example, choose whether to use the bid or offer price of a security, which can sometimes vary widely, or pick among different quotes offered by competing brokers. So if a hedge fund is looking at a possible loss for a month, a manager could pick the more optimistic prices for some securities to push the fund into positive territory while ignoring those that could exacerbate losses.

...

Typically, hedge-fund returns should fall along a familiar bell-curve pattern with a peak that is likely to be in slightly positive territory. That is how the returns play out for equity-neutral strategies, which bet on stocks either rising or falling in value. But that doesn't happen for strategies that deal with illiquid securities.

"This is perhaps no surprise: Distorting returns is more feasible when the opportunity for exerting managerial discretion is higher," the paper said.

Managerial discretion indeed.

Source

David Reilly and Gregory Zuckerman, "Pricing Tactics Of Hedge Funds Under Spotlight," Wall Street Journal, October 9, 2007

"R Word" Roundup

We've heard lots of loose talk lately about a potential/impending/inevitable recession. Though a weak and weakening housing market, tighter credit conditions, and deeply indebted consumers* clearly suggest below-trend economic growth, it's important to remember how rare (and brief) recessions have been over the last few decades.

Whether an official NBER-declared recession is in the cards or not, prudent investors should have a handle on what sort of economic slowdown we might see, what the probabilities of each appear to be, and what sort of evidence one might use to update those probabilities as new data come in.

Here are four excellent summaries of the available evidence on these and related macroeconomic questions:

• Calculated Risk reviews of 50 years of GDP change, placing each four-quarter period in one of four categories, from booming growth to severe recession.
• James Hamilton responds to Calculated Risk, arguing that the "idling of potentially productive resources" that's both cause and effect of recessionary conditions tends to develop very quickly--perhaps too quickly to have any "predictive" power.**
• John Mauldin argues that housing weakness will translate to broader economic weakness, but only slowly, and, in part because of the gradual feedback of housing weakness into the broader economy, the resulting macro weakness will "probably not be all that deep."
• John Hussman crunches the relevant numbers, concluding that recession risks have increased but aren't yet "decisive."

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*On consumer debt--and, ultimately, consumer spending and the business cycle itself--stories like these are flashing yellow lights: (1) credit card debt rose 8.1% in August as consumers rotate from mortgage equity withdrawal to revolving credit (MarketWatch) and (2) more workers appear to be taking loans against their 401(k) savings (Wall Street Journal, subscription required).

**On the inherent difficulty of forecasting unlikely events, see this excellent item from Jeff Miller.

Sources

Robert Schroeder, "U.S. consumer credit rises in August," MarketWatch, October 5, 2007

Jillian Mincer, "401(k) Loans: At Your Own Risk," Wall Street Journal, October 6, 2007 (subscription required)