Thursday, April 30, 2009

On Mutual Funds and GM Stock

The Mutual Fund community likes to sing their own praises when it comes to managing your money. The way the story goes, a team of professionals has a much better chance of finding good investment opportunities. After all, they have lots of advantages over the inexperienced layperson. For instance, they are trained in Accounting and Finance which allows them to navigate the increasingly complex slew of reports.

In addition, most investment houses have their own research teams. That way, they don't have to rely on "biased sell-side research geared towards investment banking" (they actually say this in their presentations). Naturally, these teams have full access to top management as the companies know who their actual and/or potential large investors are.

With these resources at their disposal, you would think professionals should have been able to avoid bad investments like GM stock. Oddly enough, a list of GM holders as of 12/31/08 (the closing price was $3.20 which was an all time low for the stock except for a few weeks last year so most of these were under water) shows that professional funds owned a big chunk of shares of an essentially bankrupt company. Many even added to their positions in 4Q08. Granted that a few of the names below, like Vanguard, manage indexed portfolios and, thus, expressed no opinion on the matter, but the point is why would an active manager own ANY shares of GM as late as December 31st?

I am sure that all of the portfolio managers responsible for investing your money (theirs is in the stream of fees you pay) in GM stock as of December 31st, 2008 will tell you that it was too late to sell. I may even be persuaded to think that they believe that. However, no matter how they try to explain it, the truth is that, for all their advantages, they acted no differently than a gambler on his last chip hoping for a recovery when the writing was already on the wall in neon lights.

As you may already know, most active managers underperform their indices over extended periods. Also, they do not see themselves as asset allocators so they never hold much cash nor will they tell you to redeem their funds so that you may hold cash when the time is right. They don't seem to catch the most egregious reporting misrepresentations (Enron, Worldcom, Bear Stearns, Lehman, and GM were all widely held names). The question is why do people still pay 1-2% for bulk institutional management? I suppose it is because that is the way we have always done it.

caveat emptor

Thursday, April 16, 2009

About those Google earnings...

Google has just reported Q1 earnings. As usual, they beat estimates handily and the stock is rallying in the after market.

The actual numbers show up on my screen as follows:

Google First-Quarter EPS Ex-Items $5.16; Analyst Est. $4.95

Wow! they really beat the estimates. Great surprise. How come Google always manages to surprise the analysts?

I keep on reading and something catches my eye:

Net Income rose 8.9 percent to $1.42 billion, or $4.49 a share, from $1.31 billion, or $4.12, a year earlier

I have just checked a few headlines from 4/17/2008 (one year ago):

Google-GOOG reports Q1 EPS $4.84 vs. consensus of $4.52

Google beats by $0.32, beats on revs

So what was the report a year ago? $4.12 or $4.84? It coudln't be $4.12 because that would have been $0.30 below consensus. So I checked. They reported $4.12. In fact, according to Bloomberg, Google has not reported above the estimates since 2Q06.

So what gives? I suppose the analysts give their estimates in US GAAP and they cannot be bothered with anticipating the "ex-items" adjustment. I suppose 3 years is not enough time to realize that, given the sizable adjustments, their headline estimate is useless. By the way, Bloomberg lists 39 analysts covering the stock. The guys from Google of course are perfectly happy with their ability to handily beat estimates every quarter.

Google is a great company and they seem to be doing well in a very difficult economy. They are entitled to report whatever they want within the law.

The analysts, however, by now have had enough time to either adjust their estimates to account for the difference or to highlight the discrepancy that took me 5 minutes to explain. If they haven't done so is probably because it is not in their best interest.

caveat emptor.

Good unemployment numbers again!

According to the WSJ headline jobless claims "fell" last week. Or did they?

An interesting new mantra has taken over the financial press in the past few weeks: "Things are getting better." For those who choose to see it, the impending improvement in the economy is supported by two undeniable facts, (1) the stock market is up, and (2) the data is "less bad" which must mean it is good (aka the positive second derivative).

Unfortunately, Calculus doesn't seem to be a required course for a career in financial journalism. If it was, maybe a few of our esteemed commentators would realize that the numbers are NOT getting better.

For instance, the Initial Jobless Claims number of 610,000 published today, means that many people filed for unemployment for the first time. Thus, saying that the number is better because in the previous week 660,000 did, or because a group of economists who could not predict the recession once it had already started expected a higher number is missing the point. The fact is that 610,000 additional people lost their jobs which means they will, in all likelihood, consume less and maybe even default on their mortgages and/or credit cards. Aside from the human tragedy, I fail to see how this is good news for the economy.

Which brings me to my second point.

Lets say you used to own a portfolio of investments which was worth $100. Lets say it went down 50% last year, so on 1/1/09 it was worth $50. Lets assume that it went down $1 in January which is either 2% ytd or 1% of your original amount. Are you happier in January than you were in December? How does the slower rate of deterioration help you predict what will happen in February and beyond? After all, your portfolio could rally in February or go down another $2. This is the nonsense that is being disseminated by the financial press. Things are supposed to be getting better because your portfolio is going down a slower pace which must mean it will turn around and go up soon. The part in italics, of course, is not true. There is no way to predict when the deterioration will stop (it could take years) or what will be the minimum for your portfolio (could be $5,$10) based on the change of rate of deterioration or second derivative.

Although I realize that unemployment is a lagging indicator, most pundits omit the obvious fact that unless you know when the economy will turn this knowledge is also useless. Also, I don't think anyone would disagree that fewer Americans losing their jobs, other things being equal, is a good thing. However, 610,000 initial claims is a terrible number because it is large and negative. The economy will not turn around until that number becomes small (even lagged by six months or even a year), and nobody can predict when that will happen based on the second derivative. No matter what they say or how loud they say it.

Friday, April 10, 2009

Why Journalists Should Take Calculus

It is hard to be an economics correspondent these days. On the one hand, you see the economy getting worse every day. Record foreclosures, record unemployment, rising bankruptcies, desperation in the minutes from the Federal Reserve from 3 weeks ago. You even see things you thought were not possible in this rich(?) country of ours, like an open squatters movement. Yet, the stock market keeps going up which makes you think the economy will recover in six months. After all, we all know that the market anticipates the recovery by six months. Furthermore, we also know that it is all a matter of psychology. If we believe things will get better, people will spend and things will get better. Where they are going to get the money? you don't really know. "Experts" say this is how it works and you are a journalist, not an economist.

So, following your English Composition 201 method, you go on a quest for some evidence that you can use in your article. First you talk to a few economists. You find a few optimists who tell you that things are getting better because the rate of deterioration is slowing down. Sounds good enough. Then you pick up an article from a colleague in the NYT that says the following (my comments are in [], the emphasis is also mine):

Exports, which make up about one-third of China's economy[they are close to 40%], were 17.1 percent lower in March than they were in the same month a year earlier, the government said Friday. This marked a fifth consecutive month of declines since the world economy ground to a crawl last year, sending demand for goods from China and other exporting countries sharply lower.

Imports to China fell 25.1 percent from a year ago, a slide that was steeper than that seen in February and than economists had projected.

But the fall in exports was below what economists had projected, and less severe than the 25.7 percent plunge recorded the previous month.

The slowing pace of decline in exports was the latest in a string of recent statistics that, combined, have led a growing number of economists to believe that the Chinese economy may have put the worst behind it
In summary, exports, which are extremely important to the Chinese economy, continue to drop at a high rate. However, economists missed their prediction of an even higher rate, so they feel good. In addition, since the speed of the fall is lower, they expect a change in direction. Why? because once it stops falling it will either go up or stay the same. When? they are economists, not soothsayers, however, if their predictions turn to be wrong on the pessimistic side, they will feel good and tell us about it.

The pace of decline is also as the second derivative of, in this case, the export numbers. In Physics, it represents the acceleration. In terms of your car, it is after all the same concept, the acceleration is the rate at which you are speeding or slowing down. It says nothing about the direction and, while it is true that in order for China's exports to grow they must stop declining, it is NOT true that declining at a slower rate means that they will start growing again. In other words, the exports may fall at 25% (faster), 17% (same), or 5%(an even slower rate) next month and then either fall, recover, or stay the same the following month. The real news would be if the grew which is NOT what is going on.

If you like analogies, imagine someone is beating you over the head with a baseball bat at a rate of 3 hits per minute. For some reason, this person decides to just hit you just once every minute (a slower pace). I suppose that we could find an economist to say that you are better off, but the fact remains that your headache will not go away until the beating stops. Whether your attacker is taking a breather or permanently slowing down makes a huge difference, but we just do not have enough information to know.

China has been exporting to the world at a ridiculous pace for years. Now, global consumption is slowing and some is unlikely to come back (think about consumption driven by home equity loans). Thus, I think it is logical that Chinese exports should not return to their 2006-2008 levels which means that they should keep contracting for the foreseeable future. At what pace? I don't know. I also could be wrong, but trying to extrapolate a recovery from a reduction in the pace of deterioration is misleading at best.

Friday, April 3, 2009

What Is The Stock Market Saying?

The stock market has a powerful influence in the mind of the average investor. The belief that the market carries important information is deeply ingrained in our collective psyche. "Mr. Market" is supposed to have the power to predict the future, at least 6 months ahead. Allegedly it is a "giant discounting machine" that relentlessly incorporates information about the perspectives for the companies, and thus, the economy. Naturally this theory becomes more popular when the market goes up as we would like to think that things are always getting better. In my opinion, the evidence suggests that the stock market represents investor's beliefs and, thus, its predictions are often as flawed as those of its components.

The idea of the stock market as a leading indicator does have some economic logic. As the economy begins to pick up, the first people to notice are those running actual companies in the real economy. Thus, a company sees an improvement in their business, which may result in an increase in stock buybacks and/or dividends which, other things being equal, should drive up stock prices. Similarly, as investors find out about improving earnings they are, other things being equal, willing to pay higher prices for company shares.

In the days before 24 hour dedicated financial media and internet trading there was a reasonable lag before the general public would perceive a business improvement in, say, US Steel or General Motors. In those days we had to wait for the reports to make it into the Sunday business section of the local newspaper. On the other hand, not only do we now have instant reports on every sector of the global economy, but we also have dedicated pools of capital (still) who try to exploit every piece of information (true or false) instantly. In other words, like anything else in financial markets, the financial media and the internet have significantly leveled the information advantage that a well connected investor could have enjoyed before the early 80's. In addition, the more developed the market the smaller the advantage, so there is less informational advantage in large-cap US stocks than in small-cap African stocks.

This, of course, does not mean that people won't try to anticipate earnings and that real surprises in particular companies will not occur. However, the notion that the stock market "knows" that the economy is getting better is severely challenged by the facts. For example, what was the market predicting in the Fall of 2007 when it was making new highs after the Fed began cutting interest rates? It seems to me that the answer is that it was predicting a simple liquidity problem which is what the Fed, the investor community, and most market pundits believed at the time. The same can be said for the rally from "The Bear Stearns Lows" which was hailed by most Wall St. banks as the final climax of a crisis that was barely beginning.

The stock market is nothing but the weighted sum of the beliefs of a very large group of people. Although it is based on reality as the companies do exist and represent the real economy, the fact is that its fluctuations are driven at least as much by economics as by mass psychology. The majority of the pundits, however, only emphasize the former while completely ignoring the latter. That is why, among other reasons, we have bubbles. Stocks, like paper money, are worth what people think at the time and people's thoughts can fluctuate for many reasons. That is why we had companies trading for less than their cash value in the 30's and profitless dotcom companies trading for 1000 times future earnings in the 90's.

In my opinion, this time is no different. The stock market predicted a recovery before Obama arrived because people thought he would be better than Bush. Once we saw that the problem was big enough to overwhelm even a competent administration the market predicted a worse recession. Now that it is going up we are reminded by the financial media that things must be getting better because the market is rallying.

Forgive my skepticism, but even if the monthly job losses improve to -300,000, the fact is that the economy will not really get better until that number at least gets closer to zero (i.e. we stop losing jobs at an alarming rate). It may surprise many in Wall Street, but when people are unemployed they consume less. In case you didn't know, our economy was about 70% consumption in 2008. In other words, either the jobless claims number becomes positive at some point or the economy will not improve. In fact, it may get worse. The stock market may anticipate this but the facts will not change. Putting everyone back to work may not be a necessary condition for the economy to improve but expecting a recovery because we go from losing 700,000 jobs to, say, 500,000 is a nonsensical proposition posing as analysis.

So why do people buy stocks right now? Nobody really knows. I do know, however, that most of the daily moves in the market are driven by people who manage other people's money. That is, they either get paid whether they make or lose their clients money or they have an asymmetric risk-reward payment (they get paid a lot if they win but they do not return any money if they lose). These individuals may be more prone to believe than those who have to risk their OWN kid's college fund or their OWN retirement money. In addition, they have no problem talking their book publicly on CNBC which makes them look convincing.

In summary, the economy may or may not improve in the next 6 months. The stock market, however, has a very mixed record as an accurate predictor. One thing I am sure of, the portfolio managers and other pundits parading on CNBC don't know now as they did not know in 2007 and 2008 when they predicted similar recoveries (most did not even anticipate a recession). In any case, they all have a vested interest in convincing the rest of us that the rally is "for real." As I see it, the recent rally has more to do with a change in manager's psychology than with any improvement in the real economy. As we have seen in the past, that psychology can reverse quickly and they will not even admit they were wrong.

Caveat emptor.

Thursday, April 2, 2009

Who is buying the market?

Perhaps the most misunderstood phenomenon in the structure of our financial markets is the impact of trading by mutual fund managers. Paradoxically, in my opinion, it is the single most important factor to predict market moves.

As recently as 1980, less than 6% of U.S. households owned mutual funds. That percentage increased steadily to its peak of almost 48% in 2001 and seems to have stabilized in the mid-low 40's (the data is not yet available for 2008). In terms of holdings, this translates to about $10 trillion as of Dec'08 of which about 1/3 are stock mutual funds. There is a wealth of data on this in

The rationale behind this transformation was that the individual investor did not have the time and/or expertise to manage his or her own money and would be better-off hiring a professional money manager who could do better. Furthermore, asset-pooling would give an investor with an amount as small as $500 access to a portfolio manager with perhaps billions under management and, presumably, better expertise. In the specific case of an equity fund, the manager would presumably chose the best opportunities to "buy low and sell high" which is a sensible way to money.

Unfortunately, the mutual fund industry has metamorphosed into a perverse machine that bears little resemblance with the original design. For starters, most mutual funds are always fully invested (higher than 90%) on the theory that investors who want to hold cash would just sell the fund and, thus, hold cash. Never mind that the average investor is ill-equipped to decide when to hold cash (because most stocks are expensive, for instance) which is why he or she hires a professional in the first place. The industry blissfully ignores this paradox because "stocks always go up in the long run" which means nobody should ever sell them.

In addition, most mutual funds are measured on relative performance against some index. So, according to industry practice, if the S&P goes down 20% and your mutual fund is down 19% you should consider yourself well served. Tracking error, which is the difference between the performance of the fund and its index, is the single most important driver of most managers' decisions (as opposed to cheap vs. expensive). This is why most funds own hundreds of stocks as opposed to a handful (more stocks imply higher market correlation and lower tracking error).

Furthermore, mutual funds charge a fixed percentage of assets under management for their trouble, which means it is NEVER in their best interest to advice the client to redeem the fund and hold cash. Since they never hold much cash themselves either, it is up to the client to decide when the market (or sector) is expensive and get out.

This combination leads to a very different risk reward perspective than one would ordinarily expect. For instance, consider a situation where the portfolio manager, after careful consideration, thinks the economy will be much worse at the end of 2009 than it is today. Furthermore, lets say our manager had decided accordingly to lower the risk of his/her portfolio by raising 10% of cash at the end of February. As the S&P index went from 735 to 666 our manager did not feel too bad as the 10% decline in the index resulted in only a 9% decline in the portfolio. As the index began to recover in March our manager surely dismissed it as a bear-market rally. Unfortunately for our manager, the index decided to keep going piercing the magical round number of 800 which is 9% higher than the close of February. Gone is the outperformance as we are now underperforming.

What would a sensible investor do in this circumstance assuming that he or she thinks the economy will get worse in 2009? I think most people's answer would not be buy more stocks. However, that is exactly what many, if not most, portfolio managers do when faced with this conundrum. Think about it, if the rally continues to 900 and beyond they will be accused of underperforming the market, missing the rally, or worse. On the other hand, if the market goes back down the worst they will have to face is being down with everyone else. Investors are used to bad news when the market goes down. In fact, many don't even open their statements. However, when the market goes up, they expect to make money. The marketing director at the mutual fund company knows this fact and will make sure the portfolio manager is aware of it as well.

Where does this leave the individual investor, who is the actual owner of the stocks managed this way? Thinking that his or her money is managed professionally with incentives aligned to his or her own which is hardly what is happening in reality. As for the market, the behavior I have described is exactly the same one would observe from a short-seller with a stop loss (desperate purchase on the way up, no interest on the way down).

Naturally, while this is happening (recall the period 3/17/08, aka The Bear Stearns Lows, through 5/19/08 before we found out Fannie and Freddie were not really AAA) the pundits think things are getting better because the market goes up while the market is just recovering from and oversold condition driven by performance chasing.

I have no illusions of being able to call the bottom. However, I find hard to believe that the stock market can fully recover while the economy continues to deteriorate which still seems to be the case. While I am fully aware that the market will anticipate the recovery, I think we should be able to see more meaningful signs than "it is getting worse at a slower pace." One thing I am sure of, the current rally has a lot more to do with managers covering shorts (outright or against the index) and chasing performance than with any meaningful improvement in the fundamentals of the economy.