Toro's Running of the Bulls Market Blog

Willian Tell-span

Er, we might have to revise the legend.

From Tom Toles.

 

I think 30% is generous.

Banks Feast, Seniors Starve

One of the many negative ramifications of the Fed’s grossly incompetent monetary policy over the past few decades has been to reward speculators and punish savers.  Charles Schwab makes this point, only in a much nicer way, in today’s Wall Street Journal.

In February 2006, when Ben Bernanke was first sworn in as chairman of the Federal Reserve, the federal-funds target rate stood at 4.5%. That same year, the average yield on a one-year certificate of deposit was 5.4%. A retiree who diligently saved for a lifetime and had amassed a nest egg of $100,000 could count on an added $5,400 in retirement income per year. That may not sound like much to the average Wall Street Journal subscriber, but for a senior on fixed incomes that extra money improved the quality of his life.

Today's average rate for an identical one-year CD is roughly 1.3%. On the same nest egg, that retiree will now get annual payout of just $1,300—a 76% decline in four years.

Some would argue that today's low inflation rate offsets the decline. But even at an inflation rate of zero, a 76% decline in spending power is painful. And we're already seeing signs of inflation this year. The first two months of 2010 showed an annualized inflation rate of 2%, further exacerbating the spending power problem for retirees by eroding the value of their principal. ...

We would accentuate what Mr. Schwab is saying.  In February 2006, the CPI was 3.6%.  Thus, the senior was earning a 1.8% real return.  Today, the CPI is 2.1%, earning the senior a real yield of -0.8%.

[T]hese unprecedented low rates have now been in place for almost 18 months. As a result, banks have enjoyed virtually free access to money while retirees have been deprived of any meaningful yield on their fixed-income portfolios. For a large segment of our population—people who worked long and hard, who followed the rules by spending less than they earned and putting the remainder away to keep themselves independent in retirement—the ultra-low interest rate is more than a hardship. It's a potential disaster striking at core American principles of self–reliance, individual responsibility and fairness.

The Bernanke/Greenspan solution is to push grandma and grandpa out onto the risk curve and force them to buy risky assets.  One would think that after 50 years of hard work, a person would be entitled to a sound sleep, and not have to worry about the credit quality of banks, or what this quarter’s earnings are going to be, or if we can trust the ratings agencies.  Sorry Grandma, gotta make sure those $2 million Wall Street bonuses are paid.

One lesson of the past 20 years is that it takes more and more monetary and fiscal stimulus to get less and less results.  But more and more stimulus begets more and more speculation in asset markets. 

Greenspan cut interest rates to 1%, held rates there for a year, then slowly walked rates up, igniting one of the biggest bubbles of all time.  Bernanke cut rates to 0%, has held rates there for 15 months, bought over a trillion dollars worth risky securities, guaranteed trillions more, and has indicated there will be no surprises in the unwinding of the unprecedented easing.  See the parallels? 

Artificially low interest rates encourages rank speculation and creates mal-investment within the broad economy.  This is the policy Greenspan followed.  This is the policy Bernanke is also following, only it is much, much bigger today.  There is no reason to think that the next several years will be any different than the last several years.  Sadly, nothing has changed. 

Surf the oceans liquidity, but make sure you know when to get to dry land.  In the asset-driven economy, savers are losers and speculators are winners, at least until the next bubble pops. 

 

If You Want Higher Returns, Give the CEO Less

From The WSJ

[T]wo new studies ... suggest that when chief executive officers get paid more, shareholders end up earning less.

The first study, led by corporate-governance expert Lucian Bebchuk of Harvard Law School, looked at more than 2,000 companies to see what share of the total compensation earned by the top five executives went to the CEO. The researchers call this number—which averages about 35%—the "CEO pay slice."

It turns out that the bigger the CEO's slice of the pie, the lower the company's future profitability and market valuation. "These CEOs," says Prof. Bebchuk, "seem to be trying to grab more than they should."

Finance professor Raghavendra Rau of Purdue University and two colleagues looked at CEO pay and stock returns for roughly 1,500 companies per year from 1994 through 2006. They found that the 10% of firms with the highest-paid CEOs produce stock returns that lag their industry peers by more than 12 percentage points, cumulatively, over the next five years.

Companies at the top of the pay pile, Prof. Rau concluded, award their CEOs an annual average of $23 million—but leave their shareholders poorer (relative to other companies in the same industry) by an average of $2.4 billion per year. Each dollar that goes into the CEO's pocket takes $100 out of shareholders' pockets.

America Held Hostage!

From Tom Toles.

Should You Go to Law School? Probably Not.

For most people, it makes more sense economically to not go to law school.

[B]y undertaking some straight-forward analysis of the factors that come into play I hope to spur future generations of potential law school attendees to think about the question rationally, as one of making an investment. If your law school education were a stock or a bond, offered in the marketplace, would you buy it? Should you buy it? Why or why not

My methodology is as follows. First, I identify the costs of attending law school. These are two: the opportunity cost of not entering the workforce immediately after graduation from college, and the out-of-pocket costs, primarily tuition, fees and books, inherent in attending law school. Based on these costs, I calculate the annuity-like return that must be achieved to recover the costs. This process is more complicated that it might seem, as it importantly requires isolation of the true benefits in terms of compensation offered by a law degree and the identification of an appropriate discount rate for converting such incremental compensation to net present value.  ...

Suppose we convince ourselves that 17% is the appropriate discount rate for the incremental earnings generated by a law degree. Then Solid Performer would need to expect to earn, on average, $33,121 more in his first year of legal employment than he would have earned had he not gone to law school. Given that his hurdle compensation is $80,035, it follows that he must expect to earn $113,156 in his first year. Moreover, the $33,121 wage differential would need to be maintained, and indeed increased at a rate of 3.5% per annum, throughout the remainder of his career. ...

For the Class of 2008, the last year for which statistics were available, the median salary of a fledgling lawyer was $72,000. That salary obviously does not stack up very well against the required salaries set forth in my table. But that median salary tells a hopelessly deceptive story. The distribution of salaries was in fact bi-modal, with fully 42% of salaries falling between $40,000 and $65,000, and a smaller but still very significant number clustered at the elite Biglaw starting salary of $160,000. ...

With the tiniest bit of twenty-twenty hindsight, it is possible to identify, already in the third year of law school, some of the students who have made what has turned out to be not only an ex ante bad investment but an ex post losing investment. Thus, consider the 50% of hypothetical Solid Performers who do not end up with a job offer from a Biglaw firm. They begin their legal careers at a salary that is no higher, indeed is actually lower, than the one they could have obtained without having gone to law school. They are unlikely ever to dig themselves out of that hole.

On Insider Trading

From Cafe Hayek

If insider trading (on non-proprietary information) causes asset prices to reflect more accurately the true, long-run values of those assets, then insider trading should increase confidence in markets.

Put differently, ordinary investors would be less confident in markets that take an average of t units of time to incorporate into asset prices a piece of relevant information than these investors would be in markets that take an average of t+1 units of time to achieve the same adjustments to asset prices.

To the extent that insider trading causes prices to reflect asset values more quickly and more accurately, general investors should be more confident in asset markets and, hence, more likely to invest their earnings in such markets.

The issue is what is more relevant to the market, material information or the buying and selling power of insiders? Or, what moves the market more, what insiders are saying or what they are doing?

Most of the capital stock of a publicly traded corporation is in the hands of outsiders, people who have little idea what is truly going on in a corporation.  Insiders hold very little company stock in most publicly traded companies.  If the issue is price discovery, because insiders usually hold a fairly small percentage of stock, insider transactions will have a minor effect on stock prices.  For companies where insiders hold a lot of stock, then insider transactions will have a greater effect on price discovery.  However, take a look at the ownership rosters of most publicly traded companies and you will see the same thing - stock ownership is dominated by large pools of capital such as mutual funds, pension funds, hedge funds, insurance companies, etc.  Rarely do you see insiders on that list.  What matters more for price discovery is whether or not Fidelity or T. Rowe Price is getting out of a stock than the CEO since the Fidelity's and the Price's of the world own far more stock than the CEO. Thus, for most companies, insiders buying and selling their stock will have a minor effect on price discovery. 

This incentivizes insiders to not disseminate material information as it is in the best interests of insiders to either withhold or even mislead the market.  Management has every incentive NOT to disseminate material information while they are currently buying or selling their stock.  If the stock price is $50, and management has material information that will knock the stock price down to $20, then insider selling will not knock the price down to $20 because insiders do not own enough stock to knock the stock price down to $20.  Insider selling might knock the price down to $48 but it won't go to $20.

One could counter, "Yes, but $48 is still closer than $50," but that misses the point.  Management is incentivized to not disseminate information until after they have dumped their shares.  If management discovers the $20 material information at time T, rather than disseminate it into the market at time T, they will withhold the information until time T+X after they have sold all their shares at $48.  Between periods T and T+X, investors will have purchased the stock from management that they would have not bought had the information been disseminated at time T.  The people who bought the stock between times T and T+X will not care if they bought it at $48 or $50 if it plunges to $20 after they bought it.  They will have been used by management as buyers of insiders' stock at $48.  If it is illegal for management to trade on material non-public information, there is less incentive for management to withhold disseminating information beyond time T.  Thus, it would be management who would ride the stock down to $20, not the investors who bought the stock at $48 from management.

Some might argue that there is more information in insiders buying and selling, but I have never seen a stock price get cut in half on news of insider selling whereas I have seen it happen too many times on the release of material information.

Decriminalizing insider trading is more likely to distort markets and lead to less confidence in the market by the public as it will incentivize insiders to withhold information.  This is clearly a bad thing since it would lead to less efficient capital allocation and thus higher costs of capital and slower economic growth.

Jeff Matthews has a great retort to de-criminalizing insider trading. 

Applicable Quotes

From the same article, nonetheless.

“[T]o paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.”

- Mervyn King

And

“[R]oughly every three years for the last generation a financial system that was intended to manage, distribute, and control risk has, in fact, been the source of risk – with devastating consequences for workers, consumers, and taxpayers.”

- Larry Summers

Articles and Commentary on This and That

The following are links to several articles I found interesting over the past week or so.

First, a comment on the market. 

I am still substantially net long but have not bought or sold anything over the past while. However, I am more of a seller than a buyer at these levels.

The trend is still up, though with the S&P 500 trading at about 14x normalized earnings of $68 a share, the market is more than fairly valued.  Economic and financial apocalypse is off the table but the economy still has structural problems such that earnings and equities returns will be capped for some time.

I believe that today's market most closely mirrors the latter half of the 1970s or the late-1930s to early-1940s when the market bounced hard off the bottom then meandered for several years.  We are currently in the bounce phase, and my playbook is for the S&P 500 to get over 1,000, but I am more than willing to change my mind if it appears the market is rolling over.  However, the market is showing no signs of turning, so the trend remains up.  It gets tricky when the uptrend ends.

I rely primarily on fundamental analysis when investing but I also use technical analysis as a tool for entry and exit points.  Paul Tudor Jones - perhaps the greatest hedge fund manager of all time - explains why technical analysis is important.

The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade.  ...

Today there are young men and women graduating from college who have a tremendous work ethic, but they get lost trying to understand the logic behind a whole variety of market moves. While I’m a staunch advocate of higher education, there is no training — classroom or otherwise — that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what to do during that brief, volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it — a sort of baptism by fire. One has to experience both the elation and fear as markets move five and six standard deviations from conventional definitions of value.

The OECD believes the global economy is approaching a low.

Most of the world’s big economies are close to emerging from recession, according to data published on Monday by the Organisation for Economic Co-operation and Development that pointed to a possible recovery by the end of the year.

The Paris-based organisation reported in its latest monthly analysis of forward-looking indicators that a “possible trough” had been reached in April in more developed countries that make up almost three quarters of the world’s gross domestic product.

The composite index for 30 economies rose 0.5 points in April, the second monthly rise in a row, after falling for the previous 21 months. The index seeks to identify turning points in the cycle about six months in advance.

The OECD said its overall measure of advanced member countries – ranging from the eurozone and the UK to the US, Mexico and Japan – now pointed to “recovery” instead of the “strong slowdown” they had been suffering since last August.

Good news!  Fewer and fewer Harvard grads are going into financial services.  Generally, tops are marked by more grads going into financial services and bottoms by less grads going to Wall Street.

The number of graduating Harvard seniors entering finance and consulting has fallen by half in the past year, the Harvard Crimson’s annual survey found. About one fifth of all seniors seeking full-time employment are taking jobs in one of the two sectors.

The number of seniors entering finance and consulting has fallen from 47% in 2007 to 39% in 2008 to 20% for the current Class of 2009. The financial sector saw the largest reduction, falling from 23% to 11.5%, while the share of seniors entering consulting fell from 16% to 8.5%.

Sam Zell says that commercial real estate is far from dead.

While it is true that there will be a few implosions, a housing style bust may not be in the offing. A simple reason may be the string of payments. Unlike a homeowner who loses their job then their home, the owner of CRE has a buffer. First the rents of the tenants pay the loans, and only when they are not enough to cover, do the owner then dip into their own pockets.

In short, the risk/payment responsibility is dispersed among several parties. Again, this is not to say that there will not be defaults, many of them or that REIT's will not suffer, it is just the widespread and pervasive losses we are seeing in RRE may not be in the cards (losses here are defined foreclosures on CRE).

Tobin's Q may be signaling a low in the market.

Finally, hedge funds still have too much cash, which could power the market higher as lagging hedge fund managers put cash to work.

The fast money is proving slow to jump on the market's bandwagon.

Hedge funds, decried by many as quick traders, have played catch-up during the market rally since March. The average fund was 45% "net long" as of May 19, or had investment holdings valued at 45% more than its bearish "short" positions, according to Hedge Fund Research.

That figure is up from 33% earlier this year, but still is far below its 55% level a year ago. Funds are less bullish now than they were just before the market crumbled last fall.

Hedge-fund managers, and their investors, said many remain in a neutral position. Hedge funds tend to underperform stock-market averages at inflection points, in part because they aim to create a "hedged" performance, rather than ape the market.

Potential Ph.D. Thesis

I'm sitting at home this evening reading work documents (yes, I'm a boring man) when I thought of a good topic for the thesis of an aspiring Ph.D. candidate. 

My idea is what are the post-IPO (initial public offering) returns of companies that were taken private by private equity partnerships and then floated back onto the public markets, particularly over a longer period of time such as two or three years after the companies were re-floated on the market.

Generally, IPOs underperform the market two years after the company becomes a publicly traded company.  It would be interesting to know if companies that were taken private then re-floated a few years later outperformed or underperformed both the market and the universe of IPOs.

Witty Cartoons

We are full-fledged members of the Tom Toles cheerleading squad.