Macro Bets: A general framework..

As many of you are aware, I am not a great believer in macro bets but I recognis4 that there are investors out there who not only like to make big bets on interest rates, currencies or commodities, but also make tons of money in the process. In fact, the subject of my last post, John Paulson, made a macro bet on housing and it paid off big time for him. Consequently, I thought it would make sense for me to put down my thoughts on macro bets.

Should you make macro bets?

The old rule in investing applies. If you are going to make macro bets, you need to bring something unique to the table - a competitive advantage that sets you apart from the hordes of other investors. Here are some potential advantages that you may be able to build on:

a. Time: If you have a much longer time horizon than the rest of the market (remember that this requires that you have patience and that you can live with the loss of liquidity), you may be able to bet on macro mis-pricing that is expected to persist for the short term but not the long term.

b. Trading: The second skill set you can exploit is your capacity to trade on a macro bet that others may not possess. This will generally require that you either create your own securities (synthetic calls and puts, forwards) to make money on the macro bet or that you creatively exploit securities that already exist out there (as Paulson did with the CDS market)

c. Information: As with individual stocks, there are two ways in which you can exploit information. The first is short term, where you can get ahead of macro information announcements and game them for gain. Thus, you you can try to forecast how the next Federal Open Market Committee is going to vote (I cannot think of a way legally that you could get access to this information...but you never know). The second is long term. As an example, you may be able to collect information on copper production at individual mines globally and make judgments on copper supply (and prices) in future periods.

d. Behavioral: There is evidence that investors behave in quirky (notice that I did not say irrational) ways when making investing choices. You can try to take advantage of these behavioral quirks as long as you are immune from them and believe that they will be reversed in the future. Thus, the "herd behavior" of investors can cause short term momentum in currency markets before the same behavior creates a "big correction". To take advantage of this, though, you have to be less affected by the herd than the average investor (As a kid, did you fight peer pressure or did you bend to it?) and you have to be able to gauge when the herd will turn...

What is the best way to make a macro bet?

If you are going to make a macro bet, keep it simple and make it a focused bet. If you believe that gold prices will keep going up, the best investing strategy is to buy gold futures or options.

All too often, we hear of investors finding convoluted ways of making macro bets. Buying a gold mining company, say Barrick Resources, because you believe that gold prices will go up exposes you to all kinds of other risk. The stock price of a gold mining company reflects multiple other factors: its success at finding new gold reserves, whether it hedges against gold prices or not and whether its gold reserves are in an unstable country.

It is true that in some cases, a macro bet can be combined with a micro bet. Thus, if you like Petrobras as a company (because you like its management and investment strategy), you could buy Petrobras and also make bullish bets on Brazil and oil. You should be clear, though, as to which factor is front and center in your investment decision, i.e., Are you buying Petrobras because you like the company? Like Brazil? Think oil prices are going to go up?

What are the risks of macro bets?

The risk with macro bets as with any investment strategy is that your underlying premise may be wrong and/or that the rest of the market does not buy into it. My skepticism about macro bets is based upon the difficulty I see in establishing a competitive advantage. When there are literally millions of other playing the same game and "private" information is difficult to obtain (without breaking the law), the game is a much more difficult one to win. Obviously, it is not impossible, as John Paulson and others have shown over time, but the odds remain against you.

The secrets behind John Paulson's success...

The banking and credit crisis of 2008 had few heroes and lots of investing legends who were humbled. Very few of these so called experts saw the crisis coming, and even those who did were unable to act on that belief.

One exception is John Paulson, a hedge fund manager/investor based in New York. He saw a bubble in the housing market in 2006 and created a hedge fund to bet on the bubble bursting; what made his bet unique was that his use of the Credit Default Swap (CDS) market to bet that sub-prime securities would collapse and he was right. Greg Zuckerman, a reporter at the Wall Street Journal, has a short article reviewing Paulson's strategy in the link below.
http://online.wsj.com/article/SB125823321386948789.html?mod=googlenews_wsj

Greg, whose writing I enjoy reading, is probably the world's leading authority on Paulson (other than Paulson himself), since he has spent the last year researching the man and has written a book on his investing acumen. You can get the book, titled "The Greatest Trade Ever" at your local bestseller:
http://www.amazon.com/Greatest-Trade-Behind-Scenes-ebook/dp/B002UBRFFU/ref=sr_1_1?ie=UTF8&s=books&qid=1258333719&sr=8-1

In his Wall Street Journal article, Greg has a collection of lessons that the average investor can learn from Paulson. While I agree with most of them, I do disagree with one point that he makes, i.e., that the bond market is a better predictor of problems than the stock market. The bond market is a better predictor of credit risk and default problems than the equity market, simply because it is far more focused on that risk. Equity investors juggle a lot more balls in the air- growth, risk and cash flows - and they can get distracted, especially about default risk. History suggests, however, that equities have led bonds in predicting economic growth and profitability.

Here is where I agree with Greg. I think equity investors will gain by paying attention to bond markets, just as bond investors will gain by being aware of developments in equity markets. We have compartmentalized investing to the point that investors are often unaware of when these markets become disconnected, which are the danger signals that one market has become mispriced. In the context of valuation, here is where I think this recognition is most useful.

1. Risk Premiums: In my paper on equity risk premiums, I have a section where I compare implied equity risk premiums and default spreads on bonds and not the correlation between the two over time. The periods when they have moved in opposite directions, such as 1996-99 (when equity premiums dropped and default spreads rose) and 2004-2007 (when default spreads dropped while equity risk premiums remained stagnant) were precursors to major market corrections - the dot com bubble in the equity market in 2000 and the sub-prime bubble in the bond market in 2007-08.
2. Distressed companies: When valuing equity in distressed companies, the threat of default constants overhangs the entire valuation. I believe that we can derive valuable information from the corporate bond market that can help up refine and modify the valuation of distressed companies. I describe this process in this paper.

If Paulson's lessons are heeded, we should see more joint work between equity research analysts and bond analysts and a greater willingness to look across markets for investing clues. I am not holding my breath!!!

P.S: For those of you who are conspiracy theorists, John Paulson is not related to former treasury secretary and Goldman CEO, Hank Paulso.

P.S2: A disclosure is in order. John Paulson just gave $ 20 million to the Stern School of Business at NYU, where I teach. Since did not partake in this gift, I think I can still be objective about his investing strategies.

The Agency for Financial Stability? Good idea?

In today's big news for bankers, Senator Chris Dodd has announced his intent to create an Agency for Financial Stability, which will be responsible for "identifying and removing systemic risks in the economy".
http://online.wsj.com/article/SB125786789140341325.html
Wow! What a brilliant idea? What next? How about an Agency for Everlasting Economic Growth? And an Agency for No More Defaults? Or an Agency for Full Employment?

The key part of this proposal is that it will strip away some of the powers of the Federal Reserve over banking and move them to this agency. Implicit in this proposal is the belief that the Fed has not taken its banking oversight responsibilities seriously and that this failure was at least partially to blame for the banking crisis last year. Implicit also is the belief that a different agency more focused on controlling risk would have prevented this from happening. Let's take each part separately.

Replacing the Fed
There have been many who have blamed the Fed and its chairmen (Greenspan and Bernanke) for the banking crisis last year. However, there are just as many who have blamed other institutions for the same crisis. Without revisiting that debate, let us consider some of the reasons that have been offered for why we need to take banking regulatory powers away from the Fed and see if they are justified.

1. The Fed is not professional: I don't quite buy into this critique. While I do not claim to be a Fed insider, my interactions with those who work at the Fed have reinforced my view that most Fed economists are competent and apolitical. In fact, I would wager that there is more competence and less political meddling in the Fed than there is in almost any Federal agency.

2. The Fed has conflicts of interest: This most incendiary of allegations is thrown around by conspiracy theorists. In their world, investment bankers regularly meet in back rooms with Federal Reserve decision makers and think of ways in which they can rip off the rest of the world. Again, I don't see the conflicts of interest. There is clearly no reason why the Fed cannot set monetary policy and regulate banking at the same time. (A variant of this argument is that economists who work at the Fed are looking to move on to more lucrative careers at investment banks and are therefore amenable to entreaties from investment banks...My counter is that the top decision makers at the Fed are already at the top of the profession and don't need favors from investment bankers).

3. The Fed is distracted: The most benign reason given for stripping the Fed of its banking powers is that it has too much to do and therefore is unable to allocate enough resources to banking oversight. This may very well be true but the response then would be to give the Fed the resources it needs and not to create another Federal Agency.

In summary, I see no good reason for this new agency. The only real critique that I have heard is that oversight failures at the Fed caused the last banking crisis. Since no other regulatory agency, in the US or elsewhere in the world, seems to have foreseen this crisis, I think it is unfair to pick on the Fed alone. I see no reason to believe that an Agency for Financial Stability would have somehow protected us against the risks that precipitated this crisis and lots of reasons to believe that it would have made it worse.

Systemic Risk
The essence of systemic risk is that it is risk that affects the entire financial system rather than just the risk taking entity. We have to be more precise about why this is a problem. It is not because the risk is systemic but because it is asymmetric in its effects. Put more simply, an entity (investor, investment bank or hedge fund) that takes systemic risk gets the benefit of the upside, if the risk pays off, but that the system (government, tax payers, other investors) bear the downside if there is a bad outcome.

As I read the description of the agency in yesterday's news, the message that came through was that it was the taking of systemic risk that was the problem and that the agency would reduce the problem by regulating it. That seems to me to miss the point. What you need is action to reduce the asymmetry in the pay offs. As I see it, this will require:

a. Monitoring reward/punishment mechanisms: While I have never been a fan of regulating compensation at private firms, I think we need to require that compensation systems not exaggerate the asymmetric payoffs from taking systemic risk. For instance investment banks that reward traders for making macro bets, with house money, are pushing the systemic risk envelope.... (I have no problem with rewarding traders for taking micro risks or investment bankers for doing lucrative deals... )

b. No bailouts: Firms that make systemic bets that go bad should not only be allowed to fail but every effort should be made to recoup assets that they own to cover the losses created by these systemic bets.

c. Systemic Risk Fund: This may be the controversial part of the package, but a proportion of all profits made from systemic risk taking should go into a general fund that will be used to cover future systemic risk failures. (This will require explicit definitions of what comprises systemic risk and measurement of the profits from the same... but I don't see a way around it.) This will work only if legislators are not allowed to access this fund and use it to cover pet projects. (The reason I make this point is that the fund will become very, very large during good times and legislators will be tempted to draw on the piggy bank.)

With global markets and offshore investing, we cannot outlaw the taking of systemic risk. All we can do is to try to bring some symmetry back into the process where those who make money on these systemic risks also bear the losses from taking these risks. We don't need a new agency to do this but we do need banking authorities who are proactive, more interested in winning the next battle and less in refighting the last one.

Bad companies and good investments...

One of the big news items of the week is Berkshire Hathaway's acquisition of a Burlington Northern, a large US railroad.
http://www.nytimes.com/2009/11/04/business/04deal.html
Since Berkshire Hathaway is Warren Buffett's brainchild, this has provided a platform for many analysts to read the tea leaves. Here is some of the spin that I have seen and what I think about the spin.

A significant number of the analysts have argued that Buffett is making a bet on the US economy recovering by making this investment. I find this puzzling at two levels. First, if you were going to make a bet on the US economy, railroads seem like a pretty poor choice. Unlike housing and consumer durables, railroads have not seen their earnings increase dramatically in good economic times. Second, Buffett has always expressed his skepticism about market timing and macro investing strategy and this investment would be a significant departure.

Here is my take on the investment. Railroads in the United States are the quintessential mature business. It is extremely unlikely that you will see much real growth in this business; constructing a new railroad or even adding new rail lines would have prohibitive costs in the US, given real estate costs and litigation issues. Companies in this business have earned returns on invested capital that have lagged the cost of capital for decades. Put another way, very few railroads would make the list of most glamorous companies or be featured in Tom Peter's list of excellent companies.

So, why would Buffett invest in a bad business? I have said some unfavorable things about Warren Buffett on this blog before. At the risk of repeating myself, I think he has been hypocritical on corporate governance and he plays the "I am just a hick from Omaha" role to perfection. However, I think his status as a great investor can be boiled down to his capacity to separate "great companies" from "great investments" . Put another way, Buffett has always recognized that a great company can be a terrible investment, if you pay too much for it, or that a mediocre company can be a great investment, at the right price.

Here is the bottom line. I don't think that Buffett's investment in Burlington Northern is a bet on the US economy or an expectation of a surge in profitability for railroads. I think it reflects a more prosaic choice. Buffett thinks he is getting a good deal for the company at the current price, and he has history on his side. The best investments in the market are often among the companies that are viewed as the least glamorous and most boring: Burlington Northern clearly fits the bill.

Insider Trading: My Perspective..

The recent arrest of Raj Rajaratnam, the founder of Galleon Group , a hedge fund, on charges of insider trading has generated responses from across the spectrum. At the one end, it is evoking the usual breast beating about insider trading and how unfair it is to the rest of us "non-inside" investors.
http://www.businessinsider.com/henry-blodget-moral-of-galleon-insider-trading-bust-only-fools-try-to-beat-the-street-2009-10
At the other, there are some who are pointing out that this case illustrates how ineffective insider trading laws are and that they should perhaps be abandoned.
http://online.wsj.com/article/SB10001424052748704224004574489324091790350.html
It is clearly a good time to offer my perspective on insider trading:

1. What is insider trading?
In it's most general form, insider trading refers to some investors trading on "proprietary information" that is not available to the rest of the market. The legal definition of insider trading, though, is a little more difficult to nail down. In the United States, insiders (managers of companies, directors etc.) are allowed to trade, as long at they meet two requirements:
a. They do not trade ahead of information events - acquisitions and earnings announcements, for instance - where they have access to the information prior to the rest of the world.
b. They report their trades to the SEC in filings.

Put another way, it is not illegal for a CEO or directors in a company to buy stock in the company, if they feel that it is under valued on a long term basis, even if that feeling is based upon information that only they have access to (project details). It is illegal for them to buy stock just before an acquisition or a big positive earnings surprise.

Looking at the allegations about Galleon, it seems clear that if the stories are true, the firm clearly broke insider trading laws by trying to get access to information about acquisitions, earnings announcements and other forbidden event-based information.

2. Does insider trading pay off?
Interesting question! At first sight, the answer seems to be obvious. Insiders know far more about the company than we do and should be able to leverage the information advantage into excess returns. The evidence, though, is surprisingly inconclusive. Studies that have looked at insider buying and selling as predictors of future stock prices find only a weak correlation, i,e., insider buying (selling) is not that good a predictor of stock price increases (decreases) in future periods.

One caveat about these studies is that they focus on the insider filings with the SEC. To the extent that the real insiders, i.e., the ones who are trading on real information rather than perception of value, will never register with the SEC, the suspicion is that these insiders make huge profits on their information.

Since Galleon is in the news, I decided to take a look at the returns that Galleon has made in recent years to see if they were able to convert their "illegal inside" information to higher returns. The Galleon Diversified fund, the flagship for the hedge fund, was up 22% this year, but is down 18% since its peak. Given the market performance over the period, the fund ranks close to the average. Across time, it is possible that Galleon made money using its access to "tips" from its moles in companies, but that does not seem to have generated a huge return.

I do not find it surprising. When you rely on tips from "insiders" for your investments, you generally find that four out of five tips never pan out (either because the information is bad or because the market reaction to the information does not follow the script), even when they come from those supposedly in the know. Insider trading is not a sure bet; it may not even be a good bet.

3. What should we do about insider trading?
I would like to live in a world where all investors have the same access to information and but I would also like to be able to go one-on-one against Lebron James. Life is not fair and investor access to information will vary across investors.

To me, the line between insider trading and savvy investing is a very hazy one, especially if you a short term investor. Analysts and investors often step across the line without even realizing they have.
http://www.nytimes.com/2009/10/20/business/20insider.html

I also think that banning insider trading is akin to laws forbidding alcohol or drugs. It does not make the problem go away but instead drives it underground and essentially leaves the profits from insider trading to those who are most unscrupulous among us.

I would suggest that we eliminate or at least reduce insider trading laws & restrictions and increase the transparency of the trading process. If you are trading on inside information but people can see you trading (and whether you are buying or selling), the benefits you will get will be time limited. Not only will this reduce profits from insider trading but also speed up how quickly prices adjust to information.

As a final note, insider trading cases provide excuses for the rest of us, who fail in our investing objectives. I have heard many small investors complain: "The reason I am not making any money on my portfolio is because the game is fixed." Enough of the self pity. The reality is that if your portfolio has lost money, insider trading is way down the list in terms of factors that caused those losses. In fact, my advice to those who worry about insider trading is simple. Trade as infrequently as you can and base your decisions on intrinsic value. Insiders hurt you only when you play their game, which is to try to trade short term on news (or what you think is news...) and rumors...

Equity Risk Premiums: An Update

As many of you are probably aware, I am fixated on equity risk premiums. To me they are at the center of almost every debate about equity markets - whether stocks are too low or too high, whether current market conditions are the norm or an aberration, and whether equity investors truly understand the risk associated with investing in equities.

I had a few posts during the crisis, where I noted that the implied equity risk premium for the S&P 500 had climbed at a rate never seen before in history during the twelve weeks between September 12, 2008 and late November. In fact, I reported an implied equity risk premium of 6.43% at the start of 2009, up from 4.37% at the start of 2008. The big debate at that point was whether this crisis had damaged investor psyches so much that it had caused a permanent upward shift in risk premiums, or whether this was just another bump in the road and that we would revert back to the 4% implied equity risk premiums, pre-crisis.

I have just posted an updated version of my equity risk premium paper online:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1492717
In the paper, I graph out the implied equity risk premium from January 2009 to September 30, 2009. On September 30, 2009, the implied equity risk premium stood at 4.86%. While I had anticipated at the start of the year that the premium would drift back down, I expected it to take much longer than 9 months. One more reason for constantly updating equity risk premiums! Markets are full of surprises.

The new debate that is unfolding is whether markets have gone up too far and too fast, thus exposing themselves to a correction. I don't know the answer to that question but it can be framed around the implied equity risk premium. If you think that the crisis should have changed people's attitudes about risk and that a 6% equity risk premium is the new steady state, markets are over bought and the correction will be painful (a 15%-20% drop in the S&P 500). On the other hand, if your view is that what happened last year is just part and parcel of equity risk and that investors will soon forget the scars and go back to the 4% risk premiums of 2007 and 2008, the bull market has a lot of steam left on it (a 10% up movement in the S&P 500). I am not giving away too much when I say that the long term equity risk premium that I am using for mature markets, when valuing companies, has been 5-6% since January 2009. At its current level of 4.86%, I am within reaching distance, but I will respond to the market on this number. I am not a market timer!

Bond Ratings: Why, how and what next?

In the aftermath of the bond market calamities (for investors and issuing companies), the ratings agencies (S&P, Moody's and Fitch) have come under assault from all sides. Legislators and regulators have accused them of being too close to the companies that they rate, with the implication that companies/bonds are being over rated. Academics have piled on, arguing that there is little information in bond ratings and that ratings agencies offer poor and delayed assessments of default risk. Finally, a few former employees have come forward with claims that bond ratings, at least in some cases, are stale and not backed up by serious research.
http://www.nytimes.com/2009/10/11/business/economy/11gret.html

I would like to at least step back and consider some broad issues related to ratings:

1. Why do we need bond ratings in the first place?
As long as there have been people on the face of this earth, there have been lenders and borrowers. For much of recorded time, a lender (money lenders in ancient times, banks in more recent periods) assessed the credit quality of a borrower and set the interest rate accordingly. It was the advent of the bond market in the last century that changed the dynamics and created the need for ratings agencies. When a company issues bonds and investors price these bonds, these investors do not have the resources to assess credit risk on their own. Ratings agencies stepped into the gap and provide this credit risk assessment. Thus, the ultimate service provided by bond ratings is to bond traders, and bond issuers benefit only indirectly.

2. What is the information content in a bond rating?
Ratings agencies have access to all of the financial information that the rest of us do - financial statements, past and present, analyst reports, industry analysis etc. In addition, they can ask for private information specifically related to default risk, which can then be used to finesse or modify the rating. The problem with the private information is that it comes from the management of the firm, which of course has an interest in providing more good news than bad news.

The simplest way to measure whether the market thinks there is information in a bond rating is to look at whether market prices of bonds change when their ratings are changed. The evidence there is mixed. While there is a consistent price change, with bond prices increasing (decreasing) on bond upgrades (downgrades), most of the price change seems to happen before the rating is changed. In other words, markets seem to anticipate ratings changes. That does not make ratings less useful but they are often lagged measures of default risk.

3. Is there a potential for conflict of interest and bias in ratings?
Going back to the origins of ratings, it is clear that bond buyers should be the ones paying for the ratings and they do so now, albeit indirectly. Ratings agencies are compensated by the companies that are rated, which does create a conflict of interest, though the conflict is nowhere near as intense as some other conflicts that bedevil us (such as auditors who have consulting revenue from the companies they audit or investment banks operating as deal makers & advisors on M&A deals). The price paid by companies is a relatively small one (3-5 basis points of the size of the issue) and it is not as if companies that are down graded can pull up stakes and refuse to be rated. (Let's face it. There are more ratings downgrades in a quarter than equity research analyst sell recommendations in a decade.) The price paid by companies is then passed on to bond buyers as a slightly higher interest rate on the bond.

There is a bigger potential for conflict of interest with mortgage backed securities and other bonds that are issued against pools of assets, not by companies by often by intermediaries. There, Moody's and S&P do have an interest in growing the market and attaching higher ratings does increase market growth, which increases future revenues and so on...

There is much talk now of changing this model but the alternatives are not that attractive. One is to charge a small tax on every bond sold, collect the proceeds in an entity (probably government run) which will then pay the costs to have all bonds rated. The question then becomes choosing the ratings agency (ies) to do the rating and the pricing mechanism (fixed price, auction). The other is to increase competition among ratings agencies, with the argument that competition will make them worry about getting rating right, though this would exacerbate the conflict of interest, at least in the short term.

4. What should we do going forward?
Before we pile on ratings agencies and blame them for our bond losses, we have to recognize that they were not the only ones to under estimate default risk. Most banks in developed markets made the same mistake, as is clear by the losses being written off on loan portfolios. Thus, I would not blame the ratings mistakes primarily on conflicts of interest or poorly trained ratings staff or some conspiracy the0ry too dastardly to behold. Rather, I think ratings agencies were caught up in the mood of the moment, just as the rest of world was, where housing prices always went up, people had permanently stopped defaulting and recessions were a thing of the past.

In closing, my fear is that we will throw the baby out with the bath water and make radical changes in the ratings process. Having valued companies in markets with bond ratings and in markets without, I can tell you with absolute conviction that I would rather deal with lagged and flawed bond ratings than no bond ratings at all.