What Reversed the Market in the Spring of 2009? Hint: It wasn’t QE.

On April 2, 2009 the Financial Accounting Standards Board, under intense pressure from both Congress and the US banking industry, suspended FASB 157; otherwise known as mark-to-market.   According to an article from Bloomberg on that day, the ruling would “allow companies to use ‘significant’ judgment in gauging prices of some investments on their books, including mortgage backed securities.”

Prior to this relaxation in the valuation rules, banks had to mark their assets to their current market value – something that created a crisis-induced feedback loop in MBS as margin calls forced banks to dump MBS which dropped their market value which caused more margin calls, which…   well, you get the idea.

So, Congress, Citigroup, the American Bankers Association, Blackstone Group, and the FDIC all got together to suspend FASB 157 so that banks could value their near-worthless MBS at something higher than near-worthless.

Here are a few of the quotes from that fateful, market reversing day:

Robert Rubin (former Citigroup senior counselor and Treasury Secretary):   “The rule (FASB 157) has done a great deal of damage.”

Spencer Bachus (House Financial Services Committee):   “Financial institutions and community banks have been adversely affected by the rigid application of these rules during this financial crisis, causing further instability in the banking system.”

Brian Wesbury (First Trust Advisors):   “It will put the banks back to where they would have been if the rule hadn’t been in place.   The biggest remaining question is whether the auditors will agree with the judgment of the bank management.”

William Issac (chairman of the FDIC):   “Fair value is a major cause of the credit crisis.”

Upon the news of 157’s suspension, Citigroup’s stock rallied 2.2%, Bank of America rallied 2.7%, and the KBW Bank Index rose 6.1%.

See.   Problem solved.   Using fair value is for chumps.

What seems perverse to me (much like seasonal adjustments, but don’t get me started on that), is that we improved bank earnings and stock prices by saying, “let’s not use the real number to value the holdings.   That’s way too harsh.   Let’s let the banks with the toxic assets tell us what they think the assets are worth and we’ll judge their stability based on that metric.”

And Richard Parsons approved.   As did Stephen Schwarzman.

When it was all said and done, Quantitative Easing did little to rescue the financial markets aside from causing massive mal-investment.  What turned the tide for an imploding global financial system was something so much simpler — changing the rules from “mark-to-market” to “mark-to-unicorn.”

That unicorn of ours has been getting quite the workout over the past five years.   I’d send him a new abacus, but I don’t know the zip code for Xanadu.   I guess he’ll have to make due.

– LL


Capital Accumulation, Financial Repression, and Other Stuff

I’m all for capital accumulation (financial and non-financial).   It’s the American way to concentrate these two forms of capital and that concentration has served us well over a couple of centuries.   I doubt many would argue that economic growth is not at its best when both financial and non-financial capital is accumulated and concentrated.   Financial capital is fairly self-explanatory, but by “non-financial” I’m referring to human capital.   To accumulate non-financial capital, the workforce must be better educated, better skilled, and motivated to share in the overall growth of the economy.   Bigger pie and bigger slices.

Recent years have shown a great deal of financial accumulation (a) with a decline or stagnation in non-financial capital accumulation (b).   Accumulating (a) without accumulating   (b) leads to sluggish economic growth, a bifurcation of ideology among a citizenry, and political polarization as each side puts forth its ideas as to how to grow (a) and (b) together.

This is where we find ourselves today.   You can hardly turn on the TV without hearing the expression “sluggish growth.”   Similarly, the concept of inequality has been elevated in the media by the likes of Occupy Wall Street and a recent Presidential stumping tour.   One thing has become clear since the financial crisis:   The accumulation and concentration of financial capital has been a smashing success, while the opposite is true from the standpoint of non-financial capital.

Some of the anecdotes backing up my observation are so shop worn that repeating them here would be an exercise in self- and reader-boredom.   We all know about the top 1% and the 99 percenters.   I’m more interested in trying to quantify the accumulation and concentration of capital as a way to assess potential future economic growth.   That is, if you believe that accumulating and concentrating an increasing amount of (a) + (b) is the way to grow the economy, then the rest of this blog may be modestly interesting to you.   If you don’t think that equation has merit, sorry for wasting your time up to this point.   Have a nice Holiday.

To oversimplify the analysis, I’ve put together a few tables.   Therein  you will find 1) the percentage of capital gains taxes paid by the top 400 taxpayers by AGI (from the IRS), 2) the unemployment rate (from the BLS), 3) the labor participation rate (from the BLS), and inflation adjusted (real) median wage information (from the Census Bureau).   The first item is an attempt to gauge the accumulation and concentration of financial capital as a function of how it is taxed.   While it is a blunt instrument, I think looking at the trend and magnitude can be useful.   The next three items are being used to gauge the accumulation and concentration of non-financial capital.   I selected three different metrics to view the data from a few different angles.   I selected the timeframe of 2004 – 2009 for the analysis since 2004 is post-tech bubble and 2009 is the most recent data available from the IRS.   2009 also encompasses the financial crisis and the beginnings of the recovery.

% of Capital Gains Paid by Top 400 Taxpayers Based on AGI

2004                        8.30%

2005                        7.48%

2006                        8.48%

2007                        10.07%

2008                        13.10%

2009                        16.00%

  Year-End Unemployment Rate

2004                        5.4%

2005                        4.9%

2006                        4.4%

2007                        5.0%

2008                        7.3%

2009                        9.9%

  Labor Force Participation Rate

2004                        65.9%

2005                        66.0%

2006                        65.8%

2007                        66.0%

2008                        65.8%

2009                        64.6%

Real Median Household Income

2004                        $53, 891

2005                        $54, 486

2006                        $54, 892

2007                        $55, 627

2008                        $53, 644

2009                        $53, 285

So, what do these tables say?   From the period 2004 – 2009:

·          Capital gains tax paid by top 400 taxpayers increase by 7.7% (a factor 92.8%)

·          Unemployment rate increased by 4.5% (a factor of 88.3%)

·          Labor Force participation declined by 1.3% (a factor of 2.0%)

·          Real median household income declined by $606 (a factor of 1.1%)

What seems to be shaping up based on this rudimentary analysis is that financial capital accumulation and concentration is progressing quite nicely.   While the IRS has not yet published any data post 2009, I think it is safe to assume that the accumulation and concentration has increased since then.

The non-financial factors, however, show stagnation at best, reduction at worse.   Further, we know that the unemployment rate has now fallen to 7% (better), labor participation has fallen to 63% (worse), and real median household income has fallen to $51, 017 (also worse) since 2009. Again, this points to stagnation or recession in the accumulation and concentration of non-financial capital.

One can debate the causes of the difference in the rates of accumulation and concentration of financial and non-financial capital, but I’ll posit the following as my opinion:

  • ·          Financial Repression:   Zero interest rate policy and massive bond purchases by the Federal Reserve has punished smaller savers and helped corporations materially improve their balance sheets.
  •   ·          Education mismatch:   A large percentage of the workforce is educated and skilled in fields that are becoming less viable (how many MBA’s were being cranked out just ahead of the financial crisis?).
  •   ·          Crisis of confidence:   In both the political and financial realms, confidence in the system is eroding (government shutdowns, the perception of cronyism, market flash crashes, insider trading, etc.).   Confidence is the lubrication for these systems and once it is lost it is very hard to recover.
  •   ·          Political polarity:   Pick your poison…   redistribution or trickle down.

Still…   I’m rarely paid to provide social or political commentary.   As I mentioned earlier, my professional interest in these things is to attempt to estimate the rate of future economic growth.   The reasons for the increase in financial capital and the stagnation of non-financial capital appear to be systemic – that is to say that they cannot be easily corrected in a short time horizon.   The question then becomes, “Can financial capital be accumulated and concentrated rapidly enough to spur economic growth in the absence of a similar acceleration in non-financial capital?”   I’ll let that question answer itself with one more table: Inflation Adjusted GDP Growth:

 2004                        3.1%

2005                        3.0%

2006                        2.4%

2007                        1.9%

2008                        -2.9%

2009                        -0.2%

2010                        2.8%

2011                        2.0%

2012                        2.0%

2013 (est)                2.1%

Add to this that the Federal Reserve is very likely to begin removing one of their mechanisms for aiding the accumulation of financial capital (QE) while continuing to hold interest rates at zero, and I’d argue that the accumulation of financial capital will begin to decline while little or no change will be coming to non-financial capital.   In such a scenario low growth would be expected.

I will stipulate that this analysis is very narrow and country-specific.   There are many other factors that can help to determine future US growth.   I just find these trends to be unsustainable and unhealthy in both the short- and the long-run — financially and socially.

Can we believe in next year’s expected earnings multiples for the stock market in a low growth environment when profit margins are already at record highs?   Something needs to move – either the P or the E.   – LL


Revenge of the Squirrel Part Deux?

Trumbull Connecticut is a quaint little town.  It’s home to about 35, 000 folks who play in its wetlands, enjoy its stone bridges, and bask in the natural beauty abundant in the geography.  It’s an almost idyllic setting around the winter holidays – very Norman Rockwell.

Or so it would seem on the surface.

But Trumbull around the holidays is not all about caroling and wassail.  You see, Trumbull has squirrels – evil, conspiring, anti-Capitalist squirrels.

It’s December 9, 1987, 10:48 a.m.  Investors are still grappling the magnitude of October’s market crash and stock volumes are (back in those days) at historic highs.  Yet, thoughts are turning toward the welcome mental reprieve the holidays promise to bring.

Then it happened.

The NASDAQ went black.  Gone.  Vanished.

Call it mint jelly; it was on the lam.

For 82 excruciating minutes, the automated quote system went missing.  Over 20 million trades were stranded, as other markets felt the effects of the absence of pricing for OTC options.  For all intents and purposes the US stock markets were closed.

The local CT utility desperately tried to restore the juice, but an unintended power surge blew up the NASDAQ servers and crippled its backup generators.

By 12:05 p.m., a backup computer was placed online and trading slowly returned to the NASDAQ.  By the end of the day, normalcy had been more or less restored.

All that was left was the effort to find a cause.  After extensive forensic investigation it was determined the cause was…   a suicide squirrel.    It seems that a Trumbull squirrel, possibly mentally fragile and radicalized against the free markets (due to the rapidly rising costs of hickory nuts?), decided to do its impression of an under-amped fuse and closed a circuit that would have best been left open.

Fast forward to August 22, 2013, 12:09 p.m.  I was placing a trade to cover some calls we had shorted a month ago, when the call’s bid suddenly jumped from 13 cents to $998.00 (no, that’s not a typo).  The asking price stayed at 15 cents, only to disappear entirely moments later.  Confused, I cancelled my unexecuted trade and turned to the Bloomberg terminal to get a better sense of what was happening.  What came across the Bloomberg was surreal.  In less than a minute, 969 NASDAQ traded stocks were halted, citing “Extraordinary Market Activity.”  Specifically, it was called a “T6 Halt.”  From NASDAQ’s website, here is the definition of a T6 Halt:

Halt – Extraordinary Market Activity
Trading is halted when extraordinary market activity in the security is occurring; NASDAQ determines that such extraordinary market activity is likely to have a material effect on the market for that security; and 1) NASDAQ believes that such extraordinary market activity is caused by the misuse or malfunction of an electronic quotation, communication, reporting or execution system operated by or linked to NASDAQ; or 2) after consultation with either a national securities exchange trading the security on an unlisted trading privileges basis or a non-NASDAQ FINRA facility trading the security, NASDAQ believes such extraordinary market activity is caused by the misuse or malfunction of an electronic quotation, communication, reporting or execution system operated by or linked to such national securities exchange or non- NASDAQ FINRA facility.

The T6 Halt affected over 3, 000 stocks and countless OTC options.  What was most stunning; the problem wasn’t corrected for 3 hours and 19 minutes, making the 1987 outage pale by comparison.

Over half of the trading day was rendered inoperative.

While it is too soon to accurately attribute a cause to this halt (misuse, malfunction, hacking, an error in an AAPL trade, etc.), today’s experience served to make me just a little more cautious.  When the market re-opened, the NASDAQ surged to a 1.6% gain.  The other US indexes closed positive as well.

Intuition and experience might lead a person to believe that investor confidence would be reduced by a 3 hour 19 minute outage in the second largest stock exchange.  It would therefore follow that reduced confidence would be reflected in lower stock prices after the outage was resolved.

Alas, intuition and experience were wasted.

Having witnessed the collective yawn in response to what I (and many other professional investors) perceived as a frightening milestone event, I am led to one of two conclusions.

Conclusion 1:  The markets are now so thoroughly controlled by algorithmic and high frequency trading that experience and common sense have become archaic during periods of low trading volume.  Evidence of this can be seen in stocks like AAPL that immediately traded up to their VWAP once the market re-opened.  No change in fundamentals – just a return to VWAP.

Conclusion 2:  The sleeper cell of evil, anti-Capitalist squirrels has re-awakened.  Supporting this notion is the fact that I looked out at my bird feeder this evening and the usual collection of red and gray squirrels was conspicuously absent.  I’ll admit this data point is rather anecdotal, but 26 years ago we saw just what kind of damage a determined squirrel with an agenda can do.

Maybe Nassim Taleb would consider this a “Black Squirrel” event. – LL


I Agree With George Soros

Well…  on one thing at least.

You may have noticed that I haven’t blogged yet this summer.  Hopefully this blog will shine a little light on the reason.

Last week my partner Mike posted some quotes from the Mad Hungarian.  One in particular caught my eye.

“The trouble with you is that you go to work every day (and think) you should do something.  I only go to work on the days that it makes sense to go to work.  And I really do something on that day.  But you go to work and you do something every day and you don’t realize when it’s a special day.”

Now I’ll concede that it’s generally only billionaires that have the luxury of only going to work on days they think are “special.”  But I understand, and agree with, the gist of what he’s saying.

In the money management business, we’re preconditioned to be in constant motion.  24-hour business news, up-to-the-second Fed releases, breaking earnings news, real-time charts, the quest for low latency, nearly free trading commissions…  all commiserate to make us think we need to do something.  Place a trade.  Re-allocate a portfolio.  Develop a new product to catch the latest trend.

And, with no intended malice, clients who share the same preconditioning often clamor for action if only for the sake of action.  “You haven’t traded my account for a month.”  “Why are you sitting on so much cash?”

What George and I have in common is the lack of desire to take action when there is no identifiable reason to take such action.  Asymmetries in risk and reward don’t show up every day.  Or week or month.

Fresh thoughts for a new blog post are sometimes equally hard to find unless one wants to regurgitate “The market makes another all-time high, ” or conjure up some reason why the all-time high is an illogical set-up destined to crush those who dare participate.  The former is boring and the latter is foolish speculation.

When there is a lack of asymmetry (or a missing muse for that matter), inaction is likely the best course of action.

Inaction provides benefits unique to its emptiness.  It clears the mind from stress and bias.  Better to spend the day analyzing objective data and coming to your own conclusions than to be emotionally driven to action by business news, opinion-filled business websites, or left or right wing blogs.

Inaction affords insight as you sit on the porch with a friend or family member discussing the matters of Main Street.  These insights may be more valuable than those you might get being forever mired in the matters of Wall Street.

It’s the pause that refreshes.  It allows room for gathering perspective.

Inaction offers the time to get all the tools laid out on the workbench, so when a real asymmetry (or a “special day”) arrives, action can be taken decisively.

Admittedly, there is a fine line between conscious inaction, paralysis, and laziness.  In this regard inaction can be a gateway drug.  But used judiciously it can mean the difference between being a successful long-term investor and a flash in the pan.  – LL


And Now for Something Completely Different… IT’S

Great Northern Iron Ore Properties

I hadn’t thought about this impending disaster of a company since March.  Back then, I looked at the numbers, chuckled, and moved on.  But yesterday after the close, Mark Grant made a reference to the company on CNBC and I was inspired to re-visit this hot, steaming mass of… iron ore.

Well, not really iron ore.  Temporary rights to iron ore.  GNI is a trust with rights on the Mesabi Iron Range in Minnesota.  This trust expires on 4/6/2015 and, on that date, it ceases to be.  It is no more.  It expires and meets its maker.

Per GNI’s website (http://www.gniop.com/termination.html), upon its expiration shareholders of the trust will receive $8.39 (per 12/31/2012 calculation).  In the meantime, shareholders can expect to collect $10.50 – or about 15% — per share in dividends each year (an extrapolation of the last two dividend payments).

So my math goes something like this:

All remaining dividends                                  $21.00

Expiration Value                                               $8.39

Total Value to be Received – EVER                $29.39

Why go through all this math to make a point?  Giving the future cash flows the benefit of the doubt by not applying a discount rate, you are receiving just over $29 of value for a stock that closed up 0.43% yesterday at $69.56.

What makes this abomination even more abominable is the press coverage.  Here are some recent news stories pumping GNI:

May 20:                4 Buy-rated Dividend Stocks: CXS, BKSS, GNI, EXLP

May 9:                  5 Buy-rated Dividend Stocks:  EDUC, NMM, BKCC, GNI, CODI

April 29:                3 Buy-Rated Dividend Stocks:  GNI, INTX, CODI

Who is rating this thing as a buy?   Here is a summary of points covered in the articles:

  • ·          GNI has a debt to equity ratio of zero
  • ·          Profit margins are very high at 77%
  • ·          Net income significantly exceeded that of the Metals and Mining industry average

No mention of the fact that YOU ARE GOING TO GET $29 FOR YOUR $69 STOCK COME 4/6/15.

If only you could buy puts or short this stock.  But, alas… it’s practically impossible to borrow and there are no options.

Well, you can technically borrow it if you don’t mind paying 77% per year in the negative interest rebate.  In a weird way, it may be this high level of rebate that is supporting the inexplicable price.  If I were to buy the stock and lend it out to a short seller at 77% rebate for the two years before it expires, I’d collect a tidy $106.  Less my $69 cost, I pocket $37 net out of thin air.  Meanwhile, as the lender I’m entitled to receive payment in lieu of forgone dividends – adding another $21 and bringing my take to $58.

Good for me.

In the end, all we can do is sit back and watch the slow motion train wreck of yield-seeking, uninformed investors getting wiped out.

Or stepped on.