Category Archives: securities markets

where is the stock market headed?: Wall Street strategists vs. analysts

May 13, 2013 By in Industry Analysis, Investment firms, securities markets, sell-side analysts vs. strategists, stock market, using research Tags: , , , , , , , , , , Leave a comment

 Factset:  what Wall Street thinks

Last week I got a press release from Factset, a financial data collection and analysis service, on the topic of where the S&P 500 is headed over the coming twelve months.  The short answer from Factset:  brokerage house analysts think the market is going up a little bit, strategists think the market is going down–again by just a touch.

I’m going to write about this over the next few days.  My short answer:  if history is any guide, neither outcome is likely.  The market seldom drifts along.  It either goes up a lot, or down a lot.

strategists vs. analysts

Who are these people?

First of all, they’re both sets of “researchers” who work for brokerage houses.  Now, they don’t call brokers the “sell-side” for nothing.  The number-one job of any sell-side researcher–analyst or strategist–is to persuade customers to do their trading business with their firm.  In other words, they’re primarily salespeople.  That’s important because it means that at least to some degree they both tailor what they say to fit what their buy-side audience wants to hear.

strategists

Strategists are typically economists or statisticians by training, although they are also sometimes former portfolio managers (snide pms would probably say failed portfolio managers).

Strategists normally work “top down.”  That is, they use data about the macroeconomy to make forecasts about GDP growth and  the course of interest rates.  They then derive expected future earnings growth for the overall stock market and the price earnings multiple at which they think the market will trade.  That gives them a forecast of the future stock market price.  For the S&P over the next year, Factset says the strategists’ consensus is down, but my less than 10%.

Based on their analysis, strategists also recommend sector- and industry-based portfolio structure.  In conjunction with analysts, the may also suggecst individual stock holdings.  They may also help set policy–like the official forecast of the oil price–that analysts more or less adhere to in making their company earnings forecasts.

Strategists are normally much more conservative than sell-side analysts.  Their earnings growth projections are almost always lower than analysts’.  Clients occasionally permit strategists to be bearish, and–as is the case now–to say the market is headed south.  But a prolonged bearish tilt is almost like buying a ticket for the unemployment line.

analysts

Analysts are specialists in specific industries or economic sectors.  They may have academic training in engineering or other subjects pertinent to the industry they cover.  They may have worked in the industry, often in strategic planning or M&A.  They’re invariably deeply knowledgeable about company financials and about the competitive dynamics of their coverage. They often also have privileged access to the top management of the firms they analyze.

That access usually comes at a price.  Analysts can come under considerable pressure not to deviate–either up or down–from the official earnings guidance announced by these firms.  A “sell” recommendation can sometimes trigger a violent reaction from the company in question.

Many investors–childishly–don’t like to hear bad news about the companies they own.  At the same time, the analyst won’t earn much if he doesn’t have good things to say about at lease some firms in his industry.  As a result, analysts tend to err very substantially on the side of optimism.  They turn bearish, even for a short time, at their peril.

year-ago predictions

Industry analysts make projections of earnings growth and set stock price targets for the companies they cover.  They don’t make projections for the S&P.  Factset gets an implicit analyst forecast for the market by aggregating the analyst projections for each company in the S&P 500.

Getting a strategist forecast is much more straightforward.  Factset just takes a median.

Anyway, in April 2012 the implied analysts’ forecast for the S&P was much more bullish than the strategists–at +11.9% vs. +2.6%.

No surprise there.

What is a surprise (“shock” may be a better word), however, is that the analysts were a lot closer to the actual S&P 500 results of +13.8% (capital changes only).

year-ahead projections for the S&P

That’s tomorrow’s topic.

S&P’s defense in the government’s anti-fraud lawsuit

April 23, 2013 By in Current Market Thoughts, securities markets, Securities regulation Tags: , , , , Leave a comment

the lawsuit

According to the Wall Street Journal, both S&P and its parent, McGraw-Hill, have filed responses in federal court in Los Angeles to the Justice Department’s recent civil lawsuit against S&P.  The suit accuses S&P of fraud by giving too-high ratings to mortgage-backed securities that later imploded during the financial crisis.  Among the victims cited are Citibank and Bank of America, who created some of the securities and paid S&P to rate them.

the defenses

McGraw-Hill has two points:

–it can’t have defrauded Citibank and BofA, who were in the kitchen making the toxic messes and knew what they were doing much more intimately than any outsider ever could, and

–other ratings agencies, like Moodys and Fitch, issued identical opinions bu aren’t being charged (of course they didn’t reduce their AAA rating of Treasury bonds, the way S&P did).

S&P has a more humorous defense:

–it points to two prior court rulings that the company’s claims for its ratings–that they are independent and objective–are just subjective opinions that no reasonable person would take seriously.  That casts the claims as sort of like the Kia commercials that have sock puppets or giant rodents piloting company cars through time and space.   Not very flattering–particularly to anyone who claims to have taken the ratings as either independent or objective.

my take

1.  We all know as a matter of principle that there’s no free lunch–anywhere.  Yet, every few years salesmen of financial products tout some new “miracle” of financial engineering that subtracts the risk from risky investments, leaving only super-high returns.  Bernie Madoff is an extreme example.  But junk bonds were originally marketed as having all the rewards of stocks but with the safety of bonds.  In the early 1990s, short-term European bond funds were sold as being “just like” domestic money market funds, but with 3x the yield.

When these products implode, as they invariably do, the most common reaction is not to blame one’s own bad judgment, but to point a finger at the seller of the product.   Or in this case, to the seller’s front man.

2.  In the case of professional investors, it’s inconceivable to me that any buyer relied on S&P ratings as the sole, or even one of several, important reasons for purchasing a security.  At best, the rating is a gross screening factor (bad rating = don’t buy).  Everyone is aware that S&P is paid by the issuer of the securities it rates, and that it only gets paid if the rating is high enough to let the offering take place.

Every buy-side credit analyst knows he’s a lot better than anyone at S&P.  And the buy side knows that, unlike S&P, it has to live with the consequences of its buy decisions.  While it’s easy to blame S&P when an investment goes wrong, the real fault lies with the independent credit analysis done by the buyer.

3.   Why choose a bit player like S&P to sue?   …why not the banks who issued the toxic securities?

Other than the army, I’ve never worked for the government, so I have no special insight into the Justice Department’s mindset.

My guess is that S&P is the easiest for someone who has no practical experience in financial markets to understand.  The case itself is modest in scope.   It may not raise the thorny issues of how regulators could have been so deeply asleep at the switch, or why laws were changed in the 1990s to permit banks to brew their toxic concoctions.  And of possible targets, S&P likely has the fewest political and financial resources to defend itself with.

If the WSJ is correct, though, part of S&P’s defense is that the government has already lost this case once before.  Odd.

current equity market money flows

April 2, 2013 By in Current Market Thoughts, ETFs Vs. Mutual Funds, index funds, Industry Analysis, Investment firms, securities markets, stock market Tags: , , , , , , , , 1 Comment

There’s been a lot of press recently about investors suddenly waking up after four years of strong market gains and deciding to take their money out of “safe” fixed income investments and put it into stocks.

What’s implied in many of these articles is that this flow is what’s putting the recent zip into the S&P 500.  What’s also implied, and sometimes stated, is that this is the “dumb money” whose arrival on stage is a signal that we’re entering the closing act of the current bull market.

Both implications might have some truth to them.  But neither is anything like the full story.   Most people are a lot smarter than that.  Money flows are a lot more complex.

This is what I see:

1. Any money going into stock market mutual funds or ETFs is not coming out of bonds.  Bond funds have had large inflows every month since January 2009, except for tiny outflows in December 2010 and August 2011.

Money coming into bond mutual funds accelerated in 2012, to around $25 billion a month, according to the Investment Company Institute, the mutual fund trade organization.

2.  Bond inflows have been matched by steady though smaller, outflows from stock mutual funds.  The lost stock mutual fund money may be feeding part of the bond buying binge.  But there are also two important trends within the equity world.

–There’s a big multi-year shift away from actively managed equity mutual funds toward index ETFs.  Two reasons:  better performance, and lower costs.  ETF flows are clearly much healthier than equity mutual funds’.

–Virtually all the net equity mutual fund outflows have been coming from US-only funds.  Global, international and emerging market mutual funds have been at least treading water.  Similar ETFs are seeing large inflows.  Again, this has been happening for years.

3.  So far in 2013 over $60 billion in net new money has come into equity mutual funds, breaking an almost two-year stretch of outflows.  Two-thirds of that has gone, as usual, into global etc. funds.

Much more interesting, to my mind, but almost completely unnoticed, is the HUGE outflow of over $112 billion from equity funds that occurred last year, from August through December.

Why this rush to the door?  My guess is that this is the final shoe dropping from the stock market collapse of the Great Recession. In my experience, some investors will panic and sell at the bottom.  Others will nurse their wounds and refuse to sell until they get back to breakeven.  Then nothing on heaven or earth can persuade them not to take their money and run.  I’ve turned around two woefully underperforming global funds for two different organizations.  In both cases, this sort of almost inexplicable outflow was the last step in the healing process.

If that’s what happened during the second half of 2012, it’s a significant bullish sign for stocks.

a blast from the past: eToys and the IPO market

March 11, 2013 By in internet, internet bubble, Investment firms Tags: , , , , , , , , Leave a comment

In yesterday’s New York Times, business reporter Joe Nocera wrote an opinion column about investment bankers’ behavior in bringing companies public.  It’s based on documents from an ongoing lawsuit between 1999 IPO star, eToys (which went into Chapter 11 in 2001), and its lead underwriter, Goldman Sachs.  Mr. Nocera got the data from the New York County Clerk’s office, where they were supposed to have been under court seal, but weren’t.

eToys

No, it’s not the one with the sock puppet.  That was Pets.com.  eToys was an online toy retailer.  Both made it into CNET’s Top Ten internet bubble flops, though.

The pricing range for eToys shares in the initial prospectus was $10-$12.  The final offering price was $20.  The stock closed on its opening day at $77.  It peaked a few months later at $84.  It was trading at $.09 when it went belly up.

The lawsuit:  eToys contends that Goldman failed in its fiduciary duty to get the best price for eToys shares.  Although it was losing money at the time of the IPO, eToys thinks that if it had raised, say, $400 million (an offering price just north of $50) instead of the $155 million it got, it would have been able to stay alive long enough to become profitable.  This was basically the AMZN strategy.  In eToys’ case, who knows what might have happened.

Goldman’s defense is apparently that it had no such duty.

the documents

Grammar and spelling errors aside, the Nocera documents shed some light on less well-known aspects of the IPO process.  No one comes out looking especially good.  For example:

–Goldman allocated 20% of the offering to “flippers,”  that is, to brokerage clients who had no interest in owning the IPO companies.  They just wanted to sell, or “flip,” the stock during first-day trading.

–one investment manager said he did large amounts of trades with Goldman simply to get IPO allocations.  He also appears to me to have paid commissions at almost twice the then going rate.  A cynic would say he got no services for this extra payout;  he just wanted to make the payments fatter–and thereby get a bigger IPO stock allocation.

–an internal presentation argues that Goldman should look at first-day trading gains in an IPO stock as being an asset of the firm, one that Goldman should seek to maximize the return on.

–Goldman regarded first-day gains as a quid pro quo for two things–the size of a client’s commission business and his willingness to participate in “cold” IPOs.  (“Cold” IPOs are ones with little or no upside; participation allows the underwriting syndicate to earn IPO fees at lower risk.)

–Goldman kept track of the first-day gains achieved by each client and informed at least some that it expected to receive 20%-30% of that figure back in increased trading commissions.

the underwriting fee/trading commission tradeoff

In the eToys IPO, the underwriters (I’m including the selling syndicate in here, too) received fees of $11.2 million, or 6.75% of the offering price of $20 a share.  If we assume they received from all brokerage clients what amounts to a kickback of 25% of the first-day gains of $53 on 8.2 million shares, that would have amounted to $108.7 million.

If, on the other hand, the IPO had been priced at $50, the underwriting fees would have been $28 million.  The commission “kickback” would be $47 million.

The total investment banking take at an IPO price of $20 a share would be $119.9 million; at $50 it would be $75 million.

This is Mr. Nocera’s point, and eToys lawsuit contention–that Goldman had every incentive to underprice the offering.

on the other hand…

…let’s suppose that the underwriters could only collect from flippers, who made up 20% of the eToys offering.  SEC-regulated money managers, after all, have a fiduciary obligation to get the lowest possible commissions.  If so, the “kickbacks” would have amounted to $21.7 million and $9.4 million.  The total investment banking take $20 a share would be $32.9 million; at $50 a share it would be $37.9 million.  Not a huge difference.

And I suspect this is closer to the true state of affairs.  Still, the tone of the documents Nocera unearthed suggests to me that Goldman felt it was missing a golden opportunity by not exploiting its underpricing better–not that there was something wrong with the underpricing strategy.  It may also be they knew that firms with more Internet cred, like Merrill (whose famous analyst, Henry Blodget was subsequently barred from the securities industry for fabricating his research reports) or Morgan Stanley (Mary Meeker apparently convinced the SEC she really believed the crazy stuff she wrote) were better able to cash in.

 

 

 

US bond market environment, October 2012

October 18, 2012 By in Bond Environment, Current Market Thoughts, securities markets, Strategy Tags: , , , , , , , , , , , Leave a comment

This is the quarterly letter sent by Strategy Asset Managers, LLC, a bond management firm, posted with permission from my friend and mentor, Denis Jamison.

Today’s post sketches out the current situation.  Tomorrow’s wil give Mr. Jamison’s investment conclusions.

a market of bonds

It’s an old saying on Wall Street–this isn’t a stock market but a market of stocks.  In other words, individual stocks can rise or fall regardless of the general direction of the market.  The same can now be said of the fixed income market.  formerly, the direction of interest rates dictated returns across most segments of the bond market.  If Treasuries called the tune and the rest of the fixed income market danced along–some a little slower or faster–but they were all moving to the same beat.

That’s now changed.

Policies implemented by the federal Reserve effectively have eliminated real yields for “riskless” securities like US Treasury bonds.  (By riskless, I mean credit risk–that is, the risk of not getting paid at maturity.  T-Bonds still have plenty of market risk.)  Without government bond yields calling the tune, all sorts of other factors are determining returns in various segments of the fixed income market.

The markets are now being driven by monetary policy designed to:

(1)  keep interest rates at zero for short-term, low-risk investment-like savings accounts and US Treasury bills and notes,

(2)  narrow the yield spread between “safe” investments like US Treasuries ans riskier investments like corporate bonds, and

(3) lower the return spread between fixed income assets and securities with no maturity–like common stocks.

In fact, the Federal Reserve would really like investors to go out and spend their money on real goods and services.  It has stated that zero interest rates are here to stay until the economy has fully recovered–that means much lower unemployment and much stronger economic growth.  Chairman Bernanke, unfortunately, doesn’t have a crystal ball and isn’t telling us when he thinks that will happen.  At the moment, however, he plans no change in interest rate policy through 2014.  Of course, he has pushed out the probable end date of his quantitative easing program before and is likely to do it again.  Market pundits have started referring to the Federal Reserve’s monetary policy as QE unlimited.

When the bank is playing…

…you just keep dancing.  We have just entered the third phase of the Federal Reserve quantitative easing.  in the wake of the 2008 financial collapse.  Essentially, “quantitative easing” means that the Federal Reserve will buy financial assets from banks and put cash in their–the bankers’–hands.  The hope is that, somehow, this money will filter through the system and the banks will loan that money to you and you will buy a house or a car or anything.

Why doesn’t the Federal Reserve just lower interest rates and make the loans cheaper?  Well, interest rates are already at zero so they need to do something else.  Since the banks are stuffed with money, will they loan the money to you?  No, because you don’t have a stellar credit history and your house is under water.  They refuse to take credit risk because they face political and regulatory retribution if they suffer any losses.

Has the quantitative easing program improved the economy?  Not yet, but it has certainly been a windfall for the financial markets.  The S&P market index is up 115% off the 2009 lows and every time it seems to be losing steam, we get another QE program.

Is all this going to end badly?  Probably, yes, but in the meantime don’t fight the Fed, don’t fight the tape and keep dancing.

The quantitative easing programs are having one clear impact–a massive increase in the Federal Reserve’s balance sheet.  The Federal Reserve was created in 1913 through a bill sponsored by two legislators, Carter Glass and Parker Willis.  Mr. Glass later went on to co-sponsor a bill that prohibited commercial banks from being securities firms.  (Interestingly, that 1933 piece of legislation was struck down during the Clinton administration.  Some say the repeal was a root cause of the 2008-2009 financial collapse.) The Federal reserve’s mandate was to provide liquidity to the banking system in times of crisis and to gradually expand the money supply to support non-inflationary economic growth.

Until 2008, the Federal Reserve provided that liquidity to the banking system by gradually expanding its assets through the purchase of government bonds from the banks.  That has changed.  Federal Reserve assets grew from $890 billion in June 2008 to $2.8 trillion most recently.  This is the result of asset purchases made by the Federal Reserve through its various QE programs.  Government bonds account for $1.6 trillion of those assets.  Another $800 billion are mortgage-backed securities and the Fed plans to add about $60 billion a month to that pile.  Unfortunately, the Federal Reserve’s capital base hasn’t kept up with the asset growth.  Now, $55 billion in capital supports those $2.8 trillion in assets–a leverage ratio of 50:1!

So, the Federal Reserve has done an excellent job of reducing leverage in the banking system through the purchase of all those assets and, as an additional benefit, helped keep government borrowing costs low.  But it has transferred a large portion of private sector bank leverage to its own balance sheet.  Any percentage change in the price of the assets on its balance sheet will be reflected fifty-fold as percentage change in the Fed’s capital.

In the movie”It’s a Wonderful Life,” the banker,George Bailey, was lucky enough to have an angel when his depositors make a run on the bank.  I hope Mr. Bernanke has an angel on his side if interest rates ever rise.

 

More tomorrow.

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