more on “discounting”


“Discounting” is the jargon that Wall Street uses to describe the process of factoring changes in consensus beliefs about future happenings into today’s stock prices.  I’ve outlined the basics of discounting in an earlier post.

fundamental vs. technical analysis

Fundamental analysis, the study of company-specific and economy-wide economic and financial information, and technical analysis, the study of charts, can be seen as two approaches to discounting.  In the first case, researchers try to figure out what information is most important for making a security’s price go up or down, and then actively search for relevant data.  In the second, investors study chart patterns as a way of figuring out what fundamental analysts are doing and then riding on their coattails.

the internet

The internet has changed the amount, quality and cost of information in dramatic fashion. For example:

–When I was building an international equity investing organization for a major financial institution in the early 1990s, it cost about $300,000 a year in today’s dollars to get access to all corporate SEC filings.  The data came on microfiche and was available about six weeks after the documents were filed.  Today, the information is free on the SEC’s Edgar website; documents are available the instant they’re filed (companies do this electronically).

–Thanks to regulation FD (Fair Disclosure), company presentations are routinely webcast and are available through the company website.  Typically, they’re archived for at least a year.  True, breakout sessions at conferences, small group meetings or one-on-ones aren’t, but these mostly serve to fill in the blanks for analysts not familiar with a firm.  Companies may sound like they’re revealing new information, but they’re not.

–A Bloomberg terminal still costs $30,000-$50,000 a year, depending on its capabilities.  But discount brokers offer most of what an individual investor needs to their customers on their websites for free.

discounting and Greece

Discounting isn’t a one-time event.  It’s a process.

1.  For one thing, what’s painfully obvious to a seasoned observer or an industry specialist may only dawn on the average investor a considerable time later.

2.  Also, bad news that relates to a specific event is typically not fully discounted until the event occurs–no matter how far in the future that may be.  The financial crisis in Greece is a good example.

A year ago, a new administration in Athens revealed that the country had been falsifying its national accounts for many years.  Greece had taken in less in taxes and also spent a lot more than it had ever revealed.  How so?  Its membership in the EU had allowed it to borrow much more than it could ever repay.

For at least six months, it has been clear that either the rest of the EU will be forced to pick up the tab and let Greece remain in the EU, or that Greece will default and lose its EU membership.  In default, holders of Greek sovereign debt would lose most of their money.  But, since that’s mostly big EU banks which might need government bailouts as a result, the effect is basically the same.  EU taxpayers ultimately foot the bill.

Over recent months, however, EU stock markets–and the financials, in particular–have been subject to periodic waves of selling, driving prices ever lower, as investors express their fears about Greece.  …despite the fact that in general terms everyone has already read the closing chapter of the story.

This pattern of discounting the same news over and over again is typical.  It begins in denial (inadequate discounting) and may end in despair (overdiscounting), the same emotional pattern that shapes a bear market.  While bear markets end in a whimper sometimes, however, discounting that anticipates a discrete event usually involves a final selling bout as the event actually occurs.

Over the weekend, the G-20 seems to have given the EU an ultimatum to resolve the Greek crisis quickly.  We’ll see tomorrow how the markets react.

the current selloff

concrete signs of slowdown are emerging

A few days ago, Rio Tinto, the giant Melbourne/London mining conglomerate, said some Western customers (European?) are asking the company to delay shipment of contracted amounts of industrial metals (how this works financially is an interesting, semi-complex topic, but irrelevant here) .  FedEx announced this week that orders for airfreight shipment to the US, the EU and Japan are losing momentum as customers opt for slower and cheaper ways of getting their products into retail outlets.

In other words, for the first time in two years +, some firms are beginning to worry about having too much inventory and to work it down.  In one sense, this isn’t good.  But it had to happen eventually.  And the equity markets have been discounting this development since July.  After all, FDX has lost a third of its value in the past three months; RIO has been clipped by 37% over the same span.

So this is not really news.  And as FDX said, customers’ hair isn’t on fire.  They’re just being a little cautious.

the real problem is in the EU

There, a modern version of the Iliad, sans Helen, seems to be playing out, with France and Germany taking the role of Troy and, well …Greece in the role of Greece.

In a nutshell:  the EU let Greece in about a decade ago, even though it didn’t really qualify, giving it unrestricted access to EU credit.  Greece promptly borrowed (and spent) a gazillion times what it could ever repay, funded ultimately by the ever hapless financial institutions of Germany and France.  Greece says it’s sorry and will change its ways–but is actually doing very little. It seems instead to be milking the situation for the best possible terms for default, or perhaps just for more time at the EU credit trough–which, I guess, is what almost anyone would do in their situation.

On the other hand, German politicians are on the horns of a dilemma.  They either fund a Greek bailout, in which case they’re tossed out of office, or they let Greece default and destroy their banks.  And they’ll be thrown out of office again.  So they don’t want to act, either.  Arguably, this is also their best strategy (short of actually doing their jobs and fixing things).

Having endured this stalemate for about a year, the nerve of European investors seems to me to have finally cracked.  They’re selling anything not nailed down in a classic panic.  The rest of the world is being dragged along for the ride.

If there’s silver lining to this, financial market panic may provide the political cover the EU needs to stop procrastinating and begin to act.

three stock market scenarios

I’ve sketched this out in a little more detail in Current Market Tactics this month and last.

I have three targets for the S&P over the coming year, depending on economic circumstances:

nothing wrong (hah!)     1350

muddling through          1170

recession ahead             1000.

I still think that muddling through is by far the most likely outcome.  If so, 1170 would be the central tendency around which Wall Street will revolve.  Panic aside, if an investor thought he would need a 7% return in order to be induced to take the risk of owning stocks, then he should be a buyer at an index level of 1090.  That’s about 3.5% below yesterday’s close.  Below that any selling, which I already regard as overdone, would enter into another, higher, level of craziness.

The main item on our wish list should be market stabilization.

what to do

My thoughts haven’t changed very much.

When we get to the other side of the current storm, I think the winners will be firms with Asian exposure, participants in technology-based change and companies that serve the affluent.  At some point it will be right to trade your TIF in for WMT (I own the first but not the second), but not anytime soon.

If you can force yourself to get out from under your desk and witness the carnage, look for ways to upgrade your portfolio.  When selling starts, it may be rational at first and the weakest stocks get sold off first.  But then the selling often takes on a life of its own.  When panic sets in and the bad-stock ammunition runs out, good stocks get thrown out the window at crazy prices as well.  Why?  That’s all that’s left to sell.  No other reason.

My stocks got really whacked on Thursday, so I guess I’ve got to think that we’ve entered the latter phase.

Under the desk (or the bed) is sooo much more comfortable at a time like this, but my experience is that you’ve got to force yourself to at least analyze what’s going on.

If you can’t do this, or if you know you’d just do things you’d regret later–and you know your psychological makeup better than I do–find a good book.

By the way, in my view the current selling has nothing to do with year-end mutual fund housecleaning.


I want to add something about the discounting mechanism, but I’ll save that for Sunday.


S&P 500: method to the madness?

recent S&P 500 performance

The S&P 500 hit a near-term low of 1101, intraday, on August 8th.  It has bounced between 1140, the close on that day, and 1230 since.

what’s going on?

I think(see my dipping a toe in the water posts from early August) that investors are adjusting to the (strong) possibility that economic growth in the developed world will be little changed in 2012 from what it was in 2011.  This contrasts with the prior belief of the consensus (and me, too) that the economic acceleration we saw in 2009 and 2010 wouldn’t peter out completely but would continue to some degree into next year.

The market has alternated between bouts of euphoria and despair–sometimes, like yesterday, both emotions in the same trading session.  On the one hand, corporate profits remain very good; on the other, Greece may default on its debts, messing up the EU, and the Fed has just begun another round of unconventional action to try to restore a stronger pulse to the US.  What the market is taking from the Fed move is that the US needs the stimulation, not that the Fed is riding to the rescue.

testing the lows today?  …probably

Given the sharp selloff in Asia and Europe as I’m writing this on the morning of the 22nd, we appear to be about to see in the US whether the closing low of 1140 will hold.

below the surface, …

Look a bit deeper into the market action, however, and a more complex pattern emerges.  You can look for others yourself, as I’ll explain below.

…big differences among individual stocks,

which means to me that most investors are not as panicky as the index movements might suggest.  This is what I see  (percentage stock price changes since August 9th through Tuesday, with the index up 4.2%):

retail is mixed, with the high end doing well

Tiffany     +15.9%

Dicks Sporting Goods     +13%

Macy     +8.3%

Wal-Mart     +4.9%

JC Penney     +2.7%

Ford     +.4%.

tech–e-commerce, Apple and takeovers

Yahoo     +25.9%

Amazon     +19.7%

E-Bay     +19.6%

AAPL (which it an all-time high two days ago)     +16.7%

Oracle     +13.5%

Intel     +9.0%

Adobe     +4.1%

IBM     +4.0%

Microsfot     +2.5%

Netflix     -43.3%

financials- -ugh!!

GE     +.3%

Bank of America     -2%

Citi     -8.7%

JP Morgan Chase     -10.9%


P&G     +6.3%

Coca Cola     +1.8%

Pepsi     -3.5%

casinos–high-quality/debt under control

Las Vegas Sands     +29.2%

Wynn     +16%

MGM     -6.3%

no joy in Macau, despite blowout revenue growth

China Sands     -2.8%

Wynn Macau     -6.2%

SJM     -14.7%

MGM China    -15.1%

other random stocks

Catipillar     -3.9%

Exxon Mobil     +2.5%

Intercontinental Hotels     +1.7%

doing this for you portfolio

It’s a worthwhile procedure to do  regularly.

Go to Google Finance and call up a chart for the S&P 500.  The symbol is .inx.  (I normally prefer Yahoo Finance charts, but this is one instance where Google works better.)

Enter a stock symbol into the Compare box just above the chart and hit the Add button.  The chart parameters will change; you’ll see absolute performance numbers for both the S&P and your stock appear.

For checking performance since August 9th, select a 3mo view from the Zoom choices at the top of the chart..

Move the left-hand side of the bar that’s directly under the chart to the right until the chart shrinks to the time period you want.

Type in more symbols.  You’ll see their absolute performances (on a capital changes basis, not that it matters so much) displayed in different colors.

Good luck.

Good or bad, you’ll at least know how your stocks are doing.

Netflix and the art of raising prices

NFLIX, from  afar

I don’t know NFLX well, other than as a user of its products.  I’m still annoyed at myself for not having bought it two years ago.  But I haven’t been motivated to do the work I’d need to own it, so I mostly just watch the price as a barometer of the market’s feelings about growthy, techy consumer stocks.

Clearly, the recent plunge from the $300+ high to the current $130 runs sharply counter to the experience of most consumer-oriented secular growth names (more about this tomorrow).

the recent price increase…I know that the company has other issues.  I have no opinion, positive or negative, about the stock.  I just want to make a comment about the mess that the company made about the price increases it recently announced.  My take is that the move is actually a good thing.  The way NFLX went about it, however, shows a stunning lack of basic management skill.

…is a good thing…

Why good?  Yes, there are some cases where consumers actually want to pay more for an item–like buying an $8,000 Hermès handbag– to display their wealth or sophistication.  This isn’t one of them.  So for NFLX raising prices inevitably means losing customers.  There’s no way around that.

If the early returns are reliable, however, upping prices by 15% has lost the company 4% of its subscribers.  Revenues are still at least 10% higher than they would otherwise have been.  And NFLX can presumably build from there. Also, customer defections, relative to the company’s expectations, have been concentrated in users of DVDs only, the segment that NFLX wants to de-emphasize.

…done in awful fashion

Top management of most consumer companies spend a great deal of time thinking about prices.

They know that there are tipping points where regular customers of the products/services may dramatically slow down usage if the price exceeds a certain level.  They also know that these points are virtually impossible to predict in advance.  In the casual restaurant business, for example, a venue with a $17 per person average check may have diners lining up all around the block.  An $18 per person check-less than a 6% difference, on the other hand, may translate into lots of empty tables.

They also know that any really visible price rise–one that forces the consumer to think about how much he’s actually paying in total–is particularly perilous.  As NFLX has found out the hard way, $8-$10 a month isn’t that significant for its customers.  An extra $2, or the choice of remaining at the old price for a lower level of service, is.  It focuses attention on the fact that NFLX can cost $150 or more a year.  And, of course, there are probably a certain number of people who don’t use the service but have forgotten to remove the fee from the recurring payments on their credit cards.

As well, higher prices not only can spur customers to look for substitutes; they can provide a pricing umbrella under which rivals can prosper.

Also, techy things typically don’t go up in price.  They either stay the same for a new model that’s a lot better, or they go down.  As a result, for NFLX  any price rise comes as a shock.

NFLX appears to have been completely clueless.

what could NFLX have done instead?

Remember, I haven’t studied NFLX closely, but there are a at least a couple of tried-and-true marketing tactics that companies use to raise prices.  For example:

new and improved.  Companies often offer additional features–better content, preferred access, faster access, a wider selection, other stuff you may not need/want–as at least a psychological justification for customers paying more.

a program of small but steady price rises.  To eliminate sticker shock.

a public relations campaign in advance, interviews in the media, or communication with customers, to explain the economic necessity for raising prices.

–more conservative guidance.  This may simply have transferred the negative Wall Street reaction to the earlier point in time when NFLX gave guidance, rather than when the company lowered it.  But it would have suggested that NFLX has a better feel for its customer reaction to higher pricing.

where to from here?

The Wall Street analysts’ earnings consensus for NFLX for 2011 is about $4.50 a share, meaning that the stock is trading at slightly under 30x current profits.  While the stock doesn’t appear cheap to me, the company does appear to be growing at a pace much faster than 30%, even after its current stumble.

I think a buyer has to believe two things:

–that NFLX will continue to grow profits at 30%+ for as far as the eye can see, and

–either that management has made an isolated mistake, or that having sharp people at the top isn’t crucial to the company’s success.

The company is presenting at a conference today.  We may get more input from that.

risk controls at UBS: the case of trader Kweku Adoboli

Kweku Adoboli is the UBS trader who ran up losses of $3.2 billion through unauthorized trading in stock index futures over a three-month period without being discovered.  Both the Financial Times and the Wall Street Journal have extensive accounts of what Mr. Adoboli did.

Here are my observations:


Legally, traders act as agents for the institution they work for.  Once an employer introduces an employee to counterparties as being authorized to trade for the firm, the counterparties have no obligation to try to figure out what the trader is doing.  Until the employer informs them otherwise, the counterparty’s job is simply to execute the orders they receive.

Mr. Adoboli worked on a small trading desk called Delta One, that processed buy and sell orders that UBS received for ETFs.  For this story, the most important characterisitics of ETFs (see my posts on ETFs vs mutual funds for more information) are that:

–ETFs trade continuously throughout the day, in large aggregate amounts but typically in many small orders

–firms that run ETFs have no direct dealings with the investing public.  They keep their costs low by having brokers do virtually all trade processing and record keeping for them.

Brokers recoup the administrative expenses they incur through the commissions and bid-asked spreads they charge customers.  Once they amass a large net position in a given ETF, they can close their exposure out by transacting with the firm that runs the ETF.  They may also attempt to make additional gains through the timing of these transactions.

Brokers routinely hedge part or all of their ETF exposure through derivatives markets.  The name of Mr. Adoboli’s unit, Delta One, signifies that the trading desk “delta,” or the change in value of the hedges for a given change in the underlying position UBS held, should be “one.”  That is, the two should match exactly; there should be no net exposure.

Mr. Adoboli

Mr. Adoboli’s initial job at UBS appears to have been in the back office, as one of the administrative employees processing and recording the activities of the Delta One desk.  One of his unit’s jobs would have been to reconcile the desk’s accounts of the trades it made each day with the confirmation notices sent by counterparties. 

Mr. Adoboli was a good enough employee to be promoted to the much higher status job of trader.  One key fact that he learned from his back office time was, surprisingly to  me, that for a whole class of plain vanilla short-term derivative contracts, counterparty banks never sent confirmations on the day of the trade.  Apparently, standard procedure was to only to send settlement instructions a few days before the contract came due.

on the Delta One desk

Despite the name, the Delta One desk had to take risk.  And, from Mr. Adoboli’s behavior we can conclude that the desk rewarded traders for successfully taking risk.  But these risks would have been small, like:

–widening the bid-asked spread slightly, or

–delaying making a hedging transcation by five or ten minutes in hopes of getting a higher price, or maybe even

–by “anticipatory hedging,” over-hedging at a favorable price, figuring that new orders would soon come in.

three months ago

That’s when Mr. Adoboli exceeded the risk limits specified by his desk.  Who knows what happened?  He may have accidentally added an extra zero to a trade.  More likely, he may have decided he wanted to quickly make enough trading profit to get a higher bonus, or to be recognized as an astute trader and promoted to a “prop trading” desk whose principal job is to try to make trading profit (“prop” is short for proprietary, meaning it trades with the firm’s own money).

In any event, at some point Mr. Adoboli’s trading went badly and he began to make substantial losses.  Rather than reporting what he’d done to his boss, he used his back office knowledge to record fake trades that offset his losses.  He selected instruments where he knew no confirmations would be sent–buying him time until close to settlement day for him to recoup his losses and enter more, counterbalancing, fake trades to erase them from the records.

Apparently, toward the end, Mr. Adoboli was making speculative trades covering as much as $5 billion in securities, all without being detected.

What appears to have tripped Mr. Adoboli up was that the back office noticed it was not receiving settlement instructions for fake trades set to settle on September 22nd.


In the mid-1980s as I was beginning to learn about bank stocks, a colleague who was an excellent bank analyst told me she had one main criterion for separating good banks from bad.  In a good bank, when someone makes a mistake and reports it, he’s rewarded; in a bad bank, mistakes are punished, so employees hide them.

It’s hard for me to believe that Mr. Adoboli was able to conceal his unauthorized trading from his direct supervisor–in a five- or six-person section–for so long.  That person must have been asleep at the switch.

It’s also surprising that there was such an unaddressed loophole in UBS’s trade reconciliation procedures–and that no one noticed that one person was doing so much unreconciled trading.