Bad Ideas Report

As you may know, my family and I own a number of actively-managed, investment theme-oriented ETFs run by Ark Invest. I consider myself an aggressive investor, so I like the focus and the (relatively high, in my view) degree of concentration in what ARK considers its best ideas. My one hesitation–hesitation may be the wrong word, since I own a bunch of ARK products (a risk to keep in mind might be better)–is that a given name may be prominent in more than one ARK products. Square, for example, is a 6% position in both the Ark Innovation and Ark Next Generation Internet funds; it’s also a 12% position in the Ark Fintech fund.

The position sizes don’t bother me, both because I’m aware of them and my younger son has convinced me of SQ’s appeal. The potential worry I see is the interconnectedness of the fund holdings in a time of extreme stress. If say, the Fintech fund were to have heavy redemptions requiring it to sell holdings, that could put some downward pressure on the other two through SQ. Not a worry for today and not a high probability scenario, but it’s my main concern. How to respond? …either be prepared to do nothing or to buy more.

Anyway, ARK has just issued a white paper titled Bad Ideas Report that I think is interesting. I found the autonomous driving sections the most in-depth. My reaction to the physical bank branch part is that this issue has been around since the emergence of the ATM in the 1980s. The US is way behind the rest of the world in consumer banking, so we can see the future just by looking abroad. Yes, this is bad for banks, but how bad?

the stock market crash of 1987

The Wall Street Journal has an interesting article today on the birth of the ETF–and the index fund, for that matter.

Two factors stand out to me as being missing from the account, however:

–when the S&P 500 peaked in August 1987, it was trading at 20x earnings.  This compared very unfavorably with the then 10% yield on the long Treasury bond.  A 10% Treasury yield would imply a PE multiple on the S&P of 10x–meaning either that bonds were dirt cheap or that the stock market was wildly overvalued vs. the bond market.

–a new product, called at the time portfolio insurance, a form of dynamic hedging, had very recently been created and sold to institutional investors by entrepreneurs steeped in academic efficient markets theory.  Roughly speaking, the “insurance” consisted in the intention to stabilize equity portfolio values by overlaying a program of buying and selling futures against the physical stock.  Buy futures as/if the market rises; sell futures as/if the market falls.

One of the key assumptions of the insurers was that willing/eager counterparties for their futures transactions could be found at all times and at theoretically predictable prices.  On the Friday before Black Monday–itself a down day–the insurers’ model required them to sell a large number of futures contracts.  Few buyers were available, though.  Those who were willing to transact were bidding far below the theoretical contract value.  Whoops.

On Monday morning, the insurers, who appear to have had negligible actual market experience, capitulated and began selling futures contracts at whatever price they could get.  This put downward pressure both on futures and on the physical market.  At the same time, pension funds, noting the large gap between the price of futures and the (much higher) price of the underlying stocks, began to buy futures.  But to counterbalance the added risk to their portfolios, they sold correspondingly large amounts of stocks.  A mess.

Arguably, we would shrug off at least part of this today as just being crazy hedge funds or algorithmic traders.  Back in 1987, however, equity portfolio managers had never before seen derivatives exerting such a powerful influence on the physical market.  It was VERY scary.

conclusions for today

Stocks and bonds are nowhere near as out of whack with one another as they were back in 1987.  The nearest we have today to a comparable issue is what happens as worldwide excess liquidity is drained by central banks from money markets.

The trigger for the Black Monday collapse came from an area that was little understood, even by those involved in it–activity that had severe negative unexpected consequences.  The investors who did the best after the crash, I think, were those who understood the most quickly what had happened.

Collateral damage:  one of the most important results of Black Monday, I think, was the loss of confidence in traditional investment advisers working for the big brokerage houses that it created.  This was, I think, partly because of individuals’ market losses, but partly, too, to the generally horrible executions received when they sold stocks in the aftermath.  This was the start of a significant acceleration of the shift to discount brokers and to mutual fund products.

the Wall Street Journal’s new direction

The Wall Street Journal recently announced a reorganization intended to narrow its focus back toward politics and business, as well as to shift its orientation from print  to online.

As far as the stock market is concerned, the WSJ now seems to be trying to provide less news and more analysis.

But I’m finding the new analysis tack to be quite odd.  For example:

–two days ago, an article pointed out that shoppers are frequenting low-price retailers.  Yes, that’s true, but there was no acknowledgement that this trend has been going on for ten years

–yesterday’s paper pointed out that companies are preparing for higher short-term interest rates by tightening up their working capital management.  Potentially very interesting.  Unfortunately, the authors didn’t have much of a grasp of what working capital is, so the article’s usefulness was limited

–a third article, this one also from yesterday, contrasted the performance of value-oriented ETFs and their growth counterparts.  It also would have been a lot better if the author had a basic idea of what growth investing is   …and had refrained from using the disparaging term “momentum” for growth.

 

What could be going on?

–maybe it’s just August

–it could be a change in editors or in reporters

–it might also be sources.  To the degree that the Journal relies on interviews with professional Wall Street analysts, it could be that cutbacks on the sell side have diminished the available information.  Or it might be that the sell side is preparing for the day (coming soon, I think) where it will begin to charge cash instead of soft dollars for their research.  So brokers may have already begun to limit the information they will release for free.

If it’s not the first of these, we’ll all have to become a little more creative in how we access basic data.

At least there’s still the FT.

 

reading financial newspapers

When I began working as a securities analyst, I noticed that my more experienced colleagues–and especially the most accomplished–had a peculiar reading habit.  They might glance over the front-page headlines and skim the articles.  But they spent most of their time in the back half of the paper, studying smaller pieces about more obscure economic developments or about small-cap companies.

Why do so?

reading back to front

Their idea, which I quickly adopted, was that the headlines dealt with well-known topics, whose importance was most likely already fully factored into stock prices.  The most important thing for an analyst, on the other hand, is to uncover information that is not yet discounted.  That means, of course, going beyond newspaper coverage.  But as far as the newspaper as a source of new ideas is concerned, it means reading the back half much more carefully than the front.

I, too, soon began reading the paper from back to front.

curation

In the online world, that’s hard to do, for two reasons:

–during the day, stories are constantly being rearranged, with the most-read (arguably the least valuable for us as investors) being pushed forward to the beginning pages and the least read gradually fading further and further back.  In addition,

–there’s no easy way to jump to the back of the queue, where the potentially financially valuable news should be increasingly piling up.

physical paper vs. online

The easiest way I’ve found to deal with the problem of online curation is to read the physical paper instead.  However, that isn’t always possible.  Luckily, if you hunt around on major newspaper websites, you can find an option that lets you read the news in the form the original editors laid it out for the physical paper, that is, without curation.  To my mind, that’s not as good as jumping directly into the stuff few people are paying attention to.  But it’s better than having to wade through the larger piles of non-investable stuff that the online edition creates as a “service” to us.

 

reading a financial newspaper

Early on in my investing career, I came to realize that it’s better to read financial newspapers by starting on the back page and working toward the front.

How so?

As investors, we’re searching for information that is potentially important but not yet well known.  Arguably, the best information won’t yet be in print.  But as it does appear, it will usually come in the form of small articles on the back pages.  Typically, when information is on the front page, or when it appears as a magazine cover, investors normally begin to think hard about adopting the contrary stance.

At first blush, reading from back to front is hard to do with online news services.  Worse,  the order of online news is constantly being curated, meaning that the most popular items are pushed toward the front.  The less well-received–that is, the more interesting for us–are progressively pushed toward the rear.

Interestingly, the Wall Street Journal and the Financial Times both have introduced what is being described as a “new” way of reading the newspaper, a digital form of the print newspaper.  Personally, I prefer the print newspaper.  But I find this digital form just as useful when I’m on the road.