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.

why Wall Street analysts are almost always bullish

Several days ago, the Financial Times wrote an article about the troubled Canadian pharmaceutical company Valeant (VRX) in which it observed that 21 of 23 professional Wall Street securities analysts had rated VRX a buy just as it was about to lose 50% of its value in a day.  The loss was understandable:  VRX reported weaker than expected earnings figures and said it might soon be in default on some borrowings because of its inability to produce accurate and complete financial statements.

To my mind, that isn’t necessarily the worst part.  VRX shares had fallen by 60% in a flat overall market during the prior year.  Yet very few analysts picked up on the signal that price action was flashing that something might be wrong.  Of course, the CEO of Valeant, no longer with the company, had also called his most favored analysts shortly before the announcement to say that everything was fine.

VRX isn’t a once-in-a-lifetime case.  Comments from readers accompanying the FT article correctly cite Enron and the internet bubble as prior instances of the same phenomenon.  The SEC complaint in the case of Henry Blodget, a former Merrill Lynch internet analyst who was barred from the securities business for publicly recommending stocks he privately believed had no investment merit, spells out the latter situation in detail.  (By the way, Blodget now writes for Yahoo Finance.  Go figure.)

So, why are Wall Street analysts so bullish?

–There’s a saying in commercial banking that no one ever gets promoted for not making a loan.  Same thing for securities analysts.  No one gets rich by warning what stocks not to buy.  Fame and fortune come from introducing clients to stocks that will go up.

–Having a “sell” opinion isn’t a purely intellectual stand.  It entails considerable professional risk.  Institutional/hedge fund customers who own the stock in question may call up the analyst’s boss to complain.  They may intimate, or flat out state, that they will withdraw/reduce the commission business they send the firm unless the analyst changes his opinion …or is fired.

Companies with poor ratings may complain, too, and threaten to take their investment banking business elsewhere.  They can (and do) make the offending analyst’s life miserable.  They can deny access to top management.  They won’t return phone calls. They may not attend industry conferences the analyst arranges.  They’ll ask the analyst’s rivals to set up meetings with important shareholders.  Just ask Mike Mayo, the bank analyst who suffered greatly for years for his negative view of financials.

–Brokerage firms believe that their in-house research loses them money.  They regard investment banking, trading for their own account and acting as a middleman for third-party trades as their major businesses.  Because of this, they have a tendency to think that research should support at least one of these efforts.  In my experience, they also think that the third-party trading business comes in on its own.  So, while they may not say this in public, they view their institutional research as being either an adjunct to investment banking or proprietary trading.

–During the recent recession, very many experienced sell-side securities analysts were laid off.  Their replacements have less experience, and they don’t have the same kind of personal followings with clients that can protect them from external pressure to be bullish.

 

securities analysis in the 21st century: fifty years of changes

Fifty years ago, the financial services industry in the US was a backwater, somewhere people went to work if they couldn’t find a job elsewhere.  But powerful changes were on the cards.  Americans were becoming wealthy, at least in part because the country’s industrial base was the only one in advanced economies left standing after World War II.  And they were developing an appetite for stocks.

reasons for rapid growth of financial services during 1970-90

–the maturing of the Baby Boom

–1974 ERISA legislation, which more or less compelled companies to hire competent third parties to manage their employees’ pension assets

–ERISA also established IRAs

–1978 tax legislation established 401ks

–the rise of discount brokers and no-load funds (even in the 1980s, load funds charged purchase fees of up to 8%) that made investing cheaper and easy

–the crash of 1987, which, I think, caused a fundamental shift by individual investors away from traditional brokers and individual stocks, to mutual funds

–a shift in the 1990s, motivated by wanting to reduce their legal liability, by traditional brokerage houses to convert brokers from “stock jockeys” into salesmen of packaged products like mutual funds

The result of all this was the spectacular rise of the money management industry during the second half of the last century.

seeds of decline

–downward pressure on commission rates

ERISA requires that when money managers transact, they obtain the best execution (buying/selling price) as well as the lowest transaction cost.  As technology developed, this meant that trading rooms had a legal obligation to use electronic crossing networks (“dark pools”) instead of routing orders through traditional brokers. Fidelity was a leader in this.

The move also had the positive side effect of denying brokers to opportunity to use client trading information for their own benefit–either by trading on it themselves or by blabbing about it to other money managers.

–questioning of “soft dollars”

money managers routinely buy information from research organizations, including brokers, by allowing them to charge commissions that are 50%-100% higher than normal (called “research commissions”).  Fidelity, the industry standard of best practice, has been working for years to restrict the amount of shareholder money that is being spent this way.  Yes, this is good for Fidelity–by being bad for smaller rivals.  And its efforts have been very effective in cutting the diameter of the firehose spraying commission dollars at research sources.

in recent years, there’s been a small but growing trend for big clients of money managers to demand that a portion of their soft dollar allotment be earmarked for buying services for the client, not the money manager

–the move to index funds, and ultimately to ETFs, which don’t require active management

–massive redemption of equity mutual funds during the Great Recession, reducing further the assets in the hands of active managers.  Since managers are paid a percentage of the assets they oversee as their fee, fewer assets means less money to pay employees like securities analysts and portfolio managers

–large-scale firings of experienced securities analysts by brokerage firms during the Great Recession.  Over the course of my career on Wall Street, brokerage companies have been gradually changing themselves into trading firms–because, rightly or wrongly, they regard trading as much more profitable.  They’ve been laying off experienced analysts for over a decade,  disgorging even the most deeply entrenched during 2008-9.

The net result:  the big brokerage research departments of the 1980s-90s are gone.  There may be bodies occupying seats today, but they generally lack training, supervision and experience.

Active managers, who had cut back their (mostly ineffective) research staffs in the 1980s,  in favor of buying information from brokers with soft dollars instead, have few internal assets to rely on.  They also have lower fee income.  Are they going to rebuild their own research?  If so, whose current pay gets cut?  Will new research be any better than the sub-par operations they ran last time around?

for individual investors, like you and me…

THIS IS GREAT!!!

Yes, less well-informed institutions means that day-to-day volatility may be higher.  But it also means that we have a much better chance than we did a decade ago to discover valuable information that Wall Street doesn’t know yet.

Tomorrow, what companies are doing–with an aside on AAPL.

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

 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.