discounting in the age of algorithms

what discounting is

In traditional Wall Street parlance, discounting is factoring into today’s prices the anticipated effect of expected future events.  Put another way, in the best possible case, it’s buying a stock for, say $.25 extra today, thinking that in a week, or a month or a year, news will come out that makes the stock worth $1, or $10, or $100 more than it is today.

two components

They are:

—having/developing superior information, and

–correctly gauging what effect dissemination of the news will have on the stock.

In my experience, the first of these is the easier task.  Also, the answer to the second problem will likely be imprecise.  In most cases, “The stock will go up a lot when people understand x” is good enough.

examples

In the early days of the Apple turnaround, the company launched the iPod, which ended up doubling the company’s size.  So the key to earnings growth for AAPL was the rate of increase in iPod sales.  The heart of the iPod back then was a small form factor hard disk drive.  There were only two suppliers of this component, Hitachi and Seagate (?), so publicly available information on production of the small HDDs had some use.  Much more important, however, was that there was only one supplier of the tiny spindles the disks rotated around.  And, unknown to most on Wall Street, that small Japanese firm published monthly spindle production figures, which basically revealed AAPL’s anticipated sales.

Same thing in the early 1980s.  Intel chips ran so hot that they had to be encased in ceramic packaging–for which there was only one, again Japanese, source, Kyocera.  Again, monthly production figures, in Japanese, were publicly available.

In both cases, the production figures were accurate predictors of AAPL (INTC) unit sales a few months down the road.  Production ramp-up/cutback information, again public–though not easily accessible–data, was especially useful.

Third:  Back in the days before credit card data were widely available, retail analysts used to look at cash in circulation figures that the Federal Reserve published to gauge the temper of yearend holiday spending intentions.  The fourth-quarter rally in retail stocks sometimes ended in early December if the cash figures ticked down.

In all three cases, clever analysts found leading indicators of future earnings.  As the indicators became more widely known, Wall Street would begin to trade more on the course of the indicators rather than on the actual company results.

today’s world

Withdrawal of brokerage firms from the equity research business + downward pressure on fees + investor reallocation toward index investing have made traditional active management considerably less lucrative than it was during my working career.

A common response by investment firms has been to substitute one or two economists and/or data scientists for a room full of 10k-reading securities analysts who developed especially deep knowledge of a small number of market sectors.  As far as I can see, the approach of the algorithms the economists/programmers employ isn’t much more than to react quickly to news as it’s being disseminated.  (They may also be looking for leading indicators, but, if so, I don’t see any notable success.  Having seen several failed attempts–and having worked at the one big 1950s -1970s  success in this field, Value Line–I’m not that surprised at this failure.)

My thoughts: 

–there’s never been a better time to be a contrarian.  Know a few things well and use bouts of algorithmic craziness to trade around a core position

–For anyone who is willing to spend the time watching trading during days like Wednesday there’s also lots of information to be had from how individual stocks move.  In particular, which stocks fall the most but barely rebound?   which fall a little but rise a lot when the market turns?  which are just crazy volatile?

where to from here?

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month.  He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration.  Currency futures markets are predicting a continuing deterioration in the coming years.  He thinks the two things are connected.  I do, too.

To my mind, what is happening  on Wall Street recently is that currency market worry is now seeping into stock trading as well.  If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him.  This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

 

The real economic issue is not Mr. Trump’s flawed self, though.  Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense.   In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation.  The result has been over a quarter-century of economic stagnation + a collapse in the currency.

 

More tomorrow.

trade wars

Recently President Trump announced plans to impose tariffs of 25% on imported steel and 10% on imported aluminum, citing national security reasons.  He followed this up with a Twitter comment that, for the US, trade wars are good–and easy to win.

My take:

–much of modern economics stems from study of the causes of the Great Depression of the 1930s.  The key factors:  the wrong fiscal and monetary response, world wide; and the imposition of tariffs to “protect” local industry.  These did substantial economic damage, deepening and prolonging the global slump instead.  The idea that Mr. Trump may not be aware of this is the really worrisome aspect of the current situation.

 

–the first-order effects of the proposed tariffs will, in themselves, likely be miniscule.  Domestic prices for both metals will rise.  As a result of that, and of possible tariff payments to the government, income will shift from the users of the two metals to Washington and to domestic producers of steel/aluminum.  Because of this, at least some metal fabrication will shift away from the US to other countries.  One EU-based maker of appliances has already suspended plans to increase its manufacturing capacity in the US.

–second-order effects will likely be larger.  The EU, for example, is indicating it will retaliate by placing large tariffs on several billion dollars worth of goods that it imports from the US.   Presumably, other affected countries will do so as well.

 

–there was a similar incident during the Obama administration involving Chinese-made truck tires.  Economists estimate that it resulted in the loss of 3,000 American jobs.  If there was anything good about that situation, it was that it was isolated–Washington understood this was a one-off payment to a domestic union for its political support.  Today’s concern is that, despite overwhelming economic evidence to the contrary, Mr. Trump actually believes that trade wars are good–and will continue to act on that belief.

 

 

Venezuela’s proposed “petro” cryptocurrency

the petro

Yesterday Venezuela began pre-sales of its petrocurrency, called the petro.  The idea is that each token the government creates will be freely exchangeable into Venezuelan bolivars at the previous day’s price of a barrel of a specified Venezuelan crude oil produced by the national oil company.  According to the Washington Post,  $735 million worth of the tokens were sold on the first day.

uses?

For people with money trapped inside Venezuela, the petro may have some utility, since it will be accepted by Caracas for any official payments.  For such potential users, the fact that the government determines the dollar/bolivar exchange rate and that a discount to the crude price will be applied are niggling worries.

perils

The wider issue, which remains unaddressed in this case, is that the spirit behind cryptocurrencies is a deep distrust of government, a strong belief that practically no ruling body will do the right thing to protect the fiscal well-being of users of its currency.

In Venezuela’s case, just look at the bolivar.  The official exchange rate says $US1 = B10.  But the actual rate, as far as I can tell, has fallen from that level over the past year or so to $US1 = B25000.

a little history

The more serious worry is that the history of commodity-backed currencies isn’t pretty.

Mexico

In the 1980s, for example a struggling Mexican government issued petrobonds.  The idea was that at maturity the holder could choose to receive either $1000 or the value of a specified number of barrels of Mexican state-produced crude.  Unfortunately for holders, Mexico reneged on the oil-price link.  My recollection (this happened pre-internet so I can’t find confirmation online) is the Mexico also declined to make the return of principal on time.

the US

The fate of gold-backed securities around the world during the 1930s isn’t so hot, either.  The US, for example, massively devalued (through depreciation of the gold exchange rate) the gold-backed currency it issued.  It also basically banned the private ownership of physical gold and forced holders to turn in the lion’s share of their holdings to Washington in return for paper currency.

 

In short, when the going gets tough, there’s a big risk that the terms of any government-backed financial instrument get drastically rewritten.  This recasting can come silently through inflation.  But, if history holds true, government backing of a commodity link to financial instruments gives more the illusion of protection than the reality–especially so in cases where the reality is needed.

 

 

 

going back up?

As far as US stock are concerned, I don’t know.

As/when the correction is over, however, it’s very important to look for signs of a leadership change.  At a minimum, one former hot industry/sector typically grows ice cold; at least one former laggard heats up.  Figuring this out and tweaking/reorienting your portfolio can make a big difference in this year’s returns.