“The Currency” and “the Road to the Airport”

The Currency

The UK artist Damian Hirst launched his The Currency project late last month.

He auctioned off 10,000 signed small paintings of groups of dots for $2000 each. Holders are required to choose between receiving the physical painting or a nonfungible token (NFT), that is, a crypto-protected digital file. For anyone who chooses an NFT, the corresponding painting will be destroyed.

I don’t know much about Hirst and his ideological underpinnings, although The Currency could be seen as an attempt to create a new kind of performance art, or a new criterion of authenticity in a work of art, replacing the editioning common with, say, photographs.

What interests me as an investor, though, is that:

–the entire issue was sold almost immediately, grossing $20 million, and

–in the online secondary market, 184 paintings sold online last week for an average of just under $30,000–up 15x in a month.

the Road…

In the final days of the high-yen, low interest-rate era in Japan in the late 1980s, when virtually every piece of usable Tokyo real estate had been bid to the sky, enterprising stockbrokers launched a sales campaign aimed at big institutional investors touting the companies holding the land along the forty-some mile stretch on the road from downtown Tokyo to Narita Airport. Although mostly farmland, Nomura et al claimed that the road would soon be chockablock with corporate office buildings as the Japanese industrial juggernaut kept on rolling. Therefore, get in on the ground floor, as it were, by buying equity in the otherwise ramshackle enterprises there. No economic merit for this at all.

My memory is that the Road… campaign turned out to be the last gasp of a stock market rising on fumes. But it also points to the area of the greatest speculation during the endaka era–real estate.

The carryover for here and now: the real speculative Wild West for investment today is not in stocks but in cryptoland. I can see two differences arguing that things like The Currency are less bad than the Road… The former is a speculation on the shape of the future rather than an extrapolation of the recent past into the future; and, for now a least, crypto is absorbing fewer economic resources (I think) than Japanese real estate did, so there is no urgent need to use government policy to stamp it out.

Personally, I’m thinking of NFTs as the coal mine canary for more traditional long-term investments like stocks and bonds. At the very least, however, cryptoland shows no sign of adjusting to possible higher interest rates in the way I think the stock market is beginning to. So speculation is alive and well in today’s financial markets, just not as visible to most professional investors.

my thoughts on the Chartered Financial Analyst (CFA) program

I read a Bloomberg article over the weekend that asserted that the CFA program is pretty worthless. I thought I’d add my take.

I entered the financial world in late 1978, as a trainee securities analyst. This was mostly because I needed a job and had had three serious black marks on my resume: I had been a soldier in the Vietnam War, I had studied philosophy in school and I was over thirty. But, as they say, Wall Street takes everyone.

After a short while I realized I liked the work and thought I could be good at it. I started an MBA in finance at night at NYU and at the same time began to prepare for the CFA exams. I did the first to get the accounting and economics background I needed to be an insightful analyst. I did the second as proof that my suspect background shouldn’t be fully taken against me.

Unlike today, at that time, the CFA program was only open to people actively working in the boiler room of the investment industry, either as analysts studying specific industries and companies and creating detailed spreadsheets projecting potential future earnings, or as portfolio managers (almost always former analysts) shaping packages of securities intended to generate better returns than a specified target index.

The CFA Institute and affiliated organizations focused mostly on the needs of analysts and PMs, generating papers, for example, that discussed the ins and outs of accounting for oil and gas leases or how to detect the scammy ways that 1970-80s-era tech firms artificially pumped up their earnings (and the accounting standards put in place to combat that).

Somewhere along the way, that all changed. Perhaps because practitioners (as the academics call us) weren’t paying enough attention, control of the CFAI shifted away from financial analysts to academics. Several changes resulted:

–the useful industry-specific information disappeared

–university professors with no practical knowledge or experience became board members and/or featured authors in the CFA publications

–dues went up a lot, as did the fees for taking the exams

–membership was widened to also include virtually anyone involved in marketing or administration of investment products.

As an analyst, I have to conclude that this was a brilliant move, akin to the new-management remake of a classic underachieving “value” stock. Tons more money for a watered-down product. As a former user of CFA services, I’m tempted to say this is like anti-vaxxers taking over the AMA. But that’s not right. Academic finance is crazy and irrelevant, not crazy and harmful.

My conclusion: for someone with no background in the industry, this is a good first step, like a set of online tutorials in pottery-making. Is it as useful for would-be investors as an MBA? No way, provided your school has a concentration in investments and lots of accounting and economics courses.

Me? I received my both CFA charter and my MBA in Finance (concentration in Investments) three years after I started in 1979.

Am I still an MBA? yes.

Am I still a CFA? I think I am. Unlike any institute of higher learning I’ve ever heard of, however, the CFAI requires that I pay it $275 a year to say that I am. In some sense, this is a brilliant stroke. At the same time, its scamminess says a lot about the current organization.

macroeconomic analysis vs. company analysis

There are two complementary approaches to trying to figure out the prospects for securities (both stocks and corporate bonds) and markets: analysis of economies (macroeconomic analysis) and analysis of companies and the industries they’re in (microeconomic analysis).

Around the world the favored–and much easier, in my view–path is macro analysis. It’s the focus of most academic training. There’s usually plenty of government-collected data available. And there are legions of sovereign bond analysts continuously assessing a given country’s performance as a way of gauging its creditworthiness and therefore its bond prices.

What has made the US unique over the 40+ years I’ve been watching markets–and the reason US equity investors have eaten everyone else’s lunch, has been its strong concentration on figuring out industry and individual company prospects. One or the reasons, I think, of the almost continuous underperformance of the hedge fund industry is that those firms’ principals generally have backgrounds in marketing and trading, not research or economics.

(an aside: one of the reasons for the failure of macro-only analysts is that there’s no reason to think that there’s a strong relationship between a country’s GDP and its stock market. GDP and banks, maybe (the traditional British approach). But not elsewhere. One simple example is the S&P 500, which consists completely of US-owned enterprises. About half the S&P earnings are derived abroad, however.)

I mention this because I’m struck by how much current US stock market seems to be influenced by macro data–strong GDP on the plus side, the increasingly negative effects of official pandemic denial in the South and Southwest, on the other. The ins and outs of individual company success and failure, the traditional heart of Wall Street, seem to be being ignored.

This creates an unusually good opportunity for individual stock pickers. One kind of company seems to be particularly interesting. It’s last year’s pandemic beneficiaries. These will, I think, separate into two cases: firms that had a gigantic one-time jump in sales in 2020 and are now beginning to come back to earth; and businesses that have found new customers who are sticking around even as the country starts to shift back to (what will pass for) normal.

I think there’s a potentially a big difference between companies whose profits doubled last year and are now reporting flat-to-down yoy comparisons and those who doubled in 2020 and are reporting up comparison. The latter is quite a feat, I think. Wall Street, or maybe just trading bots, seem to be lumping both together as cases of decelerating earnings gains–meaning stocks headed for trouble. That is usually the case, but 2020 was so unusual that I think dismissing the ability to make any higher earnings in 2021 is a mistake–that we can profit from by looking carefully.

the start of “tapering”

Yesterday afternoon, the Fed said the recovery was far enough along that it can start “tapering” before the end of 2021. The stock market dropped sharply on this news before recovering before yesterday’s close (btw, typical market behavior on almost any Fed news).

What does this mean?

The primary money policy tool the Fed uses is the Fed Funds rate, which it sets, and which is the rate banks use to lend and borrow money overnight. This is the shortest of short-term rates. In most circumstances, changes in the Fed Funds rate ripple quickly through longer maturities–like the Treasury market and the rates on loans banks charge their corporate customers. But during the 2008-09 financial crisis, longer-term rates stayed stubbornly unmoved by anything the Fed did with the Fed Funds rate. So the Fed resorted to “unconventional” measures. It started to buy lots of longer-dated Treasuries for itself. The relative scarcity this creates pushes Treasury yields down, because other buyers, like banks and investment companies, have to offer better terms (i.e., accept lower rates) to make a purchase than they would if they were the only ones bidding for the securities.

Yesterday, the Fed said it would begin to “taper” (reduce) the mammoth level of Treasury purchases it has been making regularly during the pandemic. When Ben Bernanke said something similar in May 2013, his statement provoked a “Taper Tantrum” of higher rates in the bond market. This time, not so much, at least so far. My guess is that’s because this is the second time we’re seeing this situation and have some past experience to rely on.

What does this mean?

For some time I think we’ve been in an inbetween conceptual space. We knew in a vague way that, at some point, the period of near-zero interest rates would be over. But because we had no firm evidence about when, the markets had no reason to react in more than in a vague iffy way.

Now the situation has changed. We don’t have the certainty that we will when tapering actually begins (December?). But the market background of near-infinite monetary accommodation (and near-zero rates), which allows firms with even so-so earnings prospects to trade well, is fading away. In its place, we’re moving into one of rising interest rates. Yes, by historical standards they’ll remain low: my idea is that the 10-year Treasury will ultimately settle in at about 3%; the consensus, as I see it, is 2.5%. But relatively strong earnings growth, and especially near-term growth, will be the principal (only?) defense against the market PE contraction that higher rates will induce.

A second, less adequate, I think, defense is what I think of as “you can’t fall off the floor” stocks. Ones that may have limited prospects but which are already trading as if they’re road kill. Macy’s (M), up by 22% today, is indicative of the type. This may be another way of saying that traditional value stocks will enjoy one of their increasingly rare days in the sun.

So we’re entering a new phase of the stock market, where valuation and conviction in the solidity of earnings growth in 2022-23 will be increasingly important considerations. Pure story stocks will do less well. PEs will count for more, although bonds at 3% imply stocks will still be selling at 33x earnings.

One complicating factor: the false Trump COVID-is-a-hoax narrative, still professed by acolytes Abbott, DeSantis et al, which continues to prolong the pandemic–and retard economic recovery in areas like travel, entertainment and dining…. We can already see this reflected in the collapse of the related stocks over the past month or two. It’s unclear, to me anyway, given the obstinacy of pandemic denial, whether weakness will be confined to the directly affected stocks or will spread wider.

income tax: mutual funds vs. ETFs

Plain-vanilla corporations in the US have their income taxed by the government in the year when the profits are recognized. If the company distributes part of those profits to shareholders as a dividend, the dividend is seen by the IRS as income for shareholders and, despite having been taxed once, is taxed again.

Mutual funds and ETFs are a special type of corporation. Their profits are not regarded as taxable income at the corporate level, and are only taxed on distribution, as shareholder income. In return for this exemption from corporate tax, mutual funds and ETFs must have a narrowly focused business purpose and must distribute virtually all their yearly income to shareholders.

Mutual funds and ETFs, however, can be very different from one another as far as distributions go, in a way that I didn’t understand at first and which can be important for us as shareholders. It has to do with how redemptions are handled.

Let’s take an ETF and a mutual fund and assume:

–each has large unrealized profits from investments made years ago (think: MSFT bought in 2014 and up by 9x since) and no cash on hand.

A traditional mutual fund has $10 million in redemptions from a long-time shareholder. It sells MSFT to get the money needed, realizing a $9 million capital gain doing so. At the end of the fiscal year, normally in October, the mutual fund distributes to each shareholder at that time their proportionate share of the MSFT gain that they must pay income tax on. It isn’t the selling shareholder who pays, even though he has most likely benefitted substantially from the 9x gain on MSFT. It’s the holder of the mutual fund shares at the time of the distribution, even if he has only bought the mutual fund shares on October 30th, who is responsible for paying the tax.

An ETF, on the other hand, does not deal directly with its shareholders. Instead, the ETF designates a small group of market-makers, typically large brokerage houses, as intermediaries to handle buying and selling. In particular, in the case of redemptions, the intermediary can present shares for redemption to the ETF and receive stock held by the ETF in exchange, instead of cash. The details of how much and how this is done are spelled out in the contract between the ETF and the intermediary. To the extent the ETF delivers stock, it it is not selling, and therefore not realizing capital gains.

This characteristic of STFs is a big reason, I think, that mutual fund complexes are beginning to convert their actively-managed offerings into ETFs. A second is that something like half the fees charged by mutual funds go to support the in-house agency that handles buy and sell orders and keeps the fund’s records. I don’t know how that compares with the bid-asked spread that ETF intermediaries maintain, but that’s invisible to shareholders while the mutual fund administrative expenses aren’t.