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.


how much does professional investment advice cost?

the article

Yesterday’s Wall Street Journal has a curious article in its monthly “Investing in Funds & EFTs” section.  It’s by Stanford graduate Andrea Fuller, a reporter whose specialty is data analysis.  It’s about her trying to find out how much she pays for professional investment advice/management.

the outcome

As she describes it, her situation is a simple one.  She uses an investment firm that’s “one of the largest in the country,” no name though.  The bottom line for her is that she pays a yearly fee, deducted daily, of 1.40% of the assets under management, which consist entirely of ETFs and mutual funds.

The fees break out in the customary way into two parts–an overall fee, sometimes called a “wrap” fee for the service of determining an appropriate asset allocation and selecting funds/ETFs,  plus providing an interface to discuss investment issues.  In Ms. Fuller’s case, that amounts to 0.85% of the assets.  In addition, she pays an average of 0.55% per year for the portfolio construction and management of the mutual funds and ETFs she owns.

pulling teeth

What’s interesting about the story is that Ms. Fuller (1) didn’t know this information before she decided to write the story, and (2) assumed, as I would have, that the figure would be easily available with a phone call or email.  In Ms. Fuller’s case, that’s wrong.

(a longish, maybe pedantic…sorry) Note:  the article implies that all the products are “in-house,” that is, provided by a single investment firm which is also the client interface.  If so, finding out costs is straightforward–what Ms. Fuller pays in total and what she pays to the firm are the same.  If, however, the investment firm uses a third-party portfolio manager for any portfolio products, it typically demands a portion of the third party’s management fee in return for providing access to “its” client.  This means that the total fees paid consist of two parts:  the fees paid to the client-facing investment firm and amounts paid to third parties.  In my experience, investment firms are very reluctant to disclose what their fee-sharing arrangements are.  A Customer Service hotline or a plain-vanilla investment adviser would never have that information.  In that case, the answer to the fee question Ms. Fuller posed is not so simple.)

Tenaciously, Ms. Fuller made a series of phone call (and email?) attempts to get this basic information from her investment adviser.  On at least two occasions, she answer she got was wrong–and, surprise, surprise, understated fees.  Although she finally verbally received the figures I cited above, she was unable to get anything in writing.  Apparently, this basic data isn’t disclosed on the firm’s website, either.  At one point during her journey, she was told to consult Morningstar and figure the fees out herself.

My thoughts:


–By and large, investment firms are run by professional marketers, not professional investors.  Their emphasis is typically on cultivating a relationship that focuses on client service and peace of mind and which deemphasizes the nuts and bolts of fees and performance vs. an index or competitors’ offerings.

Still, I’ve never encountered a situation where fees haven’t been readily available and disclosed somewhere in the small print.  To me, Ms. Fuller’s firm seems to me to be either stunningly inept or to be deliberately choosing to make fee information virtually impossible to obtain.


More tomorrow.


failed shopping malls

There was a local politician on Long Island a while ago who had an unusual campaign position on gun control.  He argued that guns don’t kill people; bullets do.   Therefore, we should not control the purchase or possession of firearms;  we should control the purchase/possession of bullets, the real culprits.  He lost–or at least I hope he did.

The Wall Street Journal ran an article yesterday, apparently based on a recent Wells Fargo research report on failed shopping malls.  Its conclusion:  dead shopping malls are being killed, not by online shopping, but by the proliferation of newer, larger, more glitzy, better-located other malls.

There is certainly something more to this argument than to the bullet one.  Commercial real estate is a boom and bust business.  Developers put up new structures with relentless fervor until the day the banks shut down their access to credit.  And that usually doesn’t happen until the first bankruptcies of failed projects begin to appear.  As the old banking adage goes, “You never get promoted by turning down a loan.”

So, yes, older, smaller, less well-located malls are losing out to newer ones.  And the loss of anchor stores is usually the signal that the party is over.

But if we do a little arithmetic with the Census Bureau data on retail sales in the US, we can conclude that although online retail sales represent less than 10% of the total, they account for half the overall growth in retail.  Bricks-and-mortar retail is advancing, if that’s the right word, at about 2% a year.  It may be that if we adjust for inflation, the movement of physical goods through the traditional retail chain is flat.  So because of the internet there is no need for any net new mall space in the US.

From a retail firm’s perspective, BAM revenue growth is probably only going to come by taking sales away from competitors.  In a mature environment like this, cost control becomes an increasingly important source of profit growth.  Both factors imply firms should have better control over floor space and adjust it frequently to be in the most attractive locations.

Who knows what mall developers actually do, but if it were me any new project would need to explicitly target aging malls in its vicinity.   Those would be the primary source of the revenues that would make the project viable.

Two conclusions:

–if half the growth in retail weren’t being siphoned off by the internet, I’d guess the tectonic plates of malldom wouldn’t be shifting as violently as they are now, and

–the idea that ownership of physical store premises is a hidden source of value for mature retail firms (think:  the attack on JC Penney) has passed its use-by date.



Warren Buffett and Dow Chemical (DOW)

Today’s Wall Street Journal contains a front page article that will be widely viewed on Wall Street, I think, as a bit of comic relief.

In times of financial stress, cash-short companies have tended to go to Berkshire Hathaway for financial assistance.  If successful, they receive both money and the implicit endorsement of Warren Buffet.

In 2009, it was DOW’s turn.  It wanted to acquire Rohm and Haas, another chemical company.   The best deal it could find for a needed $3 billion was in Omaha, where Berkshire took a private placement of $3 billion in DOW preferred stock, with an annual dividend yield of 8.5%.  The preferred has been convertible for some time now into DOW common (yielding 3.4%), at DOW’s option, provided DOW has traded above $53.72 for a period of at least 20 trading days out of 30.

DOW shares were trading below $20 each when the deal was struck seven years ago.

On July 26th, the shares breached the $53.72 barrier and traded above it for five consecutive days–the final two on extremely heavy volume–before falling back.  At the same time, according to the WSJ, short interest in the stock has risen sharply.  In other words, someone has been a heavy seller, using stock borrowed from others.

Who could that be?

Although nothing is stated outright, the strong implication of the article is that the shortseller is Berkshire, which stands to lose $150 million+ a year in dividend income on conversion.

Part of the Wall Street humor in the situation is that the playing field isn’t level.  It’s perfectly legal for Berkshire to sell DOW short, although it does seem to cut against the homespun image Mr. Buffett has been at pains to cultivate for years.  On the other hand, however, DOW would run the risk of being accused of trying to pump up its stock price (and the value of management stock options) if it went out of its way to absorb any unusual selling.


bond funds when interest rates are rising

This past weekend, the Wall Street Journal published an article in its Business and Finance section about what happens if interest rates rise and holders of bond mutual funds and ETFs start to sell in large amounts.  The article is based on a research report written by Barclays and co-authored by that firm’s co-head of fixed income research, Jeff Meli.  The article isn’t identified further.

Maybe that’s not so strange, since, as reported in the WSJ, I find the research itself to be weird.  Its conclusions seem to me to be either not that relevant or just plain wrong.  The article does, however, touch on a number of points that are important for bond fund holders to consider.


The report starts out by assuming what I guess the researchers think is a worst-case scenario:  the junk bond market drops 10% in a day, and a given mutual fund receives requests for redemptions equal to 20% of its assets.

It concludes that:

–the fund’s net asset value would fall by 12%

–the fund would sell its most liquid assets to meet redemptions

–the remaining assets would be mispriced at a value higher than the value they could be sold at

–therefore, the first investors to leave would receive more than fair value and would be the best off; later redeemers would get less than fair value for their shares

–ETFs don’t have these problems and should be preferred to mutual funds.

my thoughts

I think this is a very unlikely set of circumstances.  The most damning constraint would seem to be the “single day” provision, which is intended to give the junk bond manager in question the least possible time to raise funds to meet redemptions.  However, the other two conditions haven’t come anywhere close to being triggered on a single day, either in the downturn following the internet bubble or during the 2008-09 recession.  Some kind of gigantic external shock to the economy would seem to be necessary for either to happen– not something specific to a given type of asset.

In such a case, it’s not clear that any financial markets would be functioning normally.  It’s conceivable that trading in many/all financial instruments would be halted until calm was restored.  So the pricing of a given junk bond fund would be a moot point.

For at least the past quarter-century, junk bond funds have generally been priced by third parties at “fair value.”  I’ve seen them work for illiquid stocks or for NY pricing of stocks trading abroad.  My judgment is that they work incredible well.  So I don’t think fast redeemers get the best pricing.  The opposite may well be the case.

Fund families have lines of credit that they can use to meet unanticipated redemptions.

No portfolio manager worth his salt is going to sell only the most liquid assets first.  On the contrary, it’s better to sell illiquid ones while there are still buyers.

In the past, big investment companies have ended up buying the most illiquid assets from junk bond funds they manage at a price determined by a neutral third party, in order to make redemptions easier and shore up confidence in the fund.

In general, fund management companies have no incentive to price a fund too high.  If anything, they should want to price it too low.  That way, they can send the extra to redeemers once they find their error.  No one is going to send anything extra back.

I don’t get the ETF stuff at all.

More tomorrow.


hedge funds and investment research

On Monday, the Wall Street Journal ran an interesting article, “Hedge Funds Learn Secrets Not So Safe.”  It’s about brokerage house research reports on individual companies.

Brokers provide research to customers either by giving them access to a research website, which contains all a broker’s research reports, and/or by responding to requests for specific research items, including meetings with analysts.  The problem with this is that brokers collect and analyze all their points of contact for the information they contain.  Conclusions will certainly wind up on the firm’s sales desk and can easily end up on the firm’s proprietary trading desk, too.

The same written  information is also available to authorized customers through third-party information services like Bloomberg.  I can use my Bloomberg account not only to call up a chart of a company’s stock price, see summary financial statistics and find out who a company’s major suppliers and customers are.  I can also read brokerage research from the brokers I do business with.  Not having read the service agreements they’ve signed, hedge funds have apparently assumed that if they read brokerage house report on a given target investment using a third-party information service, the broker never finds out.  By doing so, they’ve outwitted the broker and avoided information leakage.

Not so.

The third-party information providers supply such usage data to brokers, sometimes being as specific as what person at a given firm has accessed a report.  In fact, the article cites an instance of an unnamed analyst finding out his research wasn’t as stealthy as he’d thought when the broker whose report he’d been reading called him up and offered to arrange a meeting with the target company.


What I find odd is that there’s an obvious way to prevent information leakage–do the research yourself.  There’s a ton of relevent information available from the SEC’s Edgar site, as well as from government agencies and industry trade associations.  There are also suppliers and customers to talk to.  There’s gossip on the internet, too.

In my experience, except for a narrow set of highly technical areas (where you can always hire a consultant), the picture you create yourself will be more accurate, relevant and in-depth than anything a brokerage report can provide.  Yes, the brokerage analyst may be willing to say things on the phone or in person that he wouldn’t care to commit to paper, but that’s another issue.

Two issues:  compiling a thorough analysis of a company may take a week or two, as opposed to taking an hour to read someone else’s work.  Also, the analyst has to have the skill and experience to do independent work.

I can’t imagine that taking an extra week is the crucial variable.  That leaves the possibility that the firms the WSJ is writing about are so weak they don’t know how to do research themselves.  Hard to fathom.  I guess they’re just great marketers.