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If It’s Too Good to Be True…

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I wish I could say that it’s stunning how many victims have emerged in the Bernie Madoff Ponzi Scheme that resulted in the evaporation of more than $50 billion in assets. I wish I could say that it’s stunning who those victims are, among them some of the world’s largest banks, including RBS, HSBC, Natixis and BNP-Paribas, and some famous “small” investors, including the owners of the Mets, Dolphins and Eagles.

Alas. The only part of this that is stunning is that so many seemingly intelligent people allowed themselves to be drug into this pyramid fraud. The problem is that people believe in the concept of long-term profits that exceed the market return. It’s possible to outrun the market for a while, as I have done for the past few years holding a stake in Apple, but the extra risk inherent in a technology company, as well as a lack of diversification, that brought outsized returns in years past has served to erase those profits in a matter of months recently.

The same holds true- eventually- for everyone. No mutual fund, no individual investor, no algorithm, has ever successfully beat the average market return over a long-run timeframe. This isn’t meant to be a blog specifically about the finance industry or even the stock market, but rather economics in general. The fact that the market cannot be beat in the long-run is an economic absolute, not a financial absolute.

The reason is because it’s impossible for any algorithm or investor to account for the precise demands of every market consumer in the world, every potential news story or natural disaster, every political election, etc. Markets in general are priced, at least in theory, on every piece of data in the world (or at least every piece possibly relevant in the slightest to market values). This is the meaning of an “efficient” market. And where markets are even just generally efficient, not perfectly so, achieving an outsize profit in the long-run is unfeasible.

Those that were sucked into this scheme allowed themselves to be fooled by the trappings of finance. Financial wizards have concocted a variety of complicated instruments and investment schemes meant to perfectly shield from risk, provide excess returns consistently, or otherwise “break the rules”. We see their handiwork on display right now in the utter destruction of some of Wall Street’s oldest names. This particular story is no different and brings to mind an old adage: pigs get fat, hogs get slaughtered.

Even though Mr. Madoff was reporting returns well above those of the market year after year, without disclosing any type of pricing model or particular insight that could lead to exploiting market inefficiencies to such success, some of the world’s most respected banks apparently did not think to ask how this was possible. They were willing to believe, in effect, that two equaled five, and not just once, but on a continuous basis. Shame on them. Individual investors are more likely to get cheated into such a scheme because they don’t necessarily have the requisite knowledge to know that even the best investor couldn’t achieve these gains continuously. The financial institutions, though, should have known better.

This will eventually become the overriding narrative of this market tumult: the people in charge have no idea what they’re doing. To return to an economic description, one might say that 10% of the market is a reasonable portion to dedicate to those financial middle-men that handle all other transactions in the economy. Yet nearly 20% of the economy, when seen in terms of the S&P 500, was dedicated to the financial sector as recently as last year. Does anyone reasonably believe that one in five dollars should be allocated to transaction costs in our grand technological age? Even the federal government would be impressed by this level of bloat and inefficiency.

Welcome the current market convulsions. What we are witnessing is the grand economic reallocation of a full 10% (or more!) of our economy away from poor decisions to better avenues. It is clear that many of the people currently in charge of billions of dollars of other people’s money should not have that responsibility. Market forces will, we must hope, see to their demise.

This is why opposing government bailouts is important. This meddling in the market serves to reward those that have made poor decisions. As for saving those that were hurt by frauds perpetrated by men like Madoff, this too would be a mistake. The investors here are as guilty as Mr. Madoff. They participated in a willing suspension of disbelief in order to bring home profits that they knew had little to no grounding in reality.

The automakers (or more succinctly, the UAW) are facing their own reckoning. I believe that they will emerge stronger and more competitive in the end, or they will face ruin. GM will be drug by the government or by the market to friendlier waters. Ford has already properly vectored itself for success. Chrysler will die.

As I have said before, we face a unique opportunity here. The market will decide where all of this newly-freed capital will go, unless we intervene. I don’t support doing so, but the political realities seem to make this all but inevitable. If that is the case, we should do our best to be the market’s intercessor and be active in promoting those policies that will make us all more prosperous in the end.

Written by caseyayers

15 December, 2008 at 11:02 am

The Power Vacuum

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In response to today’s Politico Arena question:

Is there a potentially disastrous economic policy power vacuum, as Paul Krugman suggests this morning? What can be done about it?

What’s disastrous is the lack of transparency in the Treasury Department as led my Hank Paulson. What confidence remained in his office evaporated when he announced recently that he had known “all along” that simply buying distressed assets wouldn’t help the current situation. This means that either he deceived the Congress and the American people when asking for the massive emergency bailout bill or that he was trying to cover for an error of judgment after the fact. Neither spurs confidence in Treasury’s operation.

The reality is that there is a perception issue that is gripping us all at the moment. I firmly believe that we’re nearing the bottom and, as I predicted in early October on Arena, the Dow will settle somewhere between 7000 and 7500. Meanwhile, fear has swept away any sense of logic in the pricing of securities and the perverse effects of tax laws and various mutual fund regulations can only serve to further distort the market picture. This isn’t to say that there aren’t true issues with the economy. Rather, people turn to leaders in times of challenge. The Bush administration has gone on permanent holiday and Obama is reluctant to fill the gap. One is left to hope that the market can simply take care of itself.

Written by caseyayers

21 November, 2008 at 9:44 am

Why Oil Is Tanking

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It’s all about what I call Illusory Perceived Demand. At least that’s what the run-up was all about. The reality is that oil is much closer to its true price. Part of the reason that it has fallen is also attributable to the dollar, which has been remarkably strong given the Treasury’s efforts to completely discredit it as a legitimate currency as of late. But we’ll talk about the incredible inflationary cycle that we’re about to undergo another time.

For now, let’s focus on oil, which was fallen as of today to under $70/barrel, from a high of around $150 as recently as this summer. In the past month alone, the value of crude has fallen by more than thirty percent. So why is oil falling so quickly?

It’s easy to blame the Hedgies, day-traders and speculators, and to say that because they have now been forced out of the market, prices are swiftly falling back to “real” values. But speculators did not cause this, or at least not the type of speculator you have in mind. Rather, actual consumers of oil, the type that purchase these contracts on futures markets, drove up the prices in a bit of a panic. Speculation-in-earnest, not greedy speculation, is the issue here.

The mentality on the futures market has been, until recently, that a massive, amorphous being called CHINA would absorb each and every drop of oil in the world unless Western companies could thwart them by consistently raising the stakes. Because “China” would pay almost anything to continue its stunning growth trend fueled largely by oil, American companies perceived that there was a massive and unquenchable demand afoot that forced them to pay ever-higher premiums to receive the oil they needed to operate. So they accepted rapidly rising oil prices as a geopolitical absolute, and continued to suck down as much of the stuff as they could possibly afford (to the economics student, right up to where marginal cost equals marginal revenue, most especially in the airline industry).

But the reality that is now prevailing in the commodities market is that China is not, indeed, insatiable. Furthermore, their economic system, although difficult for many to understand, doesn’t result in an unlimited supply of wealth with which to buy energy. Further still, their growth is not a phenomenon that will continue to gain speed no matter what. Just as America and Europe are undergoing a recessionary period at this point thanks to the recent liquidity crisis, China is facing a rocky road. Perhaps China is even worse off than America, for instance, since China is so dependent upon Western consumption to maintain its level of growth.

So the boggart has been put back in the armoire, and appropriately so: by enough people standing up to declare the current situation to be ridiculous. The market is soaked in oil, with new production coming out of every spigot at this point. Even the largest nightmares are eventually wiped away as the rational thinkers in the market begin to wake up and question exactly what makes oil almost thrice as valuable as it was just a couple years ago. China is, in fact, a normal player on the world stage, following the same rules of consumption that the rest of us follow. And oil is not in such dire low supply as to be gone within a decade. Even worse for the naysayers, watching oil prices fly so high resulted in many new fields and techniques being discussed anew for where additional oil may reside but be too expensive presently to drill out.

This isn’t to say “Drill Here Drill Now” is the end-all solution to long-term energy needs for this country or the world. Gas will not be, though, obsolete by this time next year. The decision to move to new sources of energy en masse will be made either politically, where citizens decide that they prefer short-term economic inefficiencies for purposes of national security or environmental wellfare, or it will be made economically, when oil supplies truly are outstripped by demand in the long-run.

Unfortunately, the huge run-up and present crash of oil prices is not that dissimilar from the scenario we’ll see when all of this unabsorbed liquidity catches up with the markets. The idea that credit is unavailable is almost absurd. Rather, bankers are claiming that the liquidity flowing out of the fire hydrants is poisoned. When the market quits thrashing about in hysterics and sets to the task of absorbing these funds, they will find money laying about in true excess. This will lead to massive inflation, unless the Fed can perfectly thread a needle that’s almost impossible to read. But we’ll cover that later.

Written by caseyayers

22 October, 2008 at 3:38 pm

Cheap Macs Aren’t the Point

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Here’s an excellent article from Daring Fireball’s John Gruber on why the “$800 Macbook”, a concept that began as literally one man’s rumor and grew into some sort of backwards conventional wisdom, was not announced at yesterday’s Apple event. One stat in particular that is so telling as to Apple’s philosophy toward their product line: the Mac had 18% of US marketshare, but 31% of revenue share for the industry. Where others are commodities, Macs are not. This makes Apple more protected in a period of economic uncertainty like the one we face today than, say, Dell because with the Mac, it never comes down to price. “PCs” are inferior goods (in the economic sense), but Apple’s most loyal customers are the ones that have nowhere else to turn. The creatives and professionals rely heavily on the type of tools that either only exist or exist in their best forms under OS X, an operating advantage that no other company can have.

[Disclaimer: I own AAPL shares.]

Written by caseyayers

15 October, 2008 at 3:54 pm

Bailout 2.0

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From today’s Politico Arena question, which is “Bailout II: Does the New Plan Sound Better Than the Old? What else must happen?”

It’s “better”, but only insofar as it’s shoving open the credit markets.

One of the weapons that has helped most in the past few days is one that is hardly being mentioned: FASB, an accounting standards organization, released changes regarding mark-to-market accounting for illiquid assets, suggesting that it might be okay to value mortgage packages and other securities that simply aren’t being traded at their cash value, rather than at the bidding price. This is important because the bidding price is far below both the actual hold-to-maturity value of these securities and even discounted prices many companies might accept to simply get rid of them. If the change is enough to allow auditors the latitude to sign off on less paranoid financial statements, then we may see that many companies on the cusp of problems are, in fact, doing okay from a cash flow perspective.

But the crush of new money bursting through the gates remains a big part of this, to be sure. And that’s what should be most concerning: this money may be useful to break open the clogged pipes, but now the fear should be focused on when they burst. In other words, having hundreds of billions of new dollars in the market that aren’t really needed will lead to massive inflation, and sooner than many people think.

Written by caseyayers

14 October, 2008 at 8:34 am

Government’s Role in Stability

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My answer to today’s Politico Arena question, “What can government do right now to stabilize markets or reassure the public? Bonus question: How low will the Dow go?”

The best thing government can do to stabilize the market is to declare fully, and with the greatest finality possible for such a tenuous situation, the level to which they intend to continue meddling in the markets. The reason we keep seeing day after day of multi-hundred swings this way and that is that noone can price the market. There are too many shadowy variables for traders to really get their hands around this thing.

Protect all deposits to an unlimited value. This should help to stop any runs on banks in their tracks. Provide short-term liquidity to businesses that prove both creditworthy under normal circumstances and unable to obtain credit in these troubled times. Don’t buy stakes in banks, don’t keep throwing money blindly at the sector. Doing this does very little to truly help break the credit logjam; rather, the money is simply being brought in by the truckload to any destination that might have given the slightest hint of illiquidity. This will lead to massive inflation later when we finally figure out that smaller, far more targeted sets of money, such as those the Fed auctions using its term lending facilities, were the smarter solution.

The Dow will go as low as fear can take it. But salvation here lies in greed: already valuations on some companies are absurdly low. Many companies with no exposure whatsoever to housing and with more than enough cash on hand to survive any credit freeze have been trashed. Somewhere between 7000 and 7500, the bargains will become too great to ignore for the savvy investors.

Written by caseyayers

10 October, 2008 at 8:48 am

Wesbury on Mark-to-Market

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Brian Wesbury, chief economist for FTPortfolios, has a tendency to be about twenty miles ahead of the curve and has an enviable gift when it comes to explaining complex issues in a relatively easy to understand fashion.  When you’ve seen me refer to relaxing mark to market requirements for some of the housing securities out there, this is what I mean:

Here’s something you won’t believe: Fannie Mae and Freddie Mac have not drawn a dime from the Treasury’s $200 billion facility that was created to bail them out. It was the use of mark-to-market accounting that allowed Treasury to declare them bankrupt. On a cash flow basis, they were solvent.

Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.

Wesbury’s suggestion could be implemented by the Securities and Exchange Commission very quickly and would do a lot more to settle the markets than writing a check with its basis in freshly-minted debt.  Full article can be found here.

Written by caseyayers

1 October, 2008 at 1:43 pm