“I think I’m different. I’ve got alpha, baby.”
That’s a quote from Andy Kessler’s foreword to the latest book that has surfaced to the top of my reading pile, Knowledge and Power, by “techno-utopian intellectual” (per Wikipedia), George Gilder.
“Everyone says that, of course, but most investors are all beta… when markets go up the beta warriors outperform, and when markets go down they get killed.” (Knowledge and Power, pg xii)
That sounds about right. If you want to see what the getting “killed” part looks like, check out the 2013 YTD returns of PMs who levered themselves up long of the bond market as it was traversing its all-time bubble highs.
Back to the Global Macro Grind…
As a macro risk manager, most of your alpha is generated by not being long the stuff that is getting killed. From January to July, that meant not being long Gold, Silver, etc. Since May/June, that’s meant being out of Bunds, Gilts, and Treasuries.
No, we don’t have to wake up every morning and nail every tick in Apple (AAPL) to help you generate risk-adjusted alpha. Our primary risk management focus has always been aligned with Buffett’s 1st rule of investing – “Don’t lose money.”
I think I’m different because I’ve got the ability to cut an asset allocation to 0%. #OldWall banks and broker dealers won’t opt for that strategy because they need to support their new issue markets. Rule #1 (for them) is more like ABS (always be selling).
We have a 0% asset allocation right now to Fixed Income because it’s the 1st time we’ve ever had 2 of our top 3 Global Macro risk management themes focused squarely (and bearishly) on bonds:
- #RatesRising (http://app.hedgeye.com/media/595-ratesrising-q3-macro-theme-1)
- #DebtDeflation (http://app.hedgeye.com/media/597-debtdeflation-q3-macro-theme-2)
Since these are Q313 themes and the quarter is almost half over now, we’ve re-produced these themes with our new @HedgeyeTV videos (links attached) in order to re-communicate our strongest slides on the subject matter.
The latest addition to our senior research team, Director of Financials Research, Jonathan Casteleyn, also has a video up on the front page of our site titled “Bond Bear Market: Just Beginning.” So we think we’re being pretty clear on our view here.
So far, in July-August, Mr. Market agrees. Month-over-month, look at what’s happened to 3 major sovereign debts:
- US 10yr Treasury Yield = +36 basis points (+14%) to 2.85%
- Germany’s 10yr Bund Yield = +38 basis points (+25%) to 1.90%
- UK 10yr Gilt Yields = +43 basis points (+19%) to 2.70%
So, US stocks finally having a down-week for once notwithstanding, this is where the real negative alpha is eating into the standard #OldWall pie of asset allocations – via #DebtDeflation.
The economic data in the 3 aforementioned countries supports #RatesRising. Germany’s data has improved, sequentially, for the past few months and the UK’s data has been nothing short of fantastic relative to both absolute levels of years past and market expectations. In the USA, jobless claims shocking to the upside drove last week’s +25 basis point week-over-week move too.
Now that the SP500 has corrected -3.2% from its all-time closing high of 1709 in the first week of August, we have to ask ourselves (as we have many times this year) if we A) buy the equities dip or B) join the long list of #PTCs (professional top callers) who have had issues understanding that this is a growth investors market.
If you have a 0% asset allocation to US Fixed Income, your job gets a little less complex. If you just have to break-down the US Equity pieces of the Sector Style Factor pie, you’ll note that the slow-growth sectors still look the worst, especially for the month of August to-date:
- Utilities (XLU) lead losers at -4.4% MTD
- Healthcare (XLV) is -3.2% MTD
- Consumer Staples (XLP) is -2.7% MTD
In other words, with the SP500 -1.77% MTD, being “overweight” those slow-growth sectors is also a negative alpha position relative to something that’s growthier, like Tech (XLK), which is +0.3% for August to-date.
Don’t get me wrong, there are plenty of things out there that concern me about being long US growth equities. There always will be. But the market A) doesn’t care about my concerns and B) is a lot more concerned with the bubbles that are popping in anything fixed income and/or Yield Chasing that Bernanke #force-Fed people into over the last 5 years.
Getting out of the way of Bernanke’s Bubbles as they are popping – it’s the new alpha, baby!
Our immediate-term Risk Ranges are now:
UST 10yr 2.67-2.86%
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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Takeaway: Current Investing Ideas: NSM, MD, HCA, HOLX, FDX, MPEL, WWW, NKE and SBUX
The latest comments from our Sector Heads on their high-conviction stock ideas.
NSM – What have you done for me lately? After printing very strong 2Q earnings on August 6th and closing just inside of $50 ($49.97 to be exact), NSM is now trading at $48.36 as of the time of this writing. That puts it down ~3.2% as compared with the S&P 500 down 2.1% over the same time period. The XLF, the benchmark Financials ETF, is down 2.5% over the same time period. What does this tell us?
On the one hand, it’s a reminder that Nationstar is a relatively high-beta stock, 1.88 as of the most recent data. In other words, on average, it tends to move 1.88x the movement in the underlying benchmark, the S&P 500. It also reminds us that Nationstar is seen as an interest rate-sensitive stock. Remember that Nationstar drives a significant portion of its earnings from mortgage origination, which is inversely correlated with interest rates. While we remain bullish on the intermediate and long-term outlook for the stock, in the short-term it is most likely to be whipsawed by the movement in long-term interest rates. Our firm’s view is that long-term rates will continue to move higher, making higher highs and higher lows, so this is likely to keep short-term pressure on NSM. As we continue to think 2013/2014 earnings estimates are too low, we would be buyers of any such weakness.
TRADE: In the short-term, the market is and will continue to trade NSM inversely to long-term interest rates in the absence of other data, and rates have been grinding higher of late.
TREND: Over the intermediate term, the stock will trade around announcements of servicing acquisition deals. We think NSM remains well positioned here, alongside Ocwen and Walters.
TAIL: In the long-term, there is still a tremendous opportunity for non-bank servicers like Nationstar to roll-up the servicing business. NSM is well positioned to be a prime beneficiary. We continue to think consensus earnings estimates remain too low for 2013/2014.
MD – All volume indexes from our monthly OB/GYN survey were positive in July and point to acceleration in August. Deliveries and Pregnancy look like a tailwind for MD’s Pediatrix division which cares for preterm newborns. The rising patient volume index results as well as the first run of a surgical volume tracker are both potential positives for MD’s American Anesthesiology business.
HCA – Our OB/GYN survey came back positive with volume indexes rising across Deliveries, Pregnancy, patient traffic, and surgical. We believe that this group of physicians is more representative of economically sensitive patient since 70% of all patients in an OB/GYNs office are younger and commercially insured.
We also noted this week that data from the US Treasury and an index of prescriptions predominantly used by Medicare beneficiaries are negative and may explain the softness in results across a number of companies within Healthcare this past quarter. We find it surprising that a Medicare eligible population would be economically sensitive. It continues to be likely, given the lack of any other plausible explanation, that stepped up regulatory scrutiny has chilled the provider community.
HOLX – While our OB/GYN survey looks positive for patient volume and surgical trends, two items important for HOLX’s business, the reported and forecasted decline in Pap testing appears worse than management comments. As of now, HOLX’s EV/EBITDA multiple is breaking well above its recent longer term average. Guidance is achievable in the short term, but we’re getting incrementally cautious given the price performance and the apparent weakness in their Pap business, a key revenue driver.
FDX – This past Thursday, the Wall Street Journal put out a negative article on structural changes to the Express market for both UPS and FDX. This article is about a year late. It also fails to highlight the margin expansion opportunity at FDX independent of volume growth.
MPEL – Gaming Sector Head Todd Jordan has no update on MPEL this week.
WWW – Weekly sales data continues to look good for Wolverine World Wide's key divisions – especially Sperry which is growing by roughly 50%. Merrill seems to have stabilized as well, and while sales are not growing in the double digits, the brand seems to be growing again in the US. Let’s not get too excited about this -- though Merrill is the largest brand at WWW it still accounts for just 27% of sales.
Nonetheless, with the organic domestic growth we’re seeing in the PLG businesses (Sperry, Keds) combined with International growth, a more stable Merrill is definitely a positive. We’re looking for a more meaningful ramp in top line in the early part of 2014.
NKE – Nike’s fiscal first quarter draws to a close in just another few weeks. Sales of footwear in the retail channel have been choppy in recent weeks – averaging about 1-2%, though apparel growth has been about 3x what we’re seeing out of footwear, which is a nice offset.
But the big data point we want to watch is Footlocker’s 2Q earnings, which are released on Friday the 23rd of August. The good news is that we think that expectations for Footlocker’s quarter are in check, which is positive because FL’s stock is often a barometer for NKE. After that we think that the near-term calendar lines up well for Nike with its results in late September, and then it’s analyst meeting in early October. We would not want to bet against the name before then.
SBUX – Restaurants sector head Howard Penney continues to like Starbucks’ growth story. Penney says SBUX’ strong Q3 earnings report merely highlights the power of what he continues to see as one of the best pure plays in global growth in his sector. Cyclical factors, such as what appears to be improving coffee pricing, only add to the momentum as SBUX continues to push into new food and beverage segments worldwide, as evidenced by management’s focus on high-profile partnerships such as Danone and Google.
Penney sees continued strong growth in China, even in the face of slowing Chinese GDP growth, and would not be spooked by poor compares in other restaurant companies’ China operations. Penney acknowledges that SBUX is a “top pick” for many analysts. Would it be counter-intuitive to point out that sometimes consensus is actually right? Penney wouldn’t trade his high conviction call on SBUX for all the coffee in China.
Macro Theme of the Week – Risk Is Always On
Fed Chairman Bernanke will begin the process of tapering the Fed’s $85 billion a month bond buying program next month.
Or he won’t.
Bloomberg reports 65% of economists surveyed say next month is it. And while Bernanke’s own opaque references to policy shifts have been sufficient to whipsaw the equities markets, we are already witnessing a profound impact on the fixed income markets. We can only imagine – or perhaps not – what carnage will be wrought once the policy is actually in place.
Hedgeye Director of Research Daryl Jones writes this week “there is rarely One Thing that dominates, but the seismic shift in interest rates will certainly be one of the most critical factors over the coming quarters and years.” Jones was writing in the context of one of Hedegeye’s Q3 Macro Themes – #RatesRising – but it also plays into another Theme, that of #DebtDeflation, which notes a major supply / demand imbalance in the investment markets. The world sits atop a historically wide divergence between investments in stocks (about 1/3 of global investment dollars) versus bonds (the rest). The two-to-one ratio of bond investments versus stocks is further skewed by the attractiveness of the US equities markets – which is where everyone wants to be. (Click here for Jones’ piece as featured in Fortune).
According to data from the World Bank, Germany’s stock market had a total capitalization last year of just under $1.5 trillion, and the UK’s equities market was capitalized at just over $3 trillion. At the same time, the value of all listed shares in the US was $18.7 trillion. In terms of growth, the best performing stock market in the world in the period 2011-2012 was Venezuela, where the value of listed equities jumped from a little over $5 billion, to more than $25 billion. Darn! Missed it!
Which brings us to this week’s Macro Theme: Risk.
In recent years traders have been keeping an eye on the VIX – the volatility index, measuring the magnitude of swings in equities prices. The focus on this index has led financial news media to adopt market shorthand, describing each day’s pre-market setup as “Risk On” or “Risk Off.”
In simple terms – so simple that even a major news network anchor can understand it – Risk is “On” when investors are bullish on the direction of the market and want to go along for the ride. They trade instruments that are correlated to broad market averages, such as call options on the SPY (S&P 500 index). This would be a “Risk On” trade, where the buyer expects to sell the option for a profit, after the market rises. In the global currencies markets, the concept applies to more volatile currencies. When Risk is “Off” in the global markets, investors move to more staid currencies, notably the US dollar, the Swiss franc and the Japanese yen.
Sounds simple: you like the prospects of the overall market, get your Risk On. Don’t like it? Get Risk Off – like going to 100% cash, perhaps the ultimate Risk Off trade.
But this turns out not to be a foolproof method for investing. Not only does it not work all the time, it may not really work ever. More succinctly: it generally works right up to the moment when you really need it to work. And when it fails, it fails big time. As Hedgeye CEO Keith McCullough observes, “risk is always on.”
No matter what your investing style, there are underlying assumptions. When a trader – or an academic, or a hedge fund manager – sets up a proprietary trading system, they test all their assumptions. They take the various factors of their technical model or algorithm and plug in hypothetical scenarios. Then they back-test their model, running historical data through the number cruncher and comparing the model’s results with what actually happened in the markets.
Hedgeye’s Real Time Alerts and Stock Levels products, for example, run off of Keith’s proprietary 27-factor risk management model, developed over his years as a hedge fund manager. Keith used his risk management model successfully more often than not, as demonstrated by the Real Time Alerts’ batting average, which measures the percentage of profitable trading calls generated by the model. (Note that the Real Time Alerts do not adjust for such economic factors as trade commissions or dividends, and they do not represent actual trades. For complete information about the Alerts click here.) More important, Keith constantly retests the elements of the model itself, adjusting the inner workings as he gains insight and information about how markets work.
The problem with most traders is that once they have tested, re-tested, and back-tested their model, they often stop testing. And if they have a good first year or two, as we used to say on the block, forget about it. Success represents the greatest weakness in any model. The history of the markets is littered with the corpses of brilliant managers who tested and tested their models until they were sure that they worked, then never looked back. When the models suddenly fail, these managers typically end up with large losses in their portfolios, but Wall Street’s memory being as short as it is, they generally wipe the egg off their faces in short order and in no time are back running a fresh pool of money – often from many of the same investors they blew up in their last venture.
This was true for major firms that relied on “VaR” – Value at Risk – which attempted to set a percentage probability, over a discreet time period, of a measured decline in the value of assets in a trader’s portfolio. VaR is a probability distribution, which means the numbers are likely to prove out as long as the underlying assumptions are not violated. Risk managers took to assigning traders daily dollar limits, based on VaR. As with most statistical measures, VaR had two weak points: one, it worked great on a piece of graphs paper, but real world situations had a way of throwing the occasional curve ball, upsetting the predicted outcome.
The second problem is risk management tools are based on being able to act in anticipation of what everyone else will do. By the time everyone in the marketplace was using VaR, there was no one to beat to the punch. Trading whiz kid and bestselling author Nissim Taleb (The Black Swan) said VaR was a fraud, because it claimed to be able to accurately calculate the risk of outlier events. Outlier events being, by definition, incalculable. And top hedge fund manager David Einhorn, claiming that the use of the VaR measure actually encouraged excessive risk taking, compared the statistical tool to “an airbag that works all the time, except when you have a car accident.”
As Jones pointed out this week, the bond market looks set up to deliver a painful second blow to a large number of investors, for all their risk management tools. (June, unanticipated and painful, was the “one” of the “one-two punch.” And this opponent may have more than two fists.) To give you an idea of just how fast extremes are reached in the financial markets, bond volatility has nearly doubled in the last quarter alone and is reaching two-year highs. Hedgeye senior Finanicals sector analyst Jonathan Casteleyn reviewed current bond duration measures and writes that a one-percent rise in interest rates today would result in a nearly 9% drop in the price of the 10-year Treasury bond – a world of hurt for fixed income investors.
The latest example of real-world pain came this week from Bridgewater Associates, the world’s largest hedge fund, headed by Ray Dalio, one of the true geniuses of the art and science of risk management.
Bridgewater’s $80 billion All Weather fund is designed to balance risks across low- to high-volatility asset classes. It uses a strategy that increases the return on the bond component of the portfolio by leveraging the purchases. The fund is designed to provide a four-way split between higher than expected economic growth, lower than expected growth, and higher or lower than expected inflation. Twenty-five percent of the assets in the portfolio are supposed to respond favorably, depending on which scenario dominates the economic scene at any given time, providing what are stable above-average returns “in all weather.”
Bloomberg reports that the All Weather fund has had average annual returns of 9.3% since inception in June of 1996, well above the 7% in a benchmark institutional portfolio of a straightforward 60/40 allocation of stocks to bonds. But in the second quarter alone, the All Weather fund lost 8.4%, reportedly because $56 billion out of the $80 billion portfolio was invested in inflation-linked debt.
For all the brain power underlying Bridgewater’s work, the All Weather asset allocation strategy, called Risk Parity, relies on leveraging up an asset class that is stable and working well – fixed income – giving the overall portfolio much lower risk than a straight stocks / bonds allocation, because bonds are much less volatile than stocks. The key metric produced by this structure is the Risk-Adjusted Rate of Return: since bonds are lower volatility than stocks, leveraging the fixed income piece of the portfolio still generates a lower risk reading than would result from leveraging the stock piece, or even from just increasing equities exposure on a purely cash basis.
The risk in the Risk Parity strategy is that of a sudden and outsize rise in interest rates, which is what we are seeing now. Like other strategies that rely on long-term stability in a key market, the All Weather fund risks breaking apart when that market breaks its boundaries. Hedgeye senior Macro analyst Christian Drake wrote this week, “Risk Parity is an especially cool idea when you are levering up exposure to an asset class in the midst of a 35-year bull run.” Depending on the structure of your hedge, and the degree of leverage, the slightly greater Risk-Adjusted Return on the overall portfolio can be reduced, flattened, or turned to a horrendous loss when the leverage goes against you. All Weather’s reported 8.4% loss in the quarter ending in June is a prime example of the risks of any long-term model that relies on “historically normal” standard measures – in this case, interest rates.
And if one of the best risk managers on the planet gets plugged for over 8% in one calendar quarter, how do you think everyone else is faring? If they levered up their fixed income portfolio as bond prices continued to rise, the answer is: Not well.
The risk underlying all risk-avoidance models is the risk that one day your underlying assumption will be wrong. This often comes from outsize moves in the marketplace – “outlier events” – moves over which the risk manager has no control, nor could they predict when they would hit. But only a fool speaks of “perfect storms,” and only a liar calls such risks “unforeseeable.”
Dalio’s team had reportedly been working to reduce exposure to interest rate shifts, according to the Bloomberg piece. This was specifically based on their own internal work, and not a knee-jerk reaction to sudden market moves. Still, as even the best fund managers can tell you – and for our money, Dalio is the best at what he does – when things unwind, they unwind fast. You can see it coming, and see it coming, and still not have time to get out of the way.
Just when you realized this was not the time to get into this particular strategy, Drake points out that there are two “Risk Parity” mutual funds that you can buy, and a Risk Parity ETF has been filed and is awaiting SEC approval. This is Old Wall Street at its very best: as soon as a strategy stops working for the major institutions, they roll it into a retail product and flog it to you. Buyer beware? More like, Buyer be afraid. Be very, very afraid.
Sector Spotlight – Retail: Back-To-School , or Straight To Detention?
Retail sector head Brian McGough says his sector is “in a very precarious place.” Worse than weakness in sales growth, McGough says with inventories building and margins shrinking, retailers are “very close to being in a very dangerous position.”
And you thought the only important thing going on in retail this week was Bill Ackman resigning from the JC Penney (JCP) board of directors.
World’s Largest Underperformer?
Macy’s reported earnings this week. The World’s Largest Store has been McGough’s #1 favorite stock to be short, and management did nothing to change his outlook. In today’s rising stock market, the bulls keep trotting out their arguments over why Macy’s should be bought: It’s cheap, at only 12X earnings. And the company has been run so poorly, for so long, they just have to catch a break. But when stocks are marching to all-time highs and beyond, if the top company in a sector can’t get past 12 times earnings, the message is not It’s Cheap – more like, It’s Broken.
McGough had a series of forehead-smacking moments during the Macy’s earnings call, starting with management’s announcement of a big miss on top line sales. Their explanation: people “must be” buying things like cars and houses and spending money on home improvements. McGough notes that in 2012, JC Penney lost $4.3 billion in sales, and that Macy’s gained $1.5 billion at the same time. Coincidence? Apparently only the inner circle of Macy’s senior management is perspicacious enough to realize that there is absolutely no connection between the two.
Macy’s, at $28 billion in annual revenues, represents 10% of all US retail in its category (ex big-box retailers like Wal-Mart and hard goods stores such as Home Depot). JCP does $14 billion and comes in at 6% of the sector – which is down from 8% four years ago. Does this mean that, as Macy’s goes, so goes the nation? Macy’s may not be a proxy for all retail, but what Macy’s does affects the entire sector. And what happens to Macy’s may have long-ranging impact.
Macy’s revenues are down. Their gross margins are down. And SG&A (sales, general and administrative costs) are rising, as management decided to advertise more in order to boost sales. (Do they think there are still shoppers in this galaxy who have never heard of Macy’s, or are they planning to organize shopping jaunts from Alpha Centauri?) Capital expenditures are set to rise by a third, partly driven by the advertising push. The combination of reduced revenues, squozen profit margins (that’s a technical Wall Street term), swelling inventories, and hyperventilating capital expenditures translates into sharply reduced return on invested capital (ROIC). And when ROIC goes down, multiples become… well… squozen.
This makes Macy’s current paltry 12 PE suddenly look generous. More onerous, McGough warns it could presage declines in ROIC across the sector. Macy’s is the top company in the space. Its buying patterns affect vendors and manufacturers, which in turn affects other stores. Bad management is not exactly contagious, but desperate moves at the segment’s largest company could beget panicked responses, which could snowball into a series of misses, “ultimately driving earnings multiples through the floor” says McGough. That’s not a Wall Street technical term, just a Plain English scary prospect.
JCPenney: Hit The Road, Ack!
Retail sector news was dominated this week by news that billionaire investor Bill Ackman resigned from JCP’s board of directors. In a clear-eyed analysis on the eve of the boardroom shake-up (sorry, Hedgeye did not have inside information that Ackman was on his way out – we’re just good at what we do, and we don’t mind saying so) McGough put up a note on Sunday in which he agreed with the core of Ackman’s argument, while challenging Ackman’s irresponsible communication style.
McGough says Ackman getting out of the way is the best thing that could happen to JCP (well, short of those shoppers from Alpha Centauri jetting in and buying out all their inventory at a premium). Ackman’s departure gives management and the board a clear path to unified action. CEO Ullman was brought out of retirement just this year, having stepped down as JCP head in 2011. His tenure was supposed to be transitional, cleaning up the mess left by the departure of former Apple marketing whiz Ron Johnson. McGough says there is a wide field of talented managers, none of whom wanted to talk to the JCP board as long as Ackman was involved. With Ackman out of the way, McGough believes there is the potential to hire a truly exceptional CEO.
McGough sees two immediate risks to JCP. The first is that Ackman, now an outsider, may want to get rid of his holdings. Through his Pershing Square entity, Ackman owns 18% of the company, creating a potential massive overhang in the market. Ackman will be under certain restrictions regarding selling some of the shares, but there are ways to skin a cat – such as pledging stock in a margin account, then having the broker forced to sell the shares to meet a margin call. (You didn’t get that from us!)
The bigger risk is that the JCP board may not find a replacement they can warm up to. Leaving Ullman in place for the long haul, says McGough, would be the “short this stock with impunity” call. McGough says Ullman has a dismal track record at creating shareholder value. “Ullman is very good at one thing,” says McGough, “that is, heavily discounting below-average products to average Americans.” Warming to his theme, McGough continues, “JC Penney was a rotten company to begin with. Do we want to see it return to its former disastrous self? Not a very meaty investment thesis.”
Takeaway: Buyer Beware
McGough looks under the hood of this week’s slew of earnings reports and sees inventories swelling across the Retail sector. Macy’s had a 7% swing in inventory growth over sales growth, and Kohl’s came in at about the same spread (9% inventory growth, versus only 2% sales improvement), while Wal-Mart’s spread was a more modest 3%, but still troubling, especially as retailers are casting about for an explanation for soft sales. This bodes ill for margins in the current quarter – the Back-To-School period when sales are supposed to increase seasonally. McGough says the whole segment “is one executive meeting away from putting on a massive fire sale to liquidate inventory.” A wave of “X-Treme Discounting” could spell trouble for the sector.
Shades of the Financial Crisis. You may remember the reason we had to give the banks $13 trillion dollars (an estimate of the cost of the Financial Crisis) was that they held lots of toxic investments. Never mind that they were the ones who bought the garbage – and in most cases actually created it. No bank dared be the first to book a loss, whether by selling distressed junk from their portfolios at a fraction of what they paid for it (back when it was rated AAA), or by marking their positions to market. If any one bank had taken such a move, it would have unleashed a meltdown. The retailers look like they are in a similar position today with respect to their inventory: everyone’s got way too much, everyone’s trying to do clever things to pretend it’s not a problem, and no one is willing to be the first to dump it.
Monthly Retail Sales figures account for around 25% of GDP. How does a sector-wide miss figure into Bernanke’s calculations? The banks had the “Bernanke Of Last Resort” to fall back on. How about the retailers? Will President Obama bail out retail like he did the automobile makers? (How’s that working out for you, Detroit?) Call us naïve, but we don’t see Chairman Bernanke buying $85 billion a month worth of men’s overcoats and junior miss-size Hello Kitty T-shirts.
Investing Term – Surveillance
The Justice Department has filed criminal charges against two London-based JPMorgan traders over the “London Whale” trades, which lost the bank $6 billion last year. They are charged with misstating of the magnitude of losses in the London trading unit whose role was to hedge the firm’s global exposure.
Admitting that it was not “a tempest in a teapot,” JPM head Jaime Dimon said the London unit ran a “bad strategy, badly vetted, badly monitored, badly controlled” (Financial Times, 15 August, “Whale Loss Charges For JPMorgan Ex-Traders”). “Vetting, monitoring, and controlling” come under the heading of Surveillance, the process and mechanisms that monitor a broad range of activities in financial firms.
Surveillance is carried out by two distinct groups: the Compliance and, in larger firms, Risk Management. Compliance maintains and disseminates the firm’s operating rules, educates the personnel about rules and internal policies, and monitors to ensure that firm employees operate within appropriate guidelines. Risk Management looks at practices which, while legal, are bad business decisions with the potential to expose the firm financially.
Trading desk surveillance monitors to prevent violations of marketplace rules. These include such prohibited practices as entering a fictitious order – the charge against high-frequency traders, whose algorithms may be designed purposely to enter orders and then cancel them instantaneously. This creates the false impression of trading interest in a stock and causes other traders to enter real orders, which the algorithm then executes against, usually at a more favorable price for the high frequency trader.
Other prohibited practices include trading ahead of customer orders. This is when a trader handles both a “house P&L” (the firm’s own money) and orders on behalf of the firm’s customers. It is prohibited for a trader to trade the firm’s position at the more favorable price, then give a worse execution to the customer. Compliance departments run surveillance programs that check traders’ positions, execution patterns, and the allocation of trades between firm and customer accounts.
In the “Whale” case, two employees allegedly falsified records to hide losses. The Justice Department’s criminal charges – and the SEC’s civil case – allege that, as the massive trades in the portfolio started going against the bank, the managers changed the pricing method in their daily reports to make the losses appear smaller than they actually were.
“Actual” losses are difficult to pin down, not least because of the truism that it’s not a “loss” until you close out the position. Firms must adopt a reasonable methodology for valuing difficult-to-price positions. At the conservative is the daily mark-to-market, where a firm records independent prices in the market and assigns prices to their holdings based on actual trader bids during the day. At the more aggressive end of the range, traders value their portfolio on a “held to maturity” basis, reflecting the face value of the contracts in the portfolio, regardless of current market prices.
Mark-to-market gives you a fix on what you could realize if you had to sell everything today. The justification for the more aggressive method is that, in normal circumstances, you don’t have to sell everything. If you’ve been following along, you will recognize that this is another method that works great, except when you really need it to work – that is, in a crisis.
The regulators originally took JPMorgan to task for not keeping them updated on their valuation methodology. When reviewing a firm’s business regulators adopt the firm’s own valuation methodology, rather than creating their own models. And while the SEC has leaned heavily on valuation in a number of illiquid hedge fund portfolios, it is our hallucination that nobody posed any tough questions to Jamie Dimon’s JPMorgan.
Had JPMorgan notified the regulators that they were adjusting their valuation model, the message would have probably ended up buried under a stack of examiners’ per diem receipts. The Senate report on the utterly worthless oversight of the Office of the Comptroller of the Currency – the main bank oversight body – makes it clear that the OCC’s primary job was to butt out and let rich people get richer. Opaque language would have gone far. Something like, “In light of changing dynamics of the marketplace, and the strategy of the Office to hold the majority of its positions for the long term, we have determined that the ‘midpoint of daily trading range’ basis does not provide accurate information for senior management to make critical decisions regarding the hedge program.” The change of rhetoric would not have prevented the losses, but it could have avoided criminal charges. Just ask your local Compliance Officer!
#TimeStamp – You Heard It Here
We feel safe in predicting that “Fabulous” Fabrice Tourre will be the only person charged in connection with the Financial Crisis. That’s it (or, as Tourre said in Congressional testimony, “Dat’s de deal!”) Finished. Over. Pointe a la ligne.
This is really an idiot’s bet, since the most visible players were not charged when the iron was hot, and now the statute of limitations has run on pretty much everything. So that is the deal. The financial sector took trillions of dollars of your money, paid themselves giga-normous bonuses, and walked – or stayed.
Tourre comes across in his published emails as (1) a blathering idiot, (2) supremely unconcerned about what happens to anyone else, and (3) French. Gotcha!
Goldman Sachs is known for their robust compliance process. One of the Ten Commandments for Goldman employees is: Thou shalt not put dumb stuff in an email. (When Bruno Iksil recorded a loss in the “Whale” portfolio, his boss, who has been charged in the case, emailed him, “Why did you do that? This is just what we explain tomorrow. You don’t need to explain in an email man.” For our Compliance Officer’s dime, that one email is enough to secure a conviction.)
Tourre’s idiotic emails to his girlfriend were initially sent in “Franglish,” a kooky pastiche which Tourre reportedly used on purpose, in order to prevent the firm’s surveillance programs from flagging his emails. We have read a bunch of this correspondence – mostly pillow talk and embarrassing to read. We wonder whether Tourre’s flood of idiotic verbiage lulled Goldman’s surveillance team into thinking that he was, to quote from that long-time favorite of Wall Street literati, Hitchhiker’s Guide to the Galaxy, “Mostly Harmless.”
As any compliance officer will tell you, loose lips sink ships. They certainly sank the Fabulous Fab. And, now that You The People have helped out Wall Street to the tune of $13 trillion, aren’t you glad they nailed him?
- By Moshe Silver
Moshe is a Hedgeye Managing Director and author of the Hedgeye e-book Fixing A Broken Wall Street
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This note was originally published August 16, 2013 at 08:19 in Daily Trading Ranges
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