``There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently." - Benjamin Graham
For some, there is the impression that the workings of Wall Street have to be piously followed by the letter.
The general notion is that Wall Street has devoted unremitting years of research on the subjects of risk management, portfolio allocation and asset pricing or valuations such that these need to be incorporated into conventional analysis.
That is the reason why guild like certification standard as the Chartered Finance Analyst (CFA) has emerged.
Hence, should we follow what Wall Street does?
While technically Wall Street can be identified as a symbolic location for the operating platforms of the various asset markets, it has been generally been associated with the investment community.
However, Wall Street, for me, is a broad, vague and complex issue.
Wall Street Models Are For Convenience, Myth of Blue Chip Investing
From the recent crisis, we learned that Wall Street has been ground zero for the financial alchemy crisis of turning the proverbial stones into bread via the traditional models of mortgage credit risk management of “originate and hold” into the latest model of “originate and distribute”. Where risks had been passed like a hot potato the impact has been contagion-globalized crisis.
It has been likewise the birthplace of the Shadow Banking System, which encompassed the circumvention of regulations and signified as the gaming of the system (regulatory arbitrage) in cahoots with credit ratings agencies, whose mandated revenue model had been derived from the issuers- than from the risks buyers-from whose interests it protected (Agency Problem), and regulators (regulatory capture)-who refused to take the proverbial punch bowl away.
Wall Street has most importantly played a critical role in the transmission of the US Federal Reserve policies in overextending the credit system intermediation…globally.
Here we quote Prudent Bear’s Doug Noland, ``to create Trillions of instruments (chiefly Treasuries, agency debt, MBS, and “Repos”) perceived as safe and liquid by our foreign trading partners that accommodated our massive current account deficits (and attendant domestic and international imbalances). It was contemporary risk intermediation at the heart of a historic mispricing of finance for, in particular, mortgages and U.S. international borrowings. And it was the potent interplay of contemporary risk intermediation and contemporary monetary management/central banking (i.e. “pegged” interest rates, liquidity assurances, and asymmetrical policy responses) that cultivated unprecedented financial sector and speculator leveraging.” (emphasis added)
It had likewise operated on the psychology predicated on the Greenspan or Bernanke Put or the principle of Moral Hazard that has emboldened speculation or expanded risk taking capacity.
In sum, Wall Street has been THE EPICENTER and THE EPITOME of bubble dynamics- where the rigors of long term discipline has been exchanged with short term profit and fun at the expense of the US and global economy.
The great value investor Benjamin Graham, Warren Buffet’s mentor once sardonically remarked on the same shortsightedness, ``That concerns me, doesn't it concern you?... I was shocked by what I heard at this meeting. I could not comprehend how the management of money by institutions had degenerated from the standpoint of sound investment to this rat race of trying to get the highest possible return in the shortest period of time. Those men gave me the impression of being prisoners to their own operations rather than controlling them... They are promising performance on the upside and the downside that is not practical to achieve.” (emphasis mine)
So how effective has Wall Street been to predict and respond to the crisis?
From Bruce Bartlett, author and former US Treasury department economist in a recent Forbes article, ``Economists were slow to see a recession coming and often didn't see one at all until we were already well into it.”
From Robert Samuelson, economist and contributing editor of Newsweek in his latest article Economist Out Of Lunch (bold highlights mine), ``Well, if you de-emphasize financial markets and financial markets are decisive, you're out to lunch. Financial markets pumped up the real estate bubble; greater housing and stock market wealth inspired a consumer spending boom; losses on "subprime" mortgage securities triggered a collapse of confidence. Some economists have grudgingly, if obscurely, conceded error. A study by the International Monetary Fund called "Initial Lessons of the Crisis" admits: There "was an under-appreciation of systemic risks coming from . . . financial sector feedbacks onto the real economy." That's an understatement.
``Overshadowing the misunderstanding of finance is a larger mistake: ignoring history. By and large, most economists don't care much about history. Introductory college textbooks spend little, if any, time exploring business cycles of the 19th century. The emphasis is on "principles of economics" (the title of many basic texts), as if most endure forever. Economists focused on constructing elegant, mathematical models.”
Or how about from one of my favorite contrarians Black Swan author Nassim Taleb with Mark Spitznagel in an article at the Financial Times “Time to tackle the real evil: too much debt”, ``Relying on standard models to build policies makes us all fragile and overconfident. Asking the economics establishment for guidance (particularly after its failure to see the risk in the economy) is akin to asking to be led by the blind – instead we need to rebuild the world to make it resistant to the economist’s mystifications.”
Considering the vast armies of financial experts (accountants, CFAs, economists, quant risks modelers and managers, statisticians, actuarial, research and security analysts and etc…) employed in the banking and financial industry, common sense inference suggest that we wouldn’t have seen the disappearance of the US Investment Banking Sector (bankruptcy of Lehman Bros, the acquisition of Bear Stearns and Merrill Lynch and the conversion to Bank holding companies of Goldman Sachs and Morgan Stanley) and the government takeover of AIG-once largest insurance company in the US and the 18th largest in the world, had these models or theories worked.
The fact that the crisis occurred and heavily impacted the US financial system occurred demonstrates that as the experts quoted above, Wall Street failed!
This also utterly demolishes the MYTH of BLUE CHIP investing- where the public have been ingrained to believe that investing in blue chips are safe and sound and least subjected to risks.
In bubble cycles, particularly with growing relevance today [see last week’s Worth Doing: Inflation Analytics Over Traditional Fundamentalism!], industries exposed to the extremities of misallocation due to policy based distortion are all subjected to heightened risks regardless of their stature.
The oldest of the 30 elite members of Dow Jones Industrials (Answers.com) are the Proctor and Gamble (1932), United Technologies (1939), Exxon Mobil (1928) and Du Pont (1935). All the rest have been included in since 1959 and above, and where the 30 member composite index has undergone several changes- 49 alterations according to wikipedia.org (since May 26,1896).
This means that in the US, blue chips aren’t exactly “blue” in the sense that they been exposed to the variable changes in technology or management or bubbles or other factors which prompted for the restructuring of the blue chip index.
So what has been the problem with Wall Street?
As noted in the past in How Math Models Can Lead To Disaster and in the above, “elegant” mathematical and or scientific models that has reinforced the public’s tendencies to rely on heuristics or mental shortcuts.
Like government policies, the theoretically or math constructed models served as intellectual justification or cover to advance on their biases.
Essentially it isn’t about what works or not, it is about what needs to be believed that counts. In short, it has all been about convenience.
For instance, in a bullmarket you need an excuse to push up stocks, instead of relying on gossip based information, the public embraced Wall Street’s models.
Value investor Ben Graham in his 1949 classic the Intelligent Investor castigated on the industry’s inclination towards this, when he wrote, ``security analysts today find themselves compelled to become most mathematical and 'scientific' in the very situations which lend themselves least auspiciously to exact treatment." (bold highlight mine)
Stocks For The Long Run?
One of the hardcore or popular beliefs in Wall Street is that investing in stocks would have led to an outperformance of a portfolio relative to Treasury Bonds, Bills or Gold as shown in Figure 1.
Recently at a Wall Street Journal article Mr. Jason Zweig wrote to challenge the conventional Wall Street conviction which has relied on Siegel’s chart. He stated that the data used during the earlier days had been cherry-picked (or data mined) and were therefore NOT accurate.
``There is just one problem with tracing stock performance all the way back to 1802: It isn't really valid,” wrote Mr. Zweig, ``What, then, are the odds that stocks will continue to lag behind bonds for the long run? The sad truth is that history can't tell us the answer. The 1802-to-1870 stock indexes are rotten with methodological flaws. So we have only the period since then, or four distinct and complete 30-year stretches of stock returns, to base our long-term investment decisions on. Another emperor of the late bull market, it seems, has turned out to have no clothes.” (emphasis added)
If Mr. Zweig is correct then imprecise data alone could shatter the very foundations of Wall Street’s most consecrated canon.
And this doesn’t end here.
Contrarian investor Rob Arnott has also confronted the alleged supremacy of the returns of stocks over bonds in the long run, see figure 2
In the Journal of Portfolio Management (published by indexuniverse.com), Mr. Arnott, wrote, ``Stocks for the long run? L-o-n-g run, indeed! A mere 20 percent additional drop from February 2009 levels would suffice to push the real level of the S&P 500 back down to 1968 levels. A decline of 45 percent from February 2009 levels— heaven forfend!—would actually bring us back to 1929 levels, in real inflation-adjusted terms.”
In short, stocks could invariably underperform bonds if it continues to fall in real adjusted terms.
If Wall Street icon and guru, Fidelity Investment Peter Lynch once said that, ``In stocks you've got the company's growth on your side. You're a partner in a prosperous and expanding business. In bonds, you're nothing more than the nearest source of spare change. When you lend money to somebody, the best you can hope for is to get it back, plus interest,” on the contrary, Mr. Arnott concludes, (all bold highlights mine), ``Many cherished myths drive our industry’s equity-centric worldview. The events of 2008 are shining a spotlight, for professionals and retail investors alike, on the folly of relying on false dogma.
-For the long-term investor, stocks are supposed to add 5 percent per year over bonds. They don’t. Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market.
-For the long-term investor, stock markets are supposed to give us steady gains, interrupted by periodic bear markets and occasional jolts like 1987 or 2008. The opposite—long periods of disappointment, interrupted by some wonderful gains—appears to be more accurate.
-For the long-term investor, mainstream bonds are supposed to reduce our risk and provide useful diversification, which can improve our long-term risk-adjusted returns. While they clearly reduce our risk, there are far more powerful ways to achieve true diversification—and many of them are out-of mainstream.”
So NO, there isn’t any universally accepted Wall Street wisdom, instead they seem to be conditional (cycles) and subject to time referenced debate. This also means that despite the years of drudging research, such insights risks being defective or if not outmoded.
The fact that they are constantly vulnerable to policy induced business cycles exemplifies such shortcomings.
Bluntly put, Holy Grail investing is a delusion even in Wall Street standards.
The Significance Of Policy Based Or Inflation Analytics
Today’s crisis has provoked rapid policy responses among governments.
This entails a material shift in the operating economic and financial environment which should impact the underlying drivers to the risk reward tradeoffs or to the asset pricing mechanics of diverse financial markets.
And any analysis that foregoes these changes and sticks to the old paradigms will likely misinterpret the risk return environment see Figure 3.
Take for instance this splendid observation from Centre for the Study of Financial Innovation CSFI’s Michael Mainelli and Bob Giffords ``Unexpected regulatory intervention may destroy a long-short market neutral hedge, as when short selling was suddenly restricted in several jurisdictions in late 2008. The efficiency of a diverse portfolio may similarly morph into something quite different in a bear market panic. At night all cats are black, no matter how colourful and distinctive they may appear in the daylight.” (emphasis added)
The problem is that risk managers frequently respond only to ex-post (after the fact) events rather than preparing for the ex-ante (before the event).
From the same authors, ``Most risk managers deal with the bottom loop of reacting to accidents and danger. "A one-sided concern for reducing accidents without considering the opportunity costs of so doing fosters excessive risk aversion – worthwhile activities with very small risks are inhibited or banned. Conversely, the pursuit of the rewards of risk to the neglect of social and environmental ‘externalities’ can also produce undesirable outcomes," wrote Adams [John Adams “Risks”, UCL Press London 1995]. This illustrates how easy it is for risk management to yield unexpected consequences.” (emphasis added)
In other words, risk managers like any human being tend to get swayed by emotions that foster extreme pendulum swings of fear and greed.
And why the difficulties in analyzing the dynamics of government policies? Because of the complexities derived from the interweaving feedback loops of human interactions from the web of regulations.
According to Jeffrey Friedman in his paper, A Crisis of Politics and Not Economics: Complexity, Ignorance and Policy Failure, ``The task of researching such interactions, however, illustrates the practical difficulties of minimizing the disasters to which they might lead. Just as a major problem that regulators face is their ignorance of the effects of their actions, especially in conjunction with past regulatory actions, the main problem scholars of regulation may face is that there are so many regulations, and so many historical circumstances explaining them—and so many theories about their effects—that inevitably, the scholars will, here as everywhere, be compelled to overspecialize. The predictable cost is that most scholars will overlook interactions between the rules in which they specialize and the rules studied by specialists in a different subfield—even if they are deliberately attempting (like the super-systemic regulator) to keep the big picture in mind.” (bold highlight mine)
That’s why any risk return analysis from today’s rapidly evolving conditions should always take into the account the evolving policy dynamics.
And policy dynamics tend to differ from country to country, which implies that the impact to markets or the economy could be expected to be dissimilar.
Another favorite iconoclast, Jim Rogers, hits the nail on the head in an interview at the Economic Times, ``I don't pay any attention to things like emerging markets premium. You talk about it on TV, but every market is different. Why can't I just go out and buy emerging markets when it is likely to go broke. Every market is different, every country is different, every economy is different and every sector of the economies is different. Just because you are in an emerging country does not mean you are going to make money if you get the wrong sector.”
