ShakeNBreak

What passes for a Market correction these days seems to be upon us. Whether it breaches the traditionally understood threshold of -10% remains to be seen, but at the very least the Bull spirits are taking a breather in the same way we saw this past June and January. The breakneck rise of recent weeks was unsettling (as in, that nagging voice we might call the unreality fairy, urging us to trim some while the giddiness lasts). More recently, volatility is cutting the other way. As usual, the world of commerce really hasn’t changed that much, but the seeming keepers of the cue cards have shifted our focus. Is Spain really any more of a train wreck this week than it was last week, or even a decade ago (or even a century ago, for crying out loud?) If we woke up tomorrow and the variously arrayed rock piles and sheep pens that is Greece had disappeared into the Aegean Sea, would there be a noticeable impact on the world economy, other than an end to that flow of remittances from east coast of the US? (One suspects that all the Greek owned restaurants in the US going out of business on the same Friday night would have a bigger impact on our economy.) “Contagion” seems to be paralyzing would-be investors at the margin, not that we should be surprised. After all, it was not much more than a year ago that we got a scarifying dose of contagion, a day after day kick-in-the-nuts leaving psychic bruises that will be tender for some time to come.

The outsized volatility of recent weeks has gotten me thinking about why it seems to be getting more so as time goes by. (By volatility, I mean the tendency of share prices to vary days at a time more than the intrinsic value of the underlying enterprises change years at a time.) Years ago, as the “Information Age” was dawning and academicians were framing out various notions of market efficiency, it seemed plausible that that as information flow became cheaper and “fundamental” data more accessible, “soft” market efficiency would serve to dampen volatility. Despite the cost reductions and ubiquity of such information far exceeding our decades ago expectations, the opposite seems to have occurred. A feel for, if not understanding of, Price Reality (fear & greed, money flows, sponsorship) seem to count for more and more. An approach based on Commercial reality (being able to assess the intrinsic value of an enterprise and purchasing shares at a discount adequate to compensate one for the attendant risks) seems more than ever to require an ability to avert one’s gaze. This phenomenon is akin to idea that ubiquitous information has made the world much scarier irrespective of whether it is any more dangerous than it was six, sixty or six hundred years ago. We are freaking ourselves out, and not surprisingly, there are those who are well positioned to take advantage of it.

For much of April, share price volatility tended to make me feel full of myself, as many of my holdings were delivering in a couple of weeks what I had hoped for over the next few years. More recently, that same volatility has driven me distraction, as in seeking out things to do so I won’t have to think about how much net worth evaporated that day. It’s tempting to lament how this symptom of societal credulity gets under one’s skin, but such would not be the healthiest of responses. A better response would be to recognize that as long as technology keeps making it easier for clever factions to manipulate various others, volatility is going to tend higher and not lower. As investors, this means going either grizzly bear or hedge-hog. The grizzly, or alpha predator if you will, has been endowed with the best equipment to do what he does, and goes about it with remorseless focus. It has been a great time to be a grizzly, but those of us who are not equipped to be grizzlies (by virtue of knack, experience and affiliation with resources) will get our asses handed to us if we go out and pretend to be one. Better to be a hedge-hog, to recognize one’s limitations but attune oneself to one’s surroundings and be opportunistic. Volatility can also be the friend of the scavenger.

Just as political factions can be expected to use the Infotainment deluge to stir up the rabble in unrelenting clamor to “Do Something!” about hob goblins du jour, we should understand that the volatility rendered by nearly instant dissemination of dubious information serves the purposes of various factions within the financial world.

The most obvious, from where I sit, is the patient, flexible (lifestyle is not riding on near term results) value investor. As much as it pains us if we let it, volatility is our friend. What we lived in the months leading up to March 2009 (or many of the past few days) would make us think otherwise, but whatever stocks we bought in the months approximating that dark hour should prompt us to embrace it. Here, the truly part time investor, the one who can stay on top of it with a few hours of work each week and then not even think about daily fluctuations, would seem to be at an advantage. The way volatility has evolved in recent years has strengthened my confidence that even though “low single digit” might be the best assumption for the long term rate of return for the indices going forward, an astute and patient value investor can probably generate a “high single, low double” rate of return. Emphasis on a portion of that return coming from growable dividend income, the discipline to wait for the Market to be in puke mode before buying, and to make sure one has buying power and stomach when such inevitable interludes arise are the keys.

Not surprisingly, volatility is also the friend of anyone who occupies an advantageous position in what we call “trading”. This has come to include not only hedge funds (who might not hedge much of anything, ever) but mammoth pools of capital we for some reason call “banks”. Trading would be a pretty lame business, like operating a tofu stand on the shoulder of the Interstate, if prices rarely if ever bopped around way out of step with intrinsic value. The casinos we call banks might blame volatility for their recent near death experiences, but that was just volatility that got a little out of hand for a few weeks. That “banks” have recovered so dramatically has less than nothing to do with their traditional role in that arcane activity that was lending, and everything to do with betting cost-next-to-nothing funds on the most volatile wagers they could find. The posturing, the well timed indictments, the slap on the wrist fines for abetting naked short selling will go on, but be assured that any regulation that might tamp down the volatility that the smart guys running the casinos have been feasting on will be smothered in its cradle by this faction.

It has also occurred to me that many if not most of the companies whose share prices get whacked out from time to time are also well served by exorbitant volatility. This is an outgrowth of what stock options have evolved into over the past twenty years: a non-cash form or compensation that in many cases “wags the dog”. Consider how important stock options have become. It’s not just important the buccaneers who have finagled themselves into where they get their names in the proxy statements. Its all those engineers and middle managers for whom a stock option grant or two is an important part of smoothing the bumps on the ride that is a working life. The ubiquity of this form of compensation got me thinking about what it means for share prices relative to intrinsic value. Its not a calculation lifted from the footnotes. There is an ideal pattern of share price over time, and it is not in synch with intrinsic value. Ideally, for the point of view of a company that compensates its important employees with option grants, the share price will be undervalued most of the time. It will become especially so every once in a while, at which time more grants than usual are made. It really only trade up to intrinsic value and then some for a couple of quarters, once or twice in a decade, at which time options are exercised, stock sold and the cycle repeats. Options for a stock that hardly fluctuates over time are less valuable to managers and employees than options tied to shares that get stupid from time to time, especially if the principal owners of those options can have a hand in affecting the perceptions that drive volatility. So as long as volatility is the friend of option based compensation, we should not expect those corporations whose share prices are occasionally “victimized” by volatility to lobby for policies that might tone things down.

Selling in May and Going Away is starting to seem like a good idea, but only in the marginal sense of raising buying power for the future by trimming marginal holdings. As much as the past week plus has made us want to reach for the barf bag, it is still very early in a longer term Bull Market.

Piranha-proofing the Shark Tank

While the nearly-over earnings season has had a very salubrious effect on share valuations, this week has certainly reminded us that, however spindled and mutilated, those of the bearish persuasion are still very much among us. Company results have been almost uniformly encouraging, driving yet another set of nails into the coffin of “double dip recession”. One has had to scratch hard to find exceptions. Tuesday’s swoon was triggered by rating agencies having finally caught on that the dysfunctionality of certain Euro-backwaters is more or less as persistent as it was a century or so ago. This air pocket was really not all that surprising, considering how frenetically some swathes of the Market (e.g., the Russell 2000) have been trading over the past few weeks. It also seems that those money pools who thrive on exacerbating disappointment seem to have less clout than they did a quarter ago, as if a more optimistic conviction has hardened in the minds of the unwashed masses their depredations are intended to intimidate. There is clearly a wolf pack of opportunists running screens each morning for anything resembling a “miss”, then gang banging the bids in hopes of jump starting a stint of negative momentum, but it rarely seems to be good for more than a few hours of high jinx. There is simply too much evidence of an on-the-mend global economy, and more to the point, too much money, badly in need of a greater than “risk-free” return, finding its way into US equities. This is a very tough time to be a bear, even if you didn’t bet that “Palm will go out at $1”.

As vivid as the earnings fireworks have been, we have been distracted by what amounts to a Potemkin (as in, put-up fakery) show trial (as in, politicians raking their cronies over the coals) on the Senate floor. What a surprise that the SEC serves up the staggering revelation that sharpies sometimes get hosed down by other sharpies just as the D.C. Power Grab turns its sights on the financial markets. All that’s really going on here is an effort to make something gamey even gamier (as in, advantage accrues to those politically connected enough to game the system.) Wall Street will become that much more a cash cow for funding Permanent campaigns. The occasional public floggings will continue, but with even more winking acknowledgement that such debasement is a small price to pay to have everyone think of you as a Master of the Universe. I suspect that whatever rules get crafted will make it harder for non-financial enterprises to extend credit. It will probably have some impact on marginal predators well down the financial services food chain. The “too big to fail” predators will take up the slack. Expect to what might be regarded as piranhas (e.g., small time finance companies) lose share to the Great White Sharks (GSC, et al).

All this is being foisted on us to prevent something that is very unlikely to happen anyway. We are being told that future panics/meltdowns, whatever are inevitable if we don’t “do something!”. This is true enough in the sense that as long as there is at least a modicum of freedom, and fear and greed are still part of human nature, there will be accidents, bad days for those who didn’t see it coming. What is misleading, though, is the implied likelihood that such inevitable upsets will be of a magnitude of what we just lived through. I would submit that “the black swan” flew due to conditions that were decades in the making. 2008 was “once in a generation” because it takes decades to aggregate widespread credulity into overripe systemic delusion. The scariest part of the scariest part of that episode was that nobody, even those of us who had lived through some pretty scary patches, had seen anything quite like it. It fell as hard as it did because the delusion of “real estate as impregnable in the aggregate” that underpinned it all was largely the result of policies that had been metastasizing for decades. However appropriate these policies started out (increasing home ownership was undeniably a worthy aspiration in the 1920s, by 2000, have succeeded so wildly, not so much), they were thoroughly corrupted by the time real estate became the designated engine to pull us out of the 2002 recession. The good news is that these blowups are a lot like forest fires. If the woods have been growing for a very long time without a fire, there is lots of “fuel” lying about. No one is expecting it, and so when it happens, it burns out of control. In doing so, however, it makes it much more difficult for a fire of any consequence to happen any time soon. In the financial world, the same thing happens. Lending standards swing from practically non-existent to CYA tight. The suspect mortgages of a few years back run off or are refinanced, and are replaced, bit by bit, day by day, with much more scrupulously sourced cash flows. The “fuel” for the next conflagration simply is not there like it was in 2006, nor is the complacency wrought by a rating system that had never really been tested. So yes, there will be failures, headline grabbing, day ruining upsets, but nothing with the sort of systemic risk that calls for handing more power over to those who would game the system.

“Too big to fail” seems to be one of the most intractable challenges we face, but it really doesn’t have to be. It could all be sorted out with a simple policy that if you get the guarantee that comes with FDIC, you don’t do take casino bets. Enterprises that want to be hedge funds can be hedge funds. Those who want to take deposits can act like banks in the sense that “bank” is akin to “bunker”, a putting safety ahead of opportunity. To the degree that what constitutes a casino bet is difficult to sort out (so many derivatives being rather benign ways that companies dial down their commodity or forex risk), a bit of behavior modification might be called for. How awful would it be to have a policy where if the government has to facilitate a change of control to protect depositors or prevent systemic shock waves, the hurt goes beyond the equity holders and reaches the ones who made it happen? We could fix this problem if, in the event of such failure, any compensation above some nominal threshold, say $90K/year, in the five years leading up to the event gets clawed back to help pay for the redeployment. This would include former as well as current employees, no exceptions. It would includes salary as well as bonuses, deferred or long since spent. Skin in the game, just like the share holders and, it would seem, many of the bondholders. There would seem to be a lot of unfairness in such an outcome, but one suspects that such a prospect would change an awful lot of behavior, and it would likely be a very long time before “risk taking with other people’s money” brings us to such a pass.