Posts filed under “Hedge Funds”
At this point, you would have thought the Efficient Market Hypothesis would have died a quite death. But as is its wont on Wall Street, myths, bad theories, and old information linger far longer than one would expect.
Today’s case in point: The WSJ Ahead of the Tape column today (Predicting What’s Next Gets Harder) looks at how much of a future discounting mechanism the markets actually are:
Investors often expect the stock market to behave like a crystal ball. Lately it has made a better rearview mirror.
Conventional wisdom holds that the market efficiently reflects future corporate earnings. This makes sense, as one ostensibly buys stocks in companies to claim bucketfuls of their future profits.
For decades, turns in the stock market typically led earnings by roughly six months. But during the past decade or so, stocks have moved roughly in tandem with, and occasionally lagged, the trajectory of profits, notes Tobias Levkovich, Citigroup’s chief U.S. strategist.
I have several favorite examples of where markets simply get it wrong. When I spoke with the reporter on this, I used the credit crunch as exhibit A. It began in August 2007 (though some had been warning about it long before that). Despite all of the obvious problems that were forthcoming, after a minor wobble, stock markets raced ahead. By October 2007, both the Dow Industrials and the S&P500 had set all time highs. So much for that discounting mechanism.
We’ve seen that sort of extreme mispricing on a fairly regular basis. In March 2000, the market was essentially pricing stocks as if earnings didn’t matter, growth could continue far above historical levels indefinitely, and value was irrelevant. How’d that work out?
Three years later, the market priced tech and telecom in a similarly bizarre fashion. Some of our favorite tech and telecom names — profitable, debt free firms — were trading below their book value. Some were even trading below cash on hand.
The market had "efficiently" priced a dollar at seventy-five cents.
The most fascinating aspect of this is the opportunity for anyone int he market to identify inefficiencies. Discover where the market has a non random error — we’ve called it Variant Perception over the years — and you have a potentially enormous money making opportunity.
This is the reason why everyone doesn’t simply dollar cost average into index funds — its the lure of the big score. And as the recent list of Hedge Fund Winners and Losers makes clear, the winners reap enormous windfalls:
"All of this suggests the stock market may prove less useful as a leading indicator of profits and economic growth. But it also suggests stocks are likely to get out of balance more often, creating opportunities for savvy investors."
Levkovich points to the "proliferation of hedge funds" as making
markets "increasingly focused on breaking news and short-term swings,
rather than longer-term fundamentals." I would add the narrow niche
focuses used to differentiate amongst funds and raise capital also
contribute to this phenomenon. We end up with a case of the six blind men describing the
elephant, with few seeing the big picture.
To an EMH proponent, however, hedge funds should make markets more,
not less efficient. Their long lock period (when investors cannot take
out cash) means they should have a longer time horizon for investment
themes to play out.
One of my favorite quotes on the subject comes from Yale University economist Robert Shiller. He notes the huge mistake EMH proponents have made: "Just because
markets are unpredictable doesn’t mean they are efficient." That false leap of
logic was one of "the most remarkable errors in
the history of economic thought."
Just don’t tell certain Traders that. They hate hearing that markets contain a high degree of random action and inefficiencies.
Except for the really clever ones . . .
Predicting What’s Next Gets Harder
WSJ August 11, 2008
What a crazy week — and the market is the least of it!
We moved from our old space on Park Avenue & 49th (across from
the Waldorf) to larger quarters a few blocks over on 5th Avenue. I have been switching back and forth between Starbux and Bryant Park for internet access (and posting less because I have been out of the office more than in). The
furniture is in, the phones are hooked up, and tomorrow, rumor has it
Verizon will light us up with a big fat pipe, connecting us to that
series of tubes.
But what’s been really odd is that a dozen seperate projects I have been working on for a few years now — some big, some small, all eclectic — have practically all-at-once, simultaneously, lurched towards fruition.
A major media project
I may join a new BoD
A fun little web project (its potentially very, very funny)
A significant quant application (this is a very powerful tool)
A brand new video venture
Two fascinating blog related advertising concepts
An expansion of an earlier book blogging idea
A new private equity fund
And that was just this week!
We will discuss more about these in the coming weeks; Just about all of them have a market/stock/economic component to them. I’ll keep you up to speed with these as they develop.
I expect/hope that at least 3 of these 7 close before Halloween. . .
The opening paragraph just reached out and grabbed me:
"While it is not strictly true that I caused the two great financial
crises of the late twentieth century—the 1987 stock market crash and
the Long-Term Capital Management (LTCM) hedge fund debacle 11 years
later—let’s just say I was in the vicinity. If Wall Street is the
economy’s powerhouse, I was definitely one of the guys fiddling with
the controls. My actions seemed insignificant at the time, and
certainly the consequences were unintended. You don’t deliberately
obliterate hundreds of billions of dollars of investor money. And that
is at the heart of this book—it is going to happen again. The financial
markets that we have constructed are now so complex, and the speed of
transactions so fast, that apparently isolated actions and even minor
events can have catastrophic consequences."
Indeed, I enjoyed the rest of the book. Bookstaber was on the scene in the early days of many of derivatives now contributing to market turmoil. He rather deftly makes complex issues readily understandable, regardless of how much advanced mathematics you may have under your belt.
And, he names names. LOTS of names. All the usual suspects come under scrutiny, as well as a lot of folks who probably assumed they were not int he public eye. There will be a lot of people not very happy with his blunt, insider descriptions of the analytical errors made by major players — many of whom are still around today and in positions of authority and power.
He also accepts a lot of responsibility for many costly errors he himself made.
Overall, a fun, very informative read.
I was intrigued enough by the book that I contacted Bookstaber (the author) and Wiley (the publisher), and asked for their permission to reproduce the first chapter. They graciously sent me a pdf and text version, which you will find after the jump: All of chapter one, in both text form and PDF. I also included some mainstream media reviews after the chapter.
I have pretty good relationships with many of the publishing houses — they all want to get a book or two out of me. Anyway, if it turns out you guys like this idea, perhaps we can offer up a book or two that I am reading every month in this same format. Maybe we can have an online reading group club — it could be a good place to have a full discussion. Share your thoughts.
Enjoy chapter one.
Disclosure: No, I don’t accept money for this — it was my idea, and I approached the publisher and author about this — not vice versa. Please don’t start bombarding me with offers to promote books I am not already reading. They will be unceremoniously deleted without response.
As noted in our disclosure section, we don’t do payola here (if you click thru and buy it on Amazon, I do see some scratch).