Are Markets Efficient or Irrational?

My wife, son and I took advantage of yesterday's splendid fall weather to hike Mt. Monadnock in New Hampshire.  We're a little sore today - climbing to the summit is pretty daunting - but had a terrific time.
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Earlier this week it was announced that this year's Nobel Prize in economics would be awarded to three American academics:  Robert Shiller, Eugene Fama and Lars Peter Hansen.

The men are being recognized for their pioneering work in trying to describe how markets work.  Interestingly, although they shared the award, Fama and Shiller fundamentally disagree in their conclusions.

Here's an excerpt from the New York Times:

Mr. Fama’s seminal theory of rational, efficient markets inspired the rise of index funds and contributed to the decline of financial regulation. Mr. Shiller, perhaps his most influential critic, carefully assembled evidence of irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as well as the housing crash that began in 2006...

The three economists, who worked independently, were described as collectively illuminating the workings of financial markets by showing that stock and bond prices move unpredictably in the short term but with greater predictability over longer periods. The prize committee said these findings showed that markets were moved by a mix of rational calculus and irrational behavior. 

Yet in jointly honoring the work of Mr. Fama and Mr. Shiller, the committee also highlighted how far the economics profession remains from agreeing on the answer to a basic and consequential question: How do markets work? 

http://www.nytimes.com/2013/10/15/business/3-american-professors-awarded-nobel-in-economic-sciences.html?_r=0

Writing in the Atlantic magazine, Derek Thompson makes the excellent point that while Shiller and Fama might disagree on whether markets are irrational or efficient, they both agree that it is pointless to try to guess the short term movements of any markets:

If Fama and Shiller's research disagrees about the short term, they meet, like fundamentals and asset prices, in the long run. Shiller's research showed that periods of over-enthusiasm about a stock tend to follow periods of under-enthusiasm about a stock. The year-to-year gyrations seem wild and capricious. But the fact that they follow a pattern over the course of many years suggests that, in the long run, stocks reflect certain fundamentals, like expected future earnings.
 

These findings might strike you as familiar advice. They reflect the position of some financial advisors who tell families that frenetic day-in-day-out activist investing is for chumps, and the best place for your money is a passively managed portfolio or index fund.

But it's a disquieting idea for most of the financial news industry, whose 24-7 coverage of the market implicitly presumes an audience seeking guidance about which stocks to buy and sell each day. Daily, monthly, and annual stock picks are low-probability gambles according to Fama and Shiller's research. But they're the bread-and-butter of financial media.

http://www.theatlantic.com/business/archive/2013/10/this-years-nobel-prize-in-economics-was-a-big-fat-critique-of-financial-media/280548/

So perhaps the most important conclusion from this year's Nobel winners is to turn off the television commentators and other financial media and focus on longer term trends.

Technology Tales

For people that don't actually work at a technology company, the tech world can seem pretty cool.

Working in an area where the pace of change has been breath-taking, and the potential for fabulous wealth apparently unbounded, the tech world seems to offer the best of all possible career paths.

The reality, of course, is considerably different.  High tech companies tend to be filled with brilliant employees working incredibly long hours under very stressful deadlines. Only a handful of companies ever achieve the kind of financial success that a Facebook or LinkedIn achieve; 75% of all tech companies fail, according to some estimates.

Three articles that I have read over the past week gave me a good glimpse into what it's like to work in technology.

Oracle is one of the giants in the technology business. Started 36 years ago, it has made a number of its founders incredibly wealthy, most notably multi-billionaire Larry Ellison.

Ellison hired Mark Hurd a couple of years ago.  Hurd had been head of Hewlett-Packard but became embroiled in a personal controversy that lead him to leave HP.  Ellison quickly hired Hurd, and now Hurd is one of the chief salespeople for the company.

When you reach the size of Oracle, achieving sales growth can be a daunting task, as a recent article in the New York Times reported.  Here's what a typical week for Hurd looks like:

A few hours watching Mr. Hurd (something Oracle allowed me to do on the condition that some negotiations and customers not be identified) is a healthy reminder of a basic truth about the technology industry. The world sees and thinks about its gee-whiz products. It loses sight of the reality that sales make all the rest possible.

Oracle became big in its 36 years thanks to one of the strongest sales cultures in technology. You can find so many of its former sales executives throughout the industry that sometimes is seems like the Valley’s finishing school for deals. And whatever the business, sales still is all about relationships....
 
It’s a heavy pace, but not that abnormal in Mr. Hurd’s life, says Julie Tung, Oracle’s vice president for global customer programs. “We aim to be out five weeks a quarter, generally three days of the week with customers,” she says. ”The target goal is 50 customers a day, with no more than 18 people if it is a round table, so they all feel like they’ve had some one-on-one time with Mark.” 

Ms. Tung lives in New Jersey and Mr. Hurd is based in California, but it hardly matters when you are getting up close and personal with 3,575 customers a year.

http://bits.blogs.nytimes.com/2013/10/02/mark-hurd-oracles-master-salesman-wants-your-business/

Amazon.com is another hugely successful technology company. Started by Jeff Bezos in the early days of the internet, Amazon records $75 billion a year in revenue, and continues to grow at an incredible rate.

Working at Amazon, however, is very demanding and can be very stressful. A recent article in Bloomberg Businessweek carried an excerpt from a new book on Amazon.  Here's an excerpt:

Within Amazon.com (AMZN) there’s a certain type of e-mail that elicits waves of panic. It usually originates with an annoyed customer who complains to the company’s founder and chief executive officer. Jeff Bezos has a public e-mail address, jeff@amazon.com. Not only does he read many customer complaints, he forwards them to the relevant Amazon employees, with a one-character addition: a question mark.

When Amazon employees get a Bezos question mark e-mail, they react as though they’ve discovered a ticking bomb. They’ve typically got a few hours to solve whatever issue the CEO has flagged and prepare a thorough explanation for how it occurred, a response that will be reviewed by a succession of managers before the answer is presented to Bezos himself. Such escalations, as these e-mails are known, are Bezos’s way of ensuring that the customer’s voice is constantly heard inside the company.

http://www.businessweek.com/articles/2013-10-10/jeff-bezos-and-the-age-of-amazon-excerpt-from-the-everything-store-by-brad-stone

Twitter is about to do an IPO, so it is timely that Nick Bilton of the New York Times has written a book about the company.

While some of the individuals who started at the company are soon to become wealthy, it is noteworthy that the idea of Twitter was not necessarily unique.  According to Bilton, luck plays as much a role in the success stories in technology as originality and skill:

For the ones that make it, success often comes down to a lot of luck. YouTube was one of dozens of video-sharing sites in existence when it was purchased for $1.7 billion by Google. Instagram wasn’t the first app on iTunes to share photos, yet Facebook still paid $1 billion for it.Twitter wasn’t the first place to share a status online; it was certainly the luckiest. ..Seven years after it was founded, the company with a catchy name had more than 2,000 employees, more than 200 million active users and a market value estimated at $16 billion. When it makes its initial public offering, many of Twitter’s co-founders, employees and investors are going to become very, very rich...

But in Silicon Valley, luck can be a euphemism for something more sinister. Twitter wasn’t exactly conceived in a South Park playground, and it certainly wasn’t solely {President Jack} Dorsey’s idea. In fact, Dorsey forced out the man who was arguably Twitter’s most influential co-founder before the site took off, only to be quietly pushed out of the company himself later. (At which point, he secretly considered joining his biggest competitor.) But, as luck would have it, Dorsey was able to weave a story about Twitter that was so convincing that he could put himself back in power just as it was ready to become a mature company. And, perhaps luckiest of all, until now only a handful of people knew what really turned Twitter from a vague idea into a multibillion-dollar business. 

http://www.nytimes.com/2013/10/13/magazine/all-is-fair-in-love-and-twitter.html?pagewanted=all 

Hard work, stress and luck - all ingredients, it seems to succeeding in the technology world.

What Me, Worry?

Source: Wall Street Journal
http://www.gallup.com/poll/165317/republican-party-favorability-sinks-record-low.aspx?wpisrc=nl_wonk

At an internal meeting this morning I was asked to give a few comments about the current debt ceiling debacle.

When I was first approached to discuss this topic earlier this week I hoped that it would not be necessary, and that cooler heads would have prevailed in Washington.

However, as we get closer to October 17 - which is the "drop dead" date that Treasury Secretary Jack Lew has mentioned on numerous occasions - the markets are getting nervous.

Treasury bills maturing on October 17 now offer a yield of 0.49%.  Bill maturing next January yield 0.05%.  The money markets are signalling an increased level of concern.

So too are institutional investors.  According to an Associated Press article, mutual fund giant Fidelity has sold all of the Treasury holdings in its money market funds in favor of corporate debt:

NEW YORK (AP) — Fidelity Investments, the nation's largest money market mutual fund manager, has sold all of its short-term U.S. government debt — the latest sign that investors are increasingly nervous about the possibility of a government default.

Money market portfolio managers at Fidelity Investments started selling off short-term U.S. government debt a couple of weeks ago, Nancy Prior, president of Fidelity's Money Market Group, said Wednesday. While Fidelity expects the debt ceiling issue to be resolved, the Boston-based asset manager said it has taken steps to protect investors.

"We expect Congress will take the steps necessary to avoid default, but in our position as money market managers we have to take precautionary measures," Prior said.

http://bigstory.ap.org/article/fidelity-sells-short-term-us-government-debt?ftcamp=crm%2Femail%2F20131010%2Fnbe%2FAlphavilleLondon%2Fproduct

Meanwhile they are reports that the large money center banks (Bank of America, etc.) are starting to build cash positions in case depositors start making large withdrawals.

This is getting pretty ridiculous, in my opinion.  As the chart above indicates, favorability ratings for both parties continue to sink. The 28% rating for the Republicans is the lowest rating since Gallup started this poll in 1982, according to the Wall Street Journal.

The stock markets are soaring this morning as word filters out that a compromise might be in the offing.  Let's hope this nightmare soon ends.

More Talk on Health Care

My wife and I had the chance to hear from one of the prominent experts in the health care field last night.

Arthur Garson is the former dean of the University of Virginia (UVA) medical school.  He remains active in the field as an advisor to a number of global health care initiatives, including the World Bank.  Dr. Garson has also co-authored a book on health care in the U.S. titled "Health Care Half Truths: Too Many Myths Not Enough Reality".


Dr. Garson was speaking at an event here in Boston sponsored by the UVA Club of Boston.  My daughter is a second year student at UVA.

I can't do justice to all of the remarks that Dr. Garson made over the course of his hour-long presentation, but I thought he made a number of points that you might find interesting:

• On Obamacare:  the costs of the new program are clear but the savings are not.  Dr. Garson believes that the program does not address some of the fundamental issues in our health care system, and so is skeptical of its longer-term success.
• On Our Health-Care System:  any way you measure it, our system does not stack up well versus a number of other health care systems throughout the world. We need to make fundamental changes;
• On Medical vs. Health Care:  Dr. Garson believes it is important to make the distinction.  The quality of medical treatment varies widely across the U.S.  Boston hospitals are among the finest in the world, according to Dr. Garson, but other areas come up short (including New York City, surprisingly).  Health care - which encompasses the quality of life - is poor by a number of measures, including teenage pregnancy rates; teen suicide rates; infant mortality; and fatalities due to gun violence;
• On Waste in Our Health Care System:  Most agree that hundreds of billions are wasted each year, yet the solutions are not easy.  Physicians often perform too many tests, but the reasons can vary (fear of lawsuits is one commonly-cited reason, but often it is just the doctor's style);
•  Medicare:  Dr. Garson noted that no single factor has contributed more to the growth in medical spending than Medicare.  As an example, he noted that a patient with back pain is six times as likely to have spinal surgery in Miami (with a large elderly population) than Seattle.  While medicare reimbursement rates are often the subject of complaints, the volumes often make up for lower margins;
• Doctor payments:  our medical system encourages doctors to do more procedures since they are paid by the number of procedures.  Paying doctors on a salary rather than a fee-for-service would be a much better way to contain costs;
• End of Life Care:  Most cite the fact that 40% of a typical patient's health care spending occurs in the last year of their life.  Problem is, since there is no way of knowing your final date.  Dr. Garson cited the example of his two parents who were both diagnosed with lung cancer within weeks of each other. One died within three months, while the other died three years later.

Dr. Garson said that he and his co-author were working on a new version of his book, which should be coming out soon.  If you are at all interested this complex topic, it might be worth a read.

Puerto Rico Bonds for Equity Investors?

Every once in a while an opportunity arises in the fixed income market that offers an interesting alternative to equity investors.  While they are usually high risk, the potential gains can also be intriguing.

Let me say again at the onset of this post that this is a very risky situation, and I am emphatically telling readers that this should not in any way be considered a recommendation to buy bonds.

The bonds issued by various entities in Puerto Rico have been under pressure in the last few months for several reasons.

Here's an excerpt from a recent Reuters article on the situation:


The steep decline in prices of Puerto Rican bonds on the American municipal bond market is taking a heavy toll at home, where local institutions and individuals own an estimated 30 percent of the $70 billion of outstanding bonds.

Heightening worries in recent months about Puerto Rico's shrinking economy, double-digit jobless rate and per capita debts far higher than in any U.S. state touched off a wave of selling and briefly pushed some Puerto Rico yields to over 10 percent.

The yield on Puerto Rico's general obligation 30-year bond hit a recent peak of 8.58 percent, up from 5.49 percent on June 30. The steep drop in prices, which move inversely to yields, has hit local banks and closed-end and mutual funds marketed to bond buyers in Puerto Rico. Some of the Caribbean island's bonds fell to as low as 60 cents on the dollar.

http://www.reuters.com/article/2013/09/29/puertorico-bonds-locals-idUSL2N0HM26D20130929

The problems in Puerto Rico are real:  the economy is scheduled to shrink by -5% in 2013, and the commonwealth has been essentially cut out of the public debt markets.  Instead, it has turned to the banks, who are carrying most of new lending burden but at very onerous rates.

However, here's the interesting part:  while the major rating agencies are obviously concerned, the rating of the general obligations of Puerto Rico remain investment grade.  Moreover, Puerto Rico bonds backed by a senior lien on sales taxes are still rated AA- by S&P.

So why are the prices of Puerto Rican bonds plummeting?

Much of the recent decline appears to be related to leveraged bond fund selling.  According to Forbes, brokerage firm UBS aggressively marketed leveraged bond funds investing in Puerto Rican debt over the past few years.  When prices started falling, investors and funds were forced to sell, regardless of price, which has exacerbated an already precarious credit situation.

Here's an excerpt from a recent column:

Over the past decade, UBS has sold roughly $10 billion of Puerto Rican debt, much of it packaged in its own proprietary closed-end funds. One series of such closed-ends is entitled the “Puerto Rican Fixed Income Funds.” Over the summer and into the fall, these closed-end UBS funds have cratered in value as the Puerto Rican economy has sunk in recent months...


“The bank’s clients had piled into highly leveraged bond funds run by UBS and were encouraged by its brokers to borrow even more money to invest in those funds,” Craig reported. “In some cases, money was lent improperly, exacerbating current losses, according to UBS employees in the region.”

She continued: “Now, a number of UBS clients have been forced to liquidate hundreds of millions of dollars in holdings in these funds to meet margin calls. And the bank says it has begun an internal investigation into the lending practices of some of its top-producing brokers.”

http://www.forbes.com/sites/jakezamansky/2013/10/07/created-by-ubs-muni-bond-perfect-storm-now-over-island-of-puerto-rico/

 Not only were the funds levered - many clients borrowed money to buy the funds, which dramatically increased the risk.  Here's the New York Times last week:

..many clients took out margin loans to buy into the funds. Other investors, according to local brokers and a lawyer representing some UBS clients who are considering suing the bank, were encouraged by their brokers to borrow on credit lines, which customers typically use to buy items like second homes or even to expand their businesses.

Most banks require investors who are given a credit line to sign a document saying they will not use it to buy securities. Instead, investors use margin loans, which are specifically governed by regulators and allow banks to more closely monitor what sort of risks their clients are taking on.

“When you add leverage on top of leverage, and then add more leverage, it usually doesn’t end well,” said Thomas R. Ajamie, a lawyer who frequently represents investors in financial cases.

http://dealbook.nytimes.com/2013/10/02/ubs-brokers-in-puerto-rico-create-headache-for-the-bank/?_r=1


So in my equity-trained mind, what we are seeing here is massive selling pressures, pushing prices lower, which in turn adds to the economic pressures.
But when the selling ends, at some point the bonds might be a buying opportunity.

Why do I say this?

I am not an expert on Puerto Rico, but I know that any entity that has $70 billion in bonds outstanding needs continued access to the credit markets.  While there may be a strong desire to force losses on bond holders, once a borrower stiffs its creditors it is not likely to have a welcoming reception in the future.

Moreover, while Puerto Rico is obviously not a state, it seems hard to believe that the U.S. government would let one of its protectorates go belly up.

Unfortunately, at this writing, I am not alone in my look at Puerto Rican bonds.  According to our fixed income folks, even long maturity PR bonds are trading at "only " an 8% yield - nice, to be sure, but not yet at the point where they are competitive to equities in my opinion.

But if we see more year-end selling, the situation might change.

"This Time It's Different"

You can always count on Americans to do the right thing—after they’ve tried everything else. 
                                                                     -Winston Churchill

You know we've got problems when a Russian president sympathizes with an American president.

Here's what President Vladimir Putin said about President Obama's decision to cancel his trip to Asia for Asia-Pacific Economic Cooperation (APEC) summit this week:


Oct 7 (Reuters) - Russian President Vladimir Putin said on Monday he understood U.S. President Barack Obama's decision to cancel his trip to Asia and would have done the same if faced with the same domestic challenges....

"We see what is happening in U.S. domestic politics and this is not an easy situation. I think the fact that the U.S. president did not come here is quite justified," Putin said at APEC.

"I think that if I was in his situation, I would not come either. Any head of state would do that, probably."

http://www.reuters.com/article/2013/10/07/asia-russia-usa-idUSL4N0HX1Q420131007

Famed investor John Templeton used to say that the four worst words that any investor could say would be "This time it's different".

Templeton's point - echoed by most successful investors - was that "history doesn't repeat but it rhymes" (a Mark Twain quote).  The actual path of events may vary, but ultimately markets react in predictable fashion.  The trick is to have the emotional intelligence to recognize opportunities or risks, and act accordingly.

Most of Wall Street is convinced that the current budget stalemate will be resolved, and that the U.S. will not default on its debt.  I also believe, like Winston Churchill, that Congress and the President will eventually figure out a way to avoid financial catastrophe.

Still, I worry that the investment community is not taking the current situation seriously enough.

As I read the situation, the members of the House that are leading the charge come from districts that are very conservative, and voted heavily against the President last year.  There seems to be little reason for them to compromise, especially since they are aware that any agreement with the Democrats will be used against them in the next election.

But I am not sure what investors should do.  Selling stocks or bonds and heading into cash may offer near-term appeal, but market-timing has always been a fool's errand.  Moreover, the proceeds from any sale have to be reinvested into something - but what?

Yet I think it is possible that matters get worse before they get better.  Here's an excerpt from a good piece in the blog Business Insider:


This year, the stock market has barely been paying attention. Mostly investors are convinced that there will be a deal, and nobody wants to be out of stocks for even one day, lest they miss the "deal" and subsequent rally. Unlike in 2013, when the debt ceiling was on everyone's radar for months, this year, things have only come into view with days to go until the drop-dead date.

But 2013 is scarier for what it says about the whole system.

In 2011, the crisis could be chalked up to the times. We were still (basically) in the middle of a big depression. The deficit was soaring. And there was a "wave" election for the GOP (the 2010 midterms) the likes of which rarely comes along...

So what we know now is that we can't attribute the events of 2011 to some one-off fluke that was the result of bad times. This is how politics is now.

One party takes the maximalist position, and then decides its going to take the country hostage as its prime negotiating tactic. There's no reason to think, if a "deal" is struck this time, that this won't happen again in 2014, 2015, and every other time the debt ceiling comes up.

Read more: http://www.businessinsider.com/why-the-2013-debt-ceiling-crisis-is-scarier-than-2011-2013-10#ixzz2h2anPNQV

And blogger Barry Ritholtz writes in the Big Picture that stocks could fall 20% to 30% if no resolution is reached soon:

 “It turns out the market really doesn’t care much if [the shutdown] is a day or a couple of weeks,” says Barry Ritholtz, chief investment officer of Ritholtz Wealth Management. “Where it becomes a concern…is if weeks turn into months. If it goes past three or four weeks, that could take a big chunk off GDP, effect consumer confidence and really have an impact on earnings.”

http://www.ritholtz.com/blog/2013/10/if-shutdown-isnt-resolved-stocks-could-fall-20-30/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29

Which Companies Will Benefit from Obamacare?

 

Writing in his excellent book Lives of a Cell: Notes of a Biology Watcher, author Lewis Thomas wrote that his mother cried when he became a doctor in 1938.

It wasn't that she was proud of him - although she probably was - but rather becoming a doctor in the first part of the twentieth century meant a meager living on modest wages for the rest of your career.

This all changed when the government became more involved.  With the introduction of such programs as Medicare, and allowing employers to offer tax-free health care benefits to their employees, the medical field saw a massive infusion of funds that made companies prosper and dramatically increased the income of medical professionals.

If you had simply invested in healthcare stocks in the 1960's with the introduction of Medicare and Medicaid, you would have made enormous gains over the next few decades.

With this history in mind, I have been wondering whether the new Affordable Care Act (a.k.a. Obamacare) offers the same opportunity.

Regardless of how you feel about the program, millions of people will now be covered by health insurance. Potentially this could lead to increased usage and perhaps more profits.

Hospitals should be a clear winner.  Bad debt expense at most hospitals runs in the 20% range, and Obamacare should greatly reduce the problem. 

Diagnostic companies might also benefit from increased usage.

The new law is probably a net neutral for the pharmaceutical companies. True, they may see volumes increase, but with more attention on pricing margins might be squeezed.

The same might be true for the private health insurers.  Most will probably see a dramatic increase in enrollment, but with competitive pricing available on healthcare exchanges profitability may not benefit.  There probably will be a wave of merger activity in the group - size will definitely be key to success.

The medical device companies probably will suffer due to the new tax on medical devices that Obamacare mandates.  This sector had already seen a dramatic slowdown in volumes, and the additional tax will be a further drag on usage.  Many of the companies are already focusing their attention on cost cuts in an effort to maintain profits.

Healthcare stocks have already moved up sharply in 2013, as investors anticipate the gains that the industry will see from Obamacare.  However, it seems likely that further advances are likely in the years ahead.