As a believer in market solutions/mechanisms, the last few weeks have been trying, to say the least." How, in the face of all that has happened, can you still trust markets?" is a question that I have been asked. I could give you all the facile answers - it is not the market's fault... imperfect regulatory frameworks are to blame... errant traders are the reason.. but my heart is not in any of these explanations. I think that markets did fail, at least partially, in this cycle, just as they have in other cycles in the past. The costs are being borne by all of us. Notwithstanding the failure (and...
Step away from the ledge!
Posted by Unknown
Posted on 2:01 PM
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Let's get the bad stuff out of the way first. It was an awful day for investors in every market. There was no safe haven today. I am sure that you are convinced that the end of the world is coming but let me offer you my take on the market. First, the bad news. The credit crisis is spreading beyond mortgage backed securities. As banking failures in Europe illustrate, the problem is a much wider one. Banks lost their perspective on default risk and lent money at rates that were far too low to borrowers who did not meet the creditworthy test - individuals, corporations and businesses. As...
II. Why did it happen?
Posted by Unknown
Posted on 4:01 AM
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The blame is being spread around for the current crisis: securitization, lax regulation and the housing bubble have all been fingered as culprits, but I think that these were contributing factors. I would attribute what has happened on financial markets to two phenomena, one of which is age-old and cannot be easily cured by regulation or laws and the other of which can be remedied.1. Over optimism and hubris: Through history, we (as human beings) have always exhibited these traits. In good times, we become complacent and under estimate the likelihood of their ending, and we also tend, when...
I. What happened?
Posted by Unknown
Posted on 12:51 PM
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This is the first of three posts that I hope to put up on my thoughts on what we see unfolding in financial markets. Here is my take on what happened:1. The ultimate sources of this turmoil are the real estate market and the bond market. Between 2002 and 2007, housing prices increased at rates unseen in decades and well above the inflation rate. At the same time, default spreads on bond markets converged on historical lows.2. As housing prices increased, funded by cheap mortgage financing, the mortgages themselves were bundled into mortgage backed securities, entitling buyers to different layers...
GE's aborted buybacks...
Posted by Unknown
Posted on 5:02 PM
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In news that was overshadowed by the bailout debate, GE announced today that it was suspending its stock buyback program. While the suspension was precipitated by declining earnings and worries about GE Capital, there are some general comments that I want to make about the action that relate to stock buybacks in general1. Flexibility: One of the biggest reasons for the shift among US companies from dividends to buybacks was that firms can respond much more quickly to adverse circumstances with the latter. GE's announcement on buybacks was greeted with sanguinity by markets today. If GE had cut...
The Bailout
Posted by Unknown
Posted on 5:21 AM
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The news of the week has been the proposed Federal (or Paulson) Bailout, with $700 billion being the price tag associated with it. Let me state at the outset that there is a crisis looming over many financial service firms and drastic action is unavoidable. So, is this bailout the solution? 1. The price tag on the bailout is a little misleading. The $700 billion is what the government will pay to buy mortgage backed securities off banks, but the net cost will be lower. In fact, if everyone goes back to paying their mortgages on time, the Federal Government will make money on the deal. It...
The end of investment banking?
Posted by Unknown
Posted on 5:43 AM
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The big news of the morning is that Goldman Sachs and Morgan Stanley will reorganize themselves as bank holding companies, thus ending a decades-long experiment with stand-alone public investment banking. Before we buy into the hyperbole that this represents the end of of investment banking as we know it, it behooves to us to look both back in time and into the future and examine the implications. Independent investment banks have been in existence for a long time, but for much of their existence, they were private partnerships that made the bulk of their profits from transactions and as...
Are you a contrarian?
Posted by Unknown
Posted on 5:18 AM
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In investing mythology, there is a special place reserved for the contrarian investor, i.e., the investor who goes against the crowd and makes money in the process. In fact, many investors, asked to describe themselves, describe their investment style as both contrarian and long term. But are you really a contrarian investor? Last Wednesday offered a simple test. At 3.45 pm, the S&P 500 was down to about 1150, the Dow had dropped 800 points in three days and the bottom was falling out of the market. If you were watching the screen at that time, which of the following impulses did you feel?1....
What is the risk free rate?
Posted by Unknown
Posted on 3:07 PM
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The risk free rate is the building block on which we erect risk premiums. When I was taking my first finance classes a long, long time ago, I was taught that the risk free rate for U.S. dollar based returns was the treasury rate - the T.Bill rate for short term and the T.Bond rate for long term. The implicit assumption, not often stated, was that the US Treasury was incapable of default. At worst, they would print more currency to pay off bonds coming due. This is a lesson I have passed on to students in my classes and put into print in my books. This week, that conventional wisdom was challenged...
The key number for stocks: The Equity Risk Premium (ERP)
Posted by Unknown
Posted on 7:31 AM
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If there is one number that captures what the market mood is right now and how investors feel about equities collectively, it is the equity risk premium (ERP), i.e. the additional return that investor are charging for buying equities instead of putting their money into treasuries. The equity risk premium reflects the tug-of-war between hope and fear that equity investors bring to the market, and will vary on a day-to-day basis. As investors become more risk averse, they will a higher equity risk premium, which should translate into lower stock prices. Last week provided a laboratory to observe...
The most exciting flat week ever?
Posted by Unknown
Posted on 1:34 PM
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I think we have a candidate for the most exciting flat week ever. The S&P 500 started the week at 1250 and ended the week at 1255, with two huge up days (yesterday and today) offsetting two huge down days (Monday and Wednesdays). The financial world at the end of the week looked very different from the beginning, with the ranks of investment banks thinning and government suddenly becoming the biggest player in the game. I am not willing to make a prediction of whether next week will be up or down (I know - that is quite cowardly of me) but I am willing to bet it will be volatile. Hang...
Selling Short: The debate
Posted by Unknown
Posted on 1:34 PM
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One of the big news items competing for attention today was the SEC's decision to bar short selling temporarily on more than 700 financial service companies. While the SEC statement paid the usual lip service to the importance of allowing short selling in orderly markets, it also concluded that short selling was contributing to market instability and should not be allowed for the moment. Implicit in the ban, and in the support that it is getting from many investors and portfolio managers, is the assumption that short sellers are bad people - speculators, naysayers and vultures who make money...
First thoughts
Posted by Unknown
Posted on 4:55 PM
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I must confess that I have mixed feelings about blogs. I do read quite a few on a variety of topics, but I have held back on starting one of my own for two reasons - first, I am not sure that I have enough to say that is interesting on a continuous basis and second, everything I say will be online for better or worse. Anyway, now that I have made the leap, here is what I hope to put on this blog on a regular basis. 1. I will try to put down my thoughts and reactions to the news of the day, with an emphasis on how the news fits into my big picture view of corporate finance and valuation.2....
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Market Meltdown
Posted by Unknown
Posted on 4:55 PM
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This has been a horrendous week for markets. As markets collapse globally, and doomsday scenarios are envisioned, it is time to take a step back and assess where we are. 1. Equity indices are down about 8-9% for the week in the United States and more in some emerging markets. The S&P 500 is down almost 20% for the year, a bad year by most standards but not quite a catastrophe (yet). 2. The damage to equities has been uneven. The most pain has been inflicted in financial service companies (banks and investment banks). The decline in the rest of the market is far more muted.3. While...
Risk = Danger + Opportunity
Posted by Unknown
Posted on 4:55 PM
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I have always believed that the Chinese symbol for risk, which combines the symbols for danger and opportunity, is the best definition of risk. Danger and opportunity are connected at the hip, something worth remembering in both good times and bad. In good times, opportunities abound, and the salespeople for these opportunities (brokers, hedge funds) tell us that there is little or no danger: those 70% returns are touted as "low-risk". In scary times, all we see is danger and no investment looks good. In both cases, we would be well served stepping back and looking for the link. Lucrative opportunities...