Friday, January 30, 2015

Buffett is Right! (About Bitcoin)

Every now and then, people do ask me about Bitcoin.  And my usual response is, I have no idea what that's about.  But if they are interested in buying some so they can make money, I tell them don't do it.  If there are other reasons (like arms or drug dealing), then it might be a good idea.  But whatever you do, don't do it if it's just to try to make a quick buck.

I've seen this happen (on an individual basis too where one person I know went from one bubble to the next seeking wealth (and losing every time)).  They get into the stock market, and then there is a correction or bear market.  They freak out and sell out (at the wrong time) and lose money.

So they think stocks are no good.  They go to real estate.  In this case, I strongly argued against them investing in vacation time shares.  Back then, unscrupulous promoters (maybe now too) used to try to sell them as "investments" in paradise.  Of course, when you are offered a piece of "real" property for a fraction of what a real condo would cost, it is very attractive.  But with monthly and annual fees, it's basically a prepaid vacation (forever!).  It's not a real estate investment or a hedge against inflation!

And then after being talked out of that and then, yes, even penny stocks, they got into foreign exchange trading.  Yes.  The leverage offered was irresistable.  I said, why?  They say, well, I can't pick stocks like Warren Buffett, so I'm going to speculate in foreign currencies on leverage.  OK, so they are not as smart as Warren Buffett, but suddenly they are as smart as George Soros?  I don't get it.

So maybe this is just another one of those things.  People got burned in the past decade in stocks, real estate, foreign currencies etc.  They need something else.

Back to Bitcoin
I remember the argument last spring when Buffett dissed the Bitcoin saying that it's a "mirage".  I too felt the same way and wondered why it was such a big deal.  I get the technology and things like that, but I didn't get why people would necessarily rush to it, unless they really thought the dollar was going to zero soon.

Anyway, having said that, I actually don't have that strong an opinion either way about Bitcoin.  To me, it's just another one of those things.  Will it last?  Who knows.  Will the whole world soon only transact in Bitcoin?  Will it get to $10,000?  I have no idea.  It's all possible.

But what I do know is that the pound-the-table-Buffett-doesn't-get-it crowd was telling us that the Bitcoin is better than the dollar and they were telling us when it was trading over $600.  That really reminded me of the last two times people said that Buffett is wrong (and interestingly, they all seem to get angry when they disagree with Buffett, and the angrier they sound, the more I lean towards Buffett); the internet bubble in 1999/2000 (Buffett is a has-been; he doesn't get technology so his career is over!), and gold back in 2011 (Buffett doesn't get it; how can someone so smart not see that all the central banks are debasing our currencies?!).  I remember how red-faced and angry gold bugs got when Buffett said all you could do with gold is cuddle up to it or something like that.

And then last year there was the Bitcoin.  Buffett doesn't get it.  One of them even said that investors can't ignore how much the Bitcoin has risen.  I was like, what?  So this is about speculation?

Even a famous value investor went on CNBC telling us that Buffett is wrong about the Bitcoin.

Anyway, check out this chart.  The last Bitcoin "Buffett is wrong" fever happened in March/April 2014.  Bitcoin was over $600 in March.

Bitcoin Price

And since then, Bitcoin tanked to below $200.  Now it's a little above it.  But at $200, that's a 67% depreciation.  That's like, worse than the Ruble, isn't it?  Bitcoin was over $1,000 in late 2013.  From there, it's an 80% drop.

And no, this is not a "ha-ha, you guys are wrong!" post.  Bitcoin may very well end the year at $2,000.  I have no idea.   I'm not making this post because I wanted to say how wrong those guys are.  Not at all.

What's the Point?
So here's the point I wanted to make, and it's something that just recently hit me.  I couldn't really explain why Bitcoin is not a great idea, and neither is gold (most of the time).  Buffett explained it simply by saying that with these things, there is no real intrinsic value.  You can value a farm because it generates income.  You can value a business or a bond.  But you can't value a piece of metal, however precious. The price will just depend on market sentiment.  Sure, production cost will act like a floor, maybe.  But anything above it just depends on sentiment.  What is the value of a Bitcoin?  I have no idea.

And it doesn't matter if I don't know.

Imagine This
But let's imagine that I did like Bitcoin and I told my mom to buy a bunch (grandma, sister, cousin, best friend; just imagine somebody that really trusts you and doesn't know much about markets/finance).  In fact, you hate the dollar and other paper currencies so much you tell them to get out of all their cash and put it into Bitcoins.  Or, OK, you tell them to just buy a little.

Now let's say you did that after seeing these folks on CNBC when the Bitcoin was at $600.  Now it's at $200.  Your mom calls you up and asks, why is my $100,000 now worth only $33,000?  What happened to my money?

Or what if you were really unlucky and you paid $1,000.  And then mom's $100,000 went down to $20,000.   And she calls you up; what the heck happened?

What do you tell her?  Can you explain why the "better-than-paper-currencies" Bitcoin went down 60-80%?  I don't think so.  Can anyone?

With Most Assets, We Can Know What Went Wrong
I can tell you this.  If I told someone to buy stocks and then stocks went down 50% or 80%, I can probably tell you why it happened, and I can probably even tell you what I think the stocks would be worth in three to five years.  I would have strong conviction about that (and in fact, I did talk to many nervous investors throughout the crisis and I assured them that things will eventually turn).

If I told someone to buy a stock and it tanked a lot, I can probably tell them why it went down and what I think will happen going forward.  There might have been some permanent impairment of intrinsic value; nothing is totally safe.  But I would still be able to tell them what that stock would be worth over time.   I can explain it in detail.

When we make mistakes in the market, it's usually one of two things;  we mis-evaluate the business, or we pay the wrong price.

Even with bonds, if interest rates rose and bonds tanked, I will be able to tell people what the bonds are worth.  I can't predict interest rates, but I can give a reasonable range of where I think rates should be and what the bonds would be valued at.

But can anyone do this with the Bitcoin?  I doubt it.

I know this is just a long way of saying that some things just don't have an intrinsic value to measure a price against.  But when you put it this way, that you can't explain these extreme fluctuations, you have to wonder about the wisdom of investing any meaningful amount in them.

Margin of Safety
And then this leads me to the interesting old concept about the margin of safety.  Check out this excerpt from Benjamin's Graham's classic book.  It really nails it.

From Security Analysis: The Classic 1951 Edition, page 656:

Disadvantages of Market Analysis as Compared with Security Analysis   

   We return in consequence to our earlier conclusion that market analysis is an art for which special talent is needed in order to pursue it successfully.  Security analysis is also an art;  and it, too, will not yield satisfactory results unless the analyst has ability as well as knowledge.  We think, however, that security analysis has several advantages over market analysis, which are likely to make the former a more successful field of activity for those with training and intelligence.  In security analysis the prime stress is laid upon protection against untoward events.  We obtain this protection by insisting upon margins of safety, or values well in excess of the price paid.  The underlying idea is that even if the security turns out to be less than it appeared, the commitment might still prove a satisfactory one.  In market analysis there are no margins of safety;  you are either right or wrong, and if you are wrong, you lose money. 

   The cardinal rule of the market analyst that losses should be cut short and profits safeguarded (by selling when a decline commences) leads in the direction of active trading.  This means in turn that the cost of buying and selling becomes a heavily adverse factor in aggregate results.  Operations based on security analysis are ordinarily of the investment type and do not involve active trading.
   A third disadvantage of market analysis is that it involves essentially a battle of wits.  Profits made by trading in the market are for the most part realized at the expense of others who are trying to do the same thing.  The trader necessarily favors the more active issues, and the price changes in these are the resultant of the activities of numerous operators of his own type.  The market analyst can be hopeful of success only upon the assumption that he will be more clever or perhaps luckier than his competitors.

  The work of the security analyst, on the other hand, is in no similar sense competitive with that of his fellow analysts.  In the typical case the issue that he elects to buy is not sold by some one who has made an equally painstaking analysis of its value.  We must emphasize the point that the security analyst examines a far larger list of securities than does the market analyst.   Out of this large list, he selects the exceptional cases in which the market price falls far short of reflecting intrinsic value, either through neglect or because of undue emphasis laid upon unfavorable factors that are probably temporary.

  Market analysis seems easier than security analysis, and its rewards may be realized much more quickly.  For these very reasons, it is likely to prove more disappointing in the long run.  There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else.

Note:  Viewing the two activities as possible professions, we are inclined to draw an analogous comparison between the law and the concert stage.  A talented lawyer should be able to make a respectable living; a talented, i.e., a "merely talented," musician faces heartbreaking obstacles to a successful concert career.  Thus, as we see it, a thoroughly competent security analyst should be able to obtain satisfactory results from his work, whereas permanent success as a market analyst requires unusual qualities - or unusual luck.

Graham talks about market analysis here, but this applies to things like gold and Bitcoin, I think.  I know Bitcoin and gold advocates are not telling people to trade these things, but to actually own them for the long haul.  So in that sense, it's OK.

But what clicked for me in the above passage was the concept of margin of safety.  See, when you buy gold or Bitcoin, where is the margin of safety?   OK, maybe with commodities, the production cost can be seen as a floor.  But what about Bitcoin?

When I buy a stock, I can tell you what the range of expectations are.  They may not be accurate and maybe I can't tell you exactly what will happen.  But I can give ranges.  But with Bitcoin, I can't do that, and I haven't seen any analysis to suggest that anyone can.  All the talk about Bitcoin is about how great it is.  Sure.   I'm sure it's amazing.

But if I can't tell you why it was under $100 and then over $1,000 and then under $200, then I have no business being involved in it (or telling anyone else to be in it).

Does that make any sense?  It's just a long way of saying "I don't know!".

Most people seem to want to get involved when it's going up, and not so much when it's going down.  This suggests to me that it is, however amazing the technology and concept is, at the moment, an instrument for speculation.

Margin of Safety in the Current Stock Market?
OK, so you will read this Graham passage and say, gee, where the heck is the margin of safety in the current stock market at historical high valuations?  Graham said:
We obtain this protection by insisting upon margins of safety, or values well in excess of the price paid. 
Well, where is that now?  What about indexers?  Buffett says 90% S&P 500 index fund and 10% cash.  Where is the margin of safety in buying the S&P 500 index today?!

Good point.

But let's put it this way.  The alternatives are, bonds, cash, or some sort of alternative investment (including funds/hedge funds that may not correlate with the stock market, or maybe macro funds that can benefit in a crash, or a market-timer that will stay out until it's OK to get back in etc.).

If you look at bonds and cash, stocks are easily much better.  And with the alternative investments (and here I am talking mostly about timing-oriented funds; private equity, value and activist hedge funds and others might be playing with a lot of margin of safety within their portfolios), then that's the part where you get to Graham's claim that there is no margin of safety.  The market analysts are either right or wrong.  And if they're wrong, they lose money.

Yes, stock market investors can lose money too in bear markets.  But here's the deal.  Even if we have a bear market, we know that markets eventually turn and businesses will recover (not all of them, of course).

Buffett's Hedge Fund Bet
Remember Buffett's hedge fund bet?  He said that a low cost S&P 500 index fund will do better over the next 10 years than any group of 10 hedge funds or something like that.  And I think he is far ahead on that bet.

And think about this for a second.  He made this bet back in January of 2008.  This was right before things really started to fall apart in the financial crisis.   The market was not cheap.  Things looked really, really ugly.  Who the heck would bet on the heavily financials weighted S&P 500 index back then?!  And hedge funds are supposed to benefit from this sort of volatility.  Back in the day, Soros would have been on fire in that sort of environment.

So the last few years should have been a big advantage for the hedge funds.

And yet, Buffett is winning his bet with the S&P 500 index.

If you go back and think about what Graham wrote, this margin of safety applies even when you just passively own an index!  It's the hedge funds that don't have any sort of margin of safety (I am speaking in general; there are good hedge funds too).

Would Buffett make the same bet today?  What if he had to bet between the S&P 500 index and someone who will time the market in and out (to avoid taking the risk of investing in an overvalued market); I bet Buffett would bet on the S&P 500 index (and so would I!).  And yes, even at this valuation level.

At this valuation level, the returns may be lower than historically,  but I bet a lower stock market return would still be much higher than the return of the timers.

So that's what you have to compare against;  margin of safety in owning a highly valued stock market, and then the margin of safety in investing in someone who claims to go in and out on a timely and profitable basis (or use some other strategy to beat the market).

So I've made some posts recently about market-timing and I didn't really mean to post more about it.  I know that this is one of those things, like politics and religion where everyone has their own view about it and it won't change.

But I brought it up again because this little passage in Security Analysis: The Classic 1951 Edition seems to sum up my feelings about both market-timing and investing in things like gold/Bitcoin.

It's all about the margin of safety.

Thursday, January 29, 2015

Watsa's Massive Bet

All this talk of deflate-gate got me thinking about another kind of deflation.  No, Prem Watsa (Chairman and CEO of Fairfax Financial Holdings (FRFHF)) doesn't have a put option on air pressures of footballs, but he does have a massive bet on global deflation.  It's scary how big the bet has become.

Check this out, from the 2013 letter to shareholders: 

When Watsa first put on this trade, he had $34.2 billion in notional amount on.  As of the end of 2013, there was $82.9 billion.  Now, the initial reference point was that the ten-year cumulative deflation both during the depression in the 1930's in the U.S. and recently in Japan was around 14%.  This means that the possible gain if we see similar deflation around the world can be $11.6 billion!

FRFHF's common equity was $7.2 billion as of the end of 2013, just to give you an idea how big this trade is.  

This is the breakdown by region:

And this is the cumulative loss-to-date from the deflation trade:

Hold on to your chair and look at this table from the 3Q 2014 report:

The notional amount outstanding has increased from $82.9 billion to $108 billion.   That is just staggering.

So let's see how this increase since 2010 compares to FRFHF's common equity:

                                     2010                           3Q2014
Common equity            $7.8 billion                   $8.6 billion
Notional amount         $34.2 billion               $108.0 billion
Potential gain                $4.8 billion                 $15.1 billion
   % of equity                 62%                          175%
Potential loss               $302 million               $639 million
   % of equity                 3.9%                          7.4%

The notional amount looks huge at almost 13x common equity, but since these are basically put options, only the premium paid up front is at risk.

I calculated the potential gain using 14%, which might be aggressive.   The true risk here is that deflation doesn't happen and the puts expire worthless.  In that worst case scenario, FRFHF would lose 7.4% of their common equity; not a disaster.

Remember, too, that these options have an initial period of ten years. As of the end of 2013, the remaining term on the contracts was 7.5 years, so the potential loss actually amounts to something like 1% of common equity per year.   Not a big gamble at all.

How Do Banks Hedge This Thing? 
The corollary to how interesting this trade is to FRFHF is how much of a pain it must be for the banks on the other side.  If we get into a deflationary spiral, banks can end up owing a lot of money to FRFHF.  How do they go about hedging this thing?  I know that CPI futures were planned for listing on the Chicago Mercantile Exchange (CME), but that didn't happen.  Treasury TIPs can be used to hedge, I suppose.

Big banks would also seek out counterparties to take the other side.  There must be plenty of entities wishing to hedge against inflation.   Being short puts won't help against high inflation, though, as they don't make any more than the premium initially received.

Deflation Coming?
In any case, this is very interesting and I've always seen deflation as the higher risk than inflation (again, because of my observation of Japan over the years).

For deflationists, the recent ECB decision to start massive quantitative easing may have been the final hurdle to get over.  If this doesn't stop the deflationary (or at least disinflationary) pressure, then things can get pretty interesting.  

In any case, this is an interesting situation.  This can be the trade of the century if we dip into deflation; the ultimate limited risk (don't lose much if wrong)/ high return (huge gains if right) trade.

Friday, January 23, 2015

Cowen Group, Inc. (COWN)

I was always curious about COWN; it did an interesting merger with Ramius, an alternative asset management company run by some stars from the 1980's.  I have taken a look at it a few times over the years but never really thought much of it.  I don't know what I think of it now, but I thought I'd make a post about it as I am taking a closer look.

First of all, to me, COWN the boutique broker-dealer/investment bank has always been a small company that specialized in health-care and technology; nothing special.   I don't think it has been making any money (or not much) since the 1999/2000 bubble crash.  After that, the industry sort of just seemed to shift away from these little guys and to the bigger banks.

The first time I really noticed it as something I should look at more seriously was when it showed up on Leucadia's (LUK) 13-F back in May 2011.    Many of us respect Cumming and Steinberg as great investors so obviously, anything they take a stake in is interesting to me (but of course, I would never blindly buy anything just because someone I like does).

So here is the curious holdings history of COWN at LUK:

                     COWN         #shares owned          
                     price             by LUK                       BPS    P/B        TBPS    P/TBS
3/31/2011     $4.01            1,000,000                    $5.95   0.67       $5.42     0.74
6/30/2012     $2.66            2,000,000                    $4.45   0.60       $4.23     0.63
3/31/2013     $3.09            3,000,000                    $4.40   0.70       $4.03     0.77
9/30/2013     $3.44               0                            

*shares are rounded to the nearest million.  It's pretty close, though.

Yes, it's a pretty small position for LUK.  The other stock they've owned for a long time is INTL FCStone (INTL).  We can see that after the LUK/JEF merger, they completely sold out of COWN.  This can be because they are a direct competitor to JEF.  Or maybe they (Handler, who took over from Cumming/Steinberg) just don't like COWN.  INTL also is being sold down.  

I used to follow INTL until their merger with FCStone.  I personally hated that merger because I am not a fan of the commodity futures brokerage business.  I didn't like JEF's purchase of Bache's commodities business either.   I've never worked in that industry, but it has always sort of seemed like a low-margin, low-return business.  And then every few years you have these spectacular blowups. Refco had a blowup, MF Global lost a ton on unauthorized, hidden trades (this was in 2008 and not the Corzine blowup of 2011) and there were some others.  All it takes is one bad unauthorized trade and *poof*.  I hate that.  You may argue that this is the case with any financial company.  Yes, to some extent.  But in futures, it seems much easier to blow up.  (But importantly, thanks to central clearing, those blowups rarely lead to systemic problems).

Anyway, that business sort of turned me off to INTL.  If I take a close look at it again, maybe I'll make a post about it.

If someone were to ask why LUK owned COWN, Cumming / Steinberg would have probably said, "Because we like the people and it's cheap".  I think that's exactly what they answered when someone asked about INTL at an annual meeting a few years ago.

So, Cumming / Steinberg probably like the people at COWN.  It can't be just because it was cheap; there were plenty of cheap financial stocks back in 2011.

But there is another connection.  Ramius, the alternative asset manager that merged with COWN had a stake in Linkem before LUK got involved.  So there is probably a relationship there.  All of these guys (the LUK folks and COWN folks) go way back.

COWN Management
Some of the older people will recognize these names, but the younger folks may not have ever heard of them.  Peter Cohen is sort of the original Jamie Dimon (Sandy protege).  He was a rising star, young, "boy wonder" back in the 1980's.  Thomas Strauss, of course, will make many Buffett-heads cringe as he was the President and Vice Chairman of Salomon at the time of the scandal.
       Peter A. Cohen.    Age 67. Mr. Cohen serves as Chairman of the Company's Board of Directors and Chief Executive Officer of Cowen Group and serves as a member of the Management and Operating Committees of Cowen Group since November 2009. Mr. Cohen is a founding principal of the entity that owned the Ramius business prior to the combination of Ramius and Cowen Holdings, Inc., or Cowen Holdings, in November 2009. From November 1992 to May 1994, Mr. Cohen was Vice Chairman and a director of Republic New York Corporation, as well as a member of its Executive Management Committee. Mr. Cohen was also Chairman of Republic's subsidiary, Republic New York Securities Corporation. Mr. Cohen was Chairman of the Board and Chief Executive Officer of Shearson Lehman Brothers from 1983 to 1990. Over his career, Mr. Cohen has served on a number of corporate, industry and philanthropic boards, including the New York Stock Exchange, The Federal Reserve International Capital Markets Advisory Committee, The Depository Trust Company, The American Express Company, Olivetti SpA, Telecom Italia SpA, Kroll, Inc. and L-3 Communications. He is presently a Trustee of Mount Sinai Medical Center, Vice Chairman of the Board of Directors of Scientific Games Corporation, a member of the Board of Directors of Chart Acquisition Corp. and a director of Safe Auto Insurance. Mr. Cohen provides the Board with extensive experience as a senior leader of large and diverse financial institutions, and, as Chief Executive Officer, he will be able to provide in-depth knowledge of the Company's business and affairs, management's perspective on those matters and an avenue of communication between the Board and senior management.

        Thomas W. Strauss.    Age 71. Mr. Strauss is Vice Chairman of Cowen Group, Inc. and is the Chairman of Ramius LLC. Mr. Strauss was appointed a director of Cowen Group in December 2011. Mr. Strauss previously served as Chief Executive Officer and President of Ramius Alternative Investments since February 8, 2010 and serves as a member of the Management and Operating Committees of Cowen Group. Mr. Strauss previously served as Chief Executive Officer and President of Ramius Alternative Solutions. Mr. Strauss is a founding principal of Ramius. From 1963 to 1991, Mr. Strauss was with Salomon Brothers Inc. where he was admitted as a General Partner in 1972 and was appointed to the Executive Committee in 1981. In 1986, he became President of Salomon Brothers and a Vice Chairman and member of the Board of Directors of Salomon Inc., the holding company of Salomon Brothers and Phibro Energy, Inc. In 1993, Mr. Strauss became Co-Chairman of Granite Capital International Group. Mr. Strauss is a former member of the Board of Governors of the American Stock Exchange, the Chicago Mercantile Exchange, the Public Securities Association, the Securities Industry Association, the Federal Reserve International Capital Markets Advisory Committee and the U.S. Japan Business-Council. He is a past President of the Association of Primary Dealers in U.S. Government Securities. Mr. Strauss currently serves on the Board of Trustees of the U.S.-Japan Foundation and is a member of the Board of Trustees and Executive Committee of Mount Sinai Medical Center and Mount Sinai-NYU Health System. Mr. Strauss provides the Board with extensive experience in both investment banking and asset management.

I don't have any particular opinion about these guys as they were pretty much before my time.  I only know how they have been portrayed in the media.

So why bother looking at this?   It is nominally cheap.  As of September 2014, BPS was $4.74/share and tangible BPS was $4.33/share.  It's now trading at $4.44/share which is 0.94x BPS and 1.03x TBPS.  That's not that cheap compared to when LUK owned it.

But there is a near-term catalyst that makes this valuation much cheaper.  Due to previous losses, they have a large deferred tax asset that is not reflected in book value because of the valuation allowance (as they weren't profitable enough to be able to say they can use it).

From the 3Q14 10-Q:
Due to recent and current positive operating results and, because the losses from 2011 are rolled off from the three-year rolling analysis, the Company anticipates to be in a three-year cumulative income position later in 2014. As a result of this development and other positive factors as indicated above, it is possible that the Company could release a large part of the Company’s valuation allowance in the fourth quarter of 2014, which would have a material and favorable effect on Net income and Stockholders’ equity. At September 30, 2014, the Company’s valuation allowance was $137.4 million, of which $135.2 million is related to the Company’s US operations. 
$135.2 million amounts to around $1.20/share.  If this DTA is added to the above BPS and TBPS, we get $5.94/share and $5.53/share respectively.  That makes the valuation 0.75x BPS and 0.8x TBPS.   COWN starts to look cheap again.

Of course, this assumes that COWN didn't lose money in the 4Q of 2014.  We don't know that yet.  And we don't know how much of the valuation allowance will actually be released in 4Q2014.

But if the turnaround is for real at COWN, then we can assume that the DTA will eventually be realized.

BPS History
Any time we look at something against book value, we have to see how BPS has changed over time.  It's not cheap if a company can't or hasn't grown BPS at a reasonable rate over time (or paid out dividends etc.).

Ramius and COWN merged back in 2009, so let's look at BPS and TBPS since then.  Some of the figures may be off by a penny or two since I rounded when making the BPS/TBPS calculations.

                                 BPS             TBPS
Dec 2009                 $6.34            $5.75
Dec 2010                 $5.95            $5.42
Dec 2011                 $4.45            $4.23
Dec 2012                 $4.40            $4.03
Dec 2013                 $4.41            $3.99
Sep 2014                 $4.74            $4.33

So, that's not so exciting.   BPS has been going down since the merger.  How can this be when the market has done really well, generally, since the bottom of the crisis?

OK, so COWN was probably in much worse shape and not positioned for the post-crisis world (I don't think COWN ever even recovered from the other bear market in 2000-2002; it seemed like they were just waiting around for the next bubble to come to bail them out).

But there is hope. COWN is a little complicated because they consolidate some of the funds that Ramius manages.  So we have to look at the economic income (which ignores the consolidated funds and other things).

In general, Economic Income (Loss) is a pre-tax measure that (i) eliminates the impact of consolidation for consolidated funds and (ii) excludes certain other acquisition-related and/or reorganization expenses (See Note 2). In addition, Economic Income (Loss) revenues include investment income that represents the income the Company has earned in investing its own capital, including realized and unrealized gains and losses, interest and dividends, net of associated investment related expenses. For US GAAP purposes, these items are included in each of their respective line items. Economic Income (Loss) revenues also include management fees, incentive income and investment income earned through the Company's investment as a general partner in certain real estate entities and the Company's investment in the activist business. For US GAAP purposes, all of these items are recorded in other income (loss). In addition, Economic Income (Loss) expenses are reduced by reimbursement from affiliates, which for US GAAP purposes is presented gross as part of revenue. 
Here is the economic income of the two businesses (alternative investments (Ramius) and broker-dealer (the old Cowen)) since 2009:

(in $millions)
                    Alternative     Broker-dealer
2009           -25.7                -16.3
2010            31.8                -67.4
2011            10.2                -81.7
2012            18.5                -36.1
2013            10.1                  -3.6
2014*            7.9                 17.4

*2014 is for the first nine months

So it looks like they are really turning around the broker-dealer business.  If this trend in improvement continues, that can really help the stock.  All they need to do is not lose so much money on the broker-dealer side and do well with Ramius.

They have a presentation on the website from November 2014, so let's look at that for a second.

Here are some slides:

What is interesting here is that not only do they have a broker-dealer business and an alternative asset management business; they invest a lot of their own capital into their alternative strategies.  This is different than most other listed alternative asset management companies.    Others do invest in their own funds/strategies, but it usually isn't a large part of their value (OAK, BX etc).

I think it's obvious that the merger in 2009 was driven by the needs of both sides.   Both of them were hit hard during the crisis.

This model sort of reminds me of the old Salomon model.  Salomon made a lot of money trading for itself back in the 1980's, and I think a lot of their ability to take risk came from the steady stream of revenues from their client businesses.

This is why I wondered if Long-Term Capital Management (LTCM) would do as well on its own when they split from Salomon.  For example, if you belong to an organization with a stream of $10 million per day coming in, you can take a lot more risk than if you had zero coming in every day.  With a $10 million per day revenue stream to support risk taking, you can take VAR up to $10 million and you wouldn't lose money even on the bad days ($10 million loss offset by $10 million revenue on that day).  If you include the revenue stream in the VAR, for example, you really shift the curve to the right and really minimize that nasty tail on the left side.

I think this is a big part of why Salomon was able to take such big risks back then, and this may be one of the reasons LTCM couldn't survive when they had one of their outlier days/weeks/months; there was nothing there to offset it or smooth it out.  And this too, by the way, is why JPM and GS are better off 'diversified' than not.

Anyway, moving on.  These are the different strategies that Ramius runs.  And yes, that Starboard is the "put some damn salt in the water when you boil pasta and don't give out so much friggin' bread!" Starboard.  They were spun off so COWN only owns a minority stake.  This could be a good thing or a bad thing depending on what you think of Starboard (I know there is a wide range of opinions!).

AUM growth has been good since 2009.

I am generally not a big fan of managed futures and global macro.  But who cares what I think...

And here is how they are turning around the broker-dealer business:

It is sort of stunning that they have 110% of COWN's book value invested in their proprietary trading strategies.  This could be a good thing for people who want alternative exposure.  But it can be scary; what happens in the next bear market?   If the next bear market causes the broker-dealer business to go back to losing money, it can get scary.

Here is the breakdown of how the capital is invested (by strategy):

Historical Returns
So check out this chart.  It shows how COWN's (and Ramius pre-merger) own invested capital performed since 1999.  It seems like they did fine in the 1999-2002 bear market but got killed in the financial crisis.

Since 1999 (or from the end of 1998), their gross return has been 15.4%/year.  That's not bad at all.

But let's look at it in the different time periods.   From 1998 to the top in 2007, the return was +24.6%/year.   And then they lost -23.7% in 2008.  That's not bad at all, but if this sort of loss happens in a broker-dealer and the b/d business also loses money, things can get pretty ugly pretty quickly.

Since the low in 2008, they earned +10%/year.    So there is something going on that is making it harder for alternative strategies to make money. Or they prudently scaled back their risk due to being part of a broker-dealer.  We don't know how the mix has changed over time so we can't really say.  It's not the stock market, though, because that has done really well since 2008.

Mutual Funds
Ramius runs some mutual funds too with some of these alternative strategies.  There is a website with some interesting information:

Ramius Mutual Funds website

They run four alternative investment mutual funds:

Ramius Hedged Alpha Fund  (RDRIX/RDRAX)
State Street/Ramius Managed Futures Strategy Fund  (RTSRX/RTSIX)
Ramius Strategic Volatility Fund  (RVOAX/RVOIX)
Ramius Event Driven Equity Fund  (REDIX/REDAX)

You can see for yourself at the website, but the performance is not so great.  The Strategic Volatility Fund can't be considered anything other than a total disaster.  True, most of these funds are still new so it will take time to see if they perform well.

The Ramius Event Driven Fund is run by Andrew Cohen, Peter Cohen's son.  The blurb on that fund actually looks interesting but I have no idea if Andrew Cohen has actual experience managing money and if he has a proven track record.

I wouldn't recommend any of the above funds, mostly because I am unfamiliar with the managers and I don't think some of the strategies make any sense.

I actually don't know much about Ramius and COWN.   It is an interesting play for sure if you like this sort of thing (proprietary trading / alternative investments).  But I don't know enough about them and their funds for me to be comfortable.  For alternative asset management, I would prefer the other big names (BX, OAK etc.) and for broker-dealers, I would much prefer GS and LUK.  But that's mostly because of the familiarity I have with those organizations; I have been following them for years.

To date, I have heard very little about Ramius (other than Starboard which has been in the public eye a bit lately) and I never thought much of the old Cowen.  I don't mean it was a bad company,  I just mean that I had no interest in small, boutique investment banks in general; the world seemed to have moved away from that model.

I also have no view, particularly, on the management of COWN (Cohen, Strauss) even though I used to read and hear a lot about them early on in my career.

One big concern for me is how COWN would do in a bear market.  If you get a combination of losses in proprietary / alternative strategies and the broker-dealer business, it might not be a situation I would want to sit through.

Also, Cohen/Strauss and the other old Ramius owners initially owned a bunch of COWN, but it looks like they sold that down in the past few years.  It seems clear that the merger was basically an exit strategy for the Ramius owners.

This is from the 2010 proxy:

Executive Officers and Directors
Amount and
Nature of
Percent of
Peter A. Cohen(1)(2)
Stephen Kotler
Jules B. Kroll
David M. Malcolm(3)
Jerome S. Markowitz(4)
Jack H. Nusbaum
L. Thomas Richards, M.D. 
Edoardo Spezzotti(5)
John E. Toffolon, Jr.(6)
Charles W.B. Wardell, III
Joseph R. Wright
Morgan B. Stark(1)(7)
Thomas W. Strauss(1)(8)
Stephen A. Lasota(9)
Christopher A. White(10)
All directors and named executive officers as a group (15 persons)

...and this is the 2014 proxy:
Amount and
Nature of
Percent of
Executive Officers and Directors:
Peter A. Cohen
Katherine Elizabeth Dietze
Steven Kotler
Jerome S. Markowitz
Jack H. Nusbaum
Joseph R. Wright
Jeffrey M. Solomon
Thomas W. Strauss
John Holmes
Stephen A. Lasota
Owen S. Littman
All directors and named executive officers as a group (11 persons)

It's true that these guys aren't so young anymore, so I can see selling down.  Also,  it might be safer to just own the Ramius funds instead of owning stock in COWN.  If things hit the fan, you may take big marks against you but funds generally don't go bust.  But this can't be said of broker-dealers.  (One of the ironies here is that Ramius had some assets stuck in the London prime brokerage of Lehman when they went under).

This combination of broker-dealer + alternative asset manager + capital invested in alternative strategies can be very interesting when things are going well, but if things go back to where they were (when the b/d was losing money),  and we get a bear market, things might get ugly.

Also, from a valuation viewpoint, ideally, if the broker-dealer business does OK, and the proprietary investments work out like it has historically, then you get the alternative asset management business for free.  A sum of the parts analysis might add a value using some sort of percentage of fee-earning AUM, but I have never really liked that approach since the fee structures differ between firms.

It's hard to put a value on the asset management business if the earnings are not separated out.  For example, other alternative managers are typically valued based on fee-related earnings and incentive fees.  In the case of COWN, I don't know what the fee-related earnings is; if you deduct expenses from management fees, it is negative, but some costs might be offsets to incentive income and bonuses from proprietary trading (strategies done in-house but not for any fund).

So, in any case, you can add some value based on AUM, but I haven't done it here.  (Also, if you deduct investment income from economic income of the alternative investments segment, it's negative every year.  This suggests that the asset management business is not adding value (or there are costs included that are not related to the asset management business)).

If it was clear that fee-related earnings are consistently positive, then that also would add to the stability of COWN; a stable, positive fee-related earnings would help stabilize potential volatility on the balance sheet.

But to date, this hasn't been the case.

In any case, this is an interesting investment.  If someone has more familiarity with the people and funds here (as Cumming/Steinberg presumably did), it's an interesting idea.  But for me, I don't have the comfort level but I'll keep an eye on it.

Thursday, January 15, 2015

Dimon is Right!!

Dimon sounded a bit frustrated on the 4Q 2014 conference call the other day and it is totally understandable.  Yes, JPM and other banks made some mistakes, but it's really strange how regulators are jumping on JPM.  Just like they jumped on Goldman Sachs too, when they were one of the better operators (Fabulous Fab notwithstanding).

Bass Ackwards
The regulators seem to equate size with risk, but I don't think so at all.  The biggest problem that we learned from the financial crisis is not so much the size and complexity of the banks, but the size and complexity of the alphabet soup of regulators!    Simplifying that would go much further in reducing systemic risk.

Size ≠  Risk  (Regulatory Complexity = Risk!)
If we think back to the financial crisis, Citigroup was the only large bank to get into trouble.  The big failures, remember, were Bear Stearns (not even the biggest investment bank and not integrated; it was not too big or too complex at all), Lehman (same, this was not a global bank but an independent investment bank), AIG (this was not even a bank or an investment bank!  And I don't know that complexity had anything to do with it.  Bad trades were put on, basically, in two divisions).   Of course there was Countrywide, IndyMac, Wamu and some others.   (By the way, during the S&L crisis in the late 80's, the absence of size didn't seem to help much.  Sometimes it's more complex to deal with 1,000 small problems than, say, one big one).

I remember when a reporter for the Economist wrote that the beating up of banks and investment banks after the crisis is like when a fight breaks out in a bar.  Some people don't go find the guy that started it and punch him, but just punch the guy sitting next to him because he never liked him (and it was a good time to punch him).  That's sort of what it feels like.

Also, I'm not going to bother to Google it and post it here, but U.S. banks aren't even that concentrated (large relative to economy) compared to most other large banks in the rest of the world.  The deposit share of the large U.S. banks are much smaller than, say, Japanese, German and other banks around the world.  Are those banks riskier?  (well, if the answer is yes, it's for different reasons!).

So I don't agree that size = risk.  JPM, in fact, was (as Dimon keeps saying) the strong haven during the storm of the financial crisis.  They got through the crisis without losing money in a single quarter, and they had to buy some of the failing institutions to help bail the system out.

This is hardly proof that size = risk.

In fact, when the crap hit the fan, Goldman Sachs and others rushed to find a partner that had stable deposits (banks) so as to stabilize themselves.

What does that mean?  Are independent investment banks safer than universal banks? The real life stress test of the financial crisis seems to have proven that the integrated model might be sturdier.

Break Up JPM?
And the idea of breaking up JPM is an interesting one.  Honestly, I looked at that idea too a few times in the past and thought about making it a post here, but didn't because I didn't see it as a good idea.

First of all, JPM has done really well over the years due to the many different revenue/earnings streams it has.  The volatility of the investment bank can be smoothed out by the stable consumer business.

And too, a quick back-of-the-napkin look showed that it's not really all that interesting.

This is very crude and I'm sure Goldman and others have a better analysis, but here's my simple look at the idea of a split:

Value-Enhancement From a Split
I don't know what all the different parts would trade at, but the main things that are viewed as undervalued are the Investment Bank (actually, not the whole investment bank as GS is cheap, but the advisory business which seem to trade at high multiples (Greenhill, Evercore etc...) and Asset Management.

So assuming JPM trades at 10x P/E, this is what the market is implying these divisions are worth:

                                          Net income              Value@ 10x  
Asset Management             $2.2 billion              $22 billion
Advisory                             $320 million            $3.2 billion
Total                                                                    $25.2 billion

For the investment bank, you could use the $6.6 billion investment banking fees, but that includes underwriting and that actually takes capital and size to do.  Evercore and Greenhill are valued highly because they don't need balance sheet and distribution; they just advise on mergers etc.

That's why I used the advisory fees earned by the investment bank of $1.6 billion and used a 20% profit margin to get $320 million net income.  20% happens to be the net margin for the whole investment bank for JPM, but that's a lot higher than the margins at Evercore and Greenhill so I'm being generous.

So how would the market value these independent entities?  Well, asset management used to trade at a 20x P/E; I think it's lower now (Blackrock is at 16-17x) , but let's use 20x to be generous.  Also, boutique advisory firms used to go for 30x.

So using the above net income figures and new valuation, here's what they would be worth on their own:

Asset Management:  $2.2 billion x 20x =     $44.0 billion
Advisory:                  $320 million x 30x =     $9.6 billion 
Total:                                                             $53.6 billion 

So the financial alchemy from this split would increase the value of JPM by $28.4 billion!   Yay!  Right?  But wait a second.  JPM has 3.7 billion shares outstanding and it closed at $55 or so today.   That's a $200 billion market cap.   That's a nice 13% pop!    13%?  Yup.  Just 13%.  All that work, risk, hassle for a one-time 13% pop.

Oh, and don't forget, synergies from this integrated model is $6-7 billion according to JPM's 2014 Investor Day presentation.  This synergy can come from all over the place, not just between these two entities and the bank.  But since Asset Management probably gets a lot of assets from JPM the bank, a lot of it might be from there.

If a split makes these companies independent, then that $6-7 billion might go away. Yes, maybe not.  We don't know where those synergies are.  But let's say it goes away.  What is that $6-7 billion in net profit worth to shareholders?  Let's just use the lower 10x that JPM trades at.

That's a possible $60-70 billion decrease in value due to un-synergies!  

So yeah, you might be giving up $60-70 billion value (at a cheap 10x) for an instantly gratifying one-time gain of $28.4 billion today.   Is this really a good idea?  Hmm...

Splitting the Whole Investment Bank Itself
OK, so you may be wondering, wouldn't the bank itself be worth more without the investment bank?  Maybe.  But here, in the above scenario we are just ripping out the good businesses; Asset management and Advisory.

But yes, if the whole investment bank is holding down the valuation of JPM, we can look at it the other way.  Take away the whole investment bank and put a 12x multiple on the bank (and leave the investment bank at 10x,  12x is where Wells Fargo is trading).

Well, the banking businesses had net earnings of $11.8 billion.  I'm looking at Consumer and Community Banking and Commercial Banking.  If the multiple on that goes from 10x to 12x, that's an enhancement of $23.6 billion in total value, similar to the above splitting off of the high value pieces.

And the same argument about synergies may apply.

Oh yeah, it's not that simple.  There is a cost to being big and integrated (and diversified, stabler and more Gibraltar-like).  There is that extra capital for the bigger, more complex banks (how about lower taxes for entities that have to deal with unnecessarily complicated multiple regulators?!  Banks seem to have to play a game of Twister to keep everyone happy.  It's a miracle they are still in business!).

So here's a snip from the 2014 Investor Day:

The net income contribution assumes 50% overhead ratio and 38% tax rate.  Cost of equity is 12% based on some CAPM model they used (5-year average).

But check it out.  They only need $3 - 6 billion in gross synergies to be SVA positive (Shareholder value added) on incremental capital requirement.   By the way, that equates to $1-2 billion in additional net income.

So looking at the G-SIB requirement of 2.5% (JPM falls under the 2.5% bucket), let's see how much additional capital they need to hold.  Risk-weighted assets at year-end was $1.6 trillion.   2.5% of that is $40 billion.    So JPM needs to hold $40 billion more in equity capital than others, just because they are big, sturdy, safe, diversified and rock-solid.

Assuming a 12% cost of equity capital, JPM needs to earn at least $4.8 billion in incremental net profits to justify being a Systemically Stable Important bank (remember, they were a stabilizing force during the crisis; how about negative capital requirement for that?!).  As shown above, the synergistic effects of the current integrated model is $6-7 billion.   So already, they are earning enough to more than offset that added capital requirements for their current model.

And from there, if further capital is required, as it says in the above slide, they only need another $3-6 billion (in gross synergies), or $1-2 billion on a net income equivalent basis.

But you will notice that they already earn $6 - 7 billion extra from the current model versus the $4.8 billion needed to make up for the 2.5% G-SIB, so they are already earning enough to make up for another 50-100 bps in capital.

I'm sure, though, that JPM will keep refining pricing and products so that they will more than make up for further capital requirements.

OK, so this was quick and crude so you can nitpick this and that.  I know there are other businesses within JPM that earn high ROE's, but I don't know about tearing them apart and then slapping high multiples on them.  If you do that, then you have this huge corporate piece left over.

For me, the idea of a spin-off or split to enhance value was mostly about splitting off the asset management business.  That's where the multiples differential seems to be the highest.  And the advisory business too.

But ripping the whole investment bank away probably wouldn't change the value much as Goldman Sachs, Morgan Stanley and others are not valued any higher than JPM.  It might make the lone bank trade higher (12x vs. 10x), though.  Plus, the fact that the two independent pieces would not be able to smooth each other out would suggest higher earnings volatility, lower balance sheet stability and lower credit rating, so it might be value destructive.

But I don't know.

What I do know, though, is that it seems like:
  1. Splitting up JPM might enhance value on a one-time basis, but the loss in synergies might lose more value in the end. 
  2. Splitting up JPM to escape G-SIB and other capital measures is interesting, but the above analysis shows that maybe the synergies more than offset the onerous, additional capital requirements necessary to maintain their model. 
So I think the "break up JPM!" crowd is wrong.  It may not enhance value.  I think much of JPM asset management AUM comes from the bank and investment bank.  On it's own, they don't have any of the distribution infrastructure like Fidelity and other independent fund companies.  To build this out would probably take a lot of time and money.  

Too, the advisory business on it's own would have to work harder to get business.  Oh yeah, and think about how JPM got the Shake Shack IPO partly because JPM was their banker!  That's synergy right there, right?  (OK, SHAK is not an advisory client, but an underwriting client)

And for regulators, I think they're wrong! It's not the banks and financial institutions that are too complicated.  It's the regulations and regulators!!  Simplify that alphabet soup of regulatory entities and stop making the banks play a game of Twister trying to satisfy this and that rule from all different directions!  

As usual, things are just bass ackwards, and I can see why Dimon is so frustrated these days.

Tuesday, January 13, 2015

Market Timers vs. Macro Hedge Funds

OK, so this is another post that follows a discussion in the comments section (of previous posts).  I think it's pretty important so I thought I'd expand on a comment I made and turn it into a post.

Halo Effect
No, not the book.  But the same idea.  I think some of these top-down, market-timing mutual funds in the past have benefited from a sort of halo effect.  For example, people read about how Soros made billions betting against the Bank of England.  They read about how some hedge fund wizard made a killing shorting Japanese stocks.  They read about a trader that had a massive position in index puts on the day of the crash.  They read about how someone piled into subprime default swaps and made a killing during the crisis.

So they see all these people making tons of money while other, "normal" mom and pops lose their shirts in a nasty bear market.

And then they see these funds that promise to watch out for these macro factors and structure the portfolio accordingly, promising them that they won't get crushed in the next bear market (never mind that there is a cost to that; a cost/risk that is not at first evident).

Most individual investors don't have access to hedge funds, so these market-timing funds sort of fill that need to have an 'alternative' to the usual equity funds.

The more volatile the markets, the higher returns that the big hedge funds show, the better relative performance these market-timing funds put up in the short term, the more popular these funds get.

Market Timing Funds Have to Be Right All the Time
But there is a big difference between the big hedge funds and the market timing mutual funds.  The market timing mutual funds, for the most part, have to be right just about all the time for them to do well.  If they miss one bear market, their performance is in the tank.  If they miss one rally, that can also destroy their performance.  Once you do that, it gets exponentially harder to try to make it back.

For example, you can take some of the great traders from the past.  Say, George Soros or Stanley Druckenmiller.  I can't prove this or know for sure, but I am pretty certain that if they had a mandate to hold an equity portfolio and then hedge it according to their market views over the past 30 years or so, they would not have gotten anywhere near keeping pace with the S&P 500 index.  No way.  Druckenmiller himself has said that he has predicted 15 of the last 3 bear markets (or something like that; I don't remember the numbers but you get the point!).

Difference Between Market Timing Funds and Macro Hedge Funds
Contrary to popular belief, most of the high returns generated by macro hedge funds are not from timing the stock market.   Yes, some have made tons of money shorting stocks on Black Monday (Soros was actually on the wrong side of that, famously having sold the low tick on Tuesday), shorting the Nikkei crash in 1990-1992 etc.

But most of the money, I would guess, in macro hedge funds were made in fixed income and currencies.  Back in the 1980's and 1990's, there were a lot of strong and persistent trends, macro imbalances with sudden corrections and other things that allowed hedge funds to make tons of money.  And these funds put these trades on with massive leverage; leverage that can't be replicated in the usual equity mutual fund format.

So they can be wrong about the stock market for years and still make tons of money (also, if they are bearish and short, they don't stay short for very long when the market goes against them).

However, market timing funds don't have alternative sources of income.  They live and die, basically, by being right about the U.S. stock market.  And they have to be right year in and year out.  It's just impossible to do that.  Not even Soros can do that.

A lot of macro hedge funds take massive bets, but they do so in many markets around the world.  If they have no opinion about the U.S. stock market, they can still go long something else somewhere in the world.  Like Buffett looks for the easy questions to answer, macro hedge fund traders do the same thing; they look for the easier questions to answer.  They don't have to know where the stock market will go.

One of the big macro funds today has a bunch of non-correlated trades on.  So they can be wrong about the stock market or interest rates, or even both and still make money because they have different trades on with uncorrelated factors.

If you are a market timing fund, you have to be right about the stock market.  If you are right, that's great.  If you are wrong, that's it.  It's hard to make it back.

This is not to say, of course, that all macro hedge funds are good.  It is very hard to make money in global macro hedge funds and there are plenty of failures there too.

I am only trying to illustrate the difference between market timing mutual funds and the global macro hedge funds.  Some market timing mutual funds talk about going into various asset classes and flexibility to go anywhere, but it seems like they are still mostly driven by being right or wrong about U.S. stocks.

OK, so here goes one of my analogies that might just confuse the issue.  But anyway, it goes back to Rumsfeld's known knowns, known unknowns and unknown unknowns.   By the way, I am not a fan (or unfan) of Rumsfeld; it's just a convenient expression.

Buffett is known as a great stock picker.  He has done well for more than 50 years.   But if you look at Wall Street analysts, they do no better than random.  Why is this?  The usual interpretation is that Wall Street analysts are just incompetent.  But I beg to differ.  Many Wall Street analysts are very smart.  Yes, I've met some really, truly dumb ones.  But most of them are normal, highly intelligent, hard working people.

So why are they so wrong all the time?  Well, they're not wrong all the time.  They are just no better than random.

But again, just like asking Soros to hedge and unhedge a portfolio over the years, if you ask Buffett to look at a list of the S&P 500 stocks and pick the ones that will outperform over the next year or even five years and then pick the ones that will underperform, I bet he will do no better than random.


Because for most stocks, his opinion would be "I don't know".  Most stocks would go into his "too hard pile".  If we force him to choose, buy, sell or hold, he will choose.  But he will have no conviction.   And he will probably do no better than random.

The key here is that in order for him to do well, he doesn't have to have an opinion on most stocks!  He only has to have conviction on the ones he understands well and has a strong opinion about.  He can ignore the rest.

Wall Street can't do that.  Analysts, in aggregate, can't say, "no opinion".  They have to say, buy, sell, or hold.   Not to mention that they have to guess the next quarter's EPS etc.  I don't know if Buffett would be any better at guessing EPS on a quarter to quarter basis than Wall Street analysts.

Again, it doesn't matter because he doesn't have to do that to do well!  But Wall Street does.  This is why Buffett is not often wrong while Wall Street is very often wrong.    In fact, Buffett has been wrong about all sorts of things but it hasn't hurt his performance because he knows what he doesn't know (he predicted a housing recovery that never came, higher interest rates that hasn't come yet etc.)

Back to Market Timing Mutual Funds
Similarly, market timing mutual funds, like Wall Street analysts, have to have an opinion all the time. They have to be long, flat or short.   They can't really say, "I don't know" and just stay flat, as that is their only source of profits.  Yes, some funds have flexibility to go elsewhere, but for all practical purposes, other assets will usually only be a small part of an equity mutual fund.

Macro hedge funds can afford to say I don't know about the U.S. market and choose to do something elsewhere.  They can put on massive, leveraged bets on things they have conviction about and don't have to have a view on the U.S. stock market at all.  They can just go out and find something they do have conviction about.

Fallacy of Overvalued Markets
When you look at these long term charts, it's really easy to fall into the trap of saying, "gee, look how expensive the market was in 1929, 1962, 1972, 1987, 1997, 1999 etc...  We should have shorted the market at these levels!".

Yes, expensive markets are often followed by corrections.  Sometimes corrections are meaningful, like in 1929, 1999 and 2008.  Sometimes they are not, like 1987.

But this is sort of like the guns and bank robbers fallacy.  All bank robbers have guns, but not all gun owners are bank robbers.  Many large corrections and bear markets are preceded by overvalued markets, but not all overvalued markets are followed by bear markets or corrections.

Here, check this out:

CAPE 10 (inverse): 1909 - 1992

Again, Excel couldn't handle the length of data so I chopped it off at 1909.  If you go back further, the chart is even more convincing as CAPE10 (inverse) was under 5 in 1901.

If you saw this in December 1992 when the CAPE10 yield fell under 5% for the first time since the late 1960's, it would have been perfectly reasonable to assume that the market is very overvalued, even more so than right before Black Monday.  I didn't do it, but you can put an average on here and then standard deviation bands around the 100-year average, and it would have told you that the market was really, really outlier expensive in late 1992.  Look what happened to the market in that past after it got below 5% CAPE yield; 1929, 1937, mid 1960's etc.

It is a visually compelling argument.  It's hard to argue that the market is not overvalued at this point.  I just picked a 5% yield because it corresponds to a 20x P/E ratio that usually makes people think the market is expensive.

But check this out.

Where was the Dow and S&P 500 index back then?

                        December 1992                   Now          Chg       per year
DJIA                3301                                    17613         5.3x       +7.9%
S&P 500            436                                      2023         4,6x       +7.2%

And this 7-8%/year return since then, when the market was just about as overvalued as ever is excluding dividends.  That's just the change in the index level.  Throw in dividends and it's probably close to 10%/year.  From an expensive market!

And then check this out:

CAPE 10 (inverse):  1992 - 2014

If 5% earnings yield was silly expensive and you held to that 'standard' which has proven itself over 100+ years in the stock market, you would have basically been out of the market (or even short) for just about the whole period since 1992.  You may have gotten in during the financial crisis, but then you would have gotten out again pretty soon after that.

It's crazy, isn't it?   Now you see why a lot of people have been saying that the market is overvalued for more than 20 years!

This is why it's so dangerous to make investment decisions based on this stuff.  And again, this is why Buffett is such a great investor; he ignores it.  Well, I'm sure he sees the graphs and charts and goes, whoa...  But he doesn't let this stuff distract him from doing what he knows what to do.  And he isn't tricked by these charts into thinking that he can guess where the market will go in the future.

As great as any argument sounds, you still really can't know what is going to happen to the stock market going forward.

You can look at these charts and go, wow, returns are going to be lower going forward.  I've seen those tables that show stock market return based on the P/E ratio of the market on the initiation date.  Yes, higher P/E's mean lower prospective returns.

But what I haven't yet seen is a table that shows, for example, that when a P/E is 25x, that, say, there is a 30% probability of a 30% correction within the next three years such that if we get long at the bottom of such bear market, our total return from this timing strategy will be Y%.  This could be a table.  Maybe there is a 50% chance of a correction of 30% or more within the next five years after such a valuation, and if this happened, and we were able to go 100% long at the bottom of that bear market, our prospective return would Y% etc...

All of these possible scenarios have to be calculated, including the probability that there won't be any correction greater than 20% within the next five years.  And if the sum of all the expected returns in all those scenarios is higher than the prospective, buy-and-hold expected return, then you can say maybe it's a good idea to try to time the market.  But then again, we all know how these complicated calculations with layers and layers of assumptions go.

But anyone who has traded (and/or studied) equity derivatives knows, there is a cost to such opportunism and it can be calculated.  For example, in the old days, there used to be interesting-sounding options like "down-and-in" options, or "lookback" options, and other trigger or barrier type options.  These options were designed for buy-the-dippers.  For example, you can create  a call option that becomes effective when the market goes down 10%, and the strike price becomes the stock market level 10% lower than when you put on the trade.  Of course, you would have to pay a call option premium to the seller for them to take that risk, and for them to effectively 'trade' for you.  If the market didn't go down 10% within the time period of the call option, it expires worthless and you lose your premium.

The theoretical value of these options can be calculated, incorporating the probability of the movements in the market, trading costs etc.  And this theoretical cost would effectively be the opportunity cost of waiting for the market to come to your level.  This has to be compared to the buy-and-hold, fully invested return.   If, say, interest rates were 8% and the expected return in the stock market is (unlikely in this scenario) 1%, and the knock-in option is worth 3%, then maybe it's a good idea to sit it out; you are getting paid 8% to wait, and out of that you pay 3% for an opportunity to get in lower, so you are earning 5% already; much better than the 1% you would get by investing fully now.   Again, unlikely scenario, but I just did that to illustrate the thought process that would go into something like this.

Even simple hedges have their costs.  You can buy put options to hedge against stock market risk, but those premiums can add up over time.  And especially in this lower return environment, it's going to be hard to make money with low return stocks when you dish out a bunch of money on put premiums.

But again, if you can precisely calculate the odds, maybe some sort of hedging structure makes sense.

But  you never really hear anything like that.  Usually, it's something much simpler, like, "the market is overvalued because the P/E ratio is as high as it's been in 100 years, therefore the market must go down soon so we will buy puts, short futures and buy gold", or something like that.

So anyway, market timing mutual funds and macro hedge funds are very, very different animals. They are not even close in terms of what they do and how they make money.  Even the best traders of all time, I don't think, could time in and out of the markets if his sole mandate was to hold a U.S. equity portfolio and then hedge / unhedge according to his market views.  No way.  In fact, many of the great macro hedge fund traders have lost tons of money trying to short the U.S. market.  But they make it up elsewhere in other massive, leveraged trades so it's not an issue for them.  Each trade is like a single poker hand; one bad hand or bad beat is not going to ruin their year; and macro hedge fund traders typically make many, many trades a year (as opposed to market timing funds that make very few decisions; if they are bearish due to market valuations, they will stay bearish etc.)

If a market timing mutual fund gets the timing wrong, it's just going to be a total disaster.

Just as there is no way that even Warren Buffett can predict which stocks will go up and down in the future (out of, say, a list of the 2000 Russell stocks), even the best macro hedge fund traders couldn't time in and out of the markets consistently.

And the key is that neither Buffett nor macro hedge funds have to do that.  Just like Buffett has to only find the questions he knows he can answer (just buy the stocks that he thinks will go up and then ignore the rest), macro hedge funds can take massive bets when they see an opportunity and can throw the direction of the U.S. stock market in the "don't know" bucket and leave it there for years if need be.

But just like analysts have to have an opinion on every single stock they cover (even if they personally may be indifferent and have no strong opinion either way most of the time), market timing funds have to always have an opinion on the market, and if they are wrong, they are dead.

It is impossible for market timers to get it right consistently all the time just as it is impossible for analysts to be right on every opinion they have on every single stock they cover.

But unfortunately, those people are in a game they can't win.  Buffett and macro hedge fund traders have the luxury to only pick their shots when they have conviction.

Having said that, not all macro hedge funds are good.  Most are probably no good.  And having said what I said about analysts, they do have a role to play in the financial markets.  It's not always critical for them to be right or wrong on stocks; they do act as a conduit between companies and investors.  And they have sort of a high level 'reporter' role in keeping a professional eye on companies and report on various developments.   Many analysts are valued not necessarily for being right or wrong, but for their deep knowledge about companies and industries that can be helpful to investors.

And no, I am not arguing that the markets will stay expensive forever.  I am just trying to point out that it is not so easy as saying "the market is expensive, let's get short!".