Friday, April 23, 2010

Sometimes Wall Street provides more entertainment than Hollywood: PART 1 the winners

Goldman Sachs as entertainment; stop dancing on graves; make some money instead

Many people take a very narcissistic view of Goldman Sachs (GS) without realizing it. GS serves an audience. But, like the line in the Bob Dylan song says, “It ain’t me babe. No. No. No. It ain’t me.” The idea that a high profile institution exists to serve someone other than them really gets many peoples’ nose out of joint. Many people figure any institution that doesn’t put them at the center of the universe must be evil. It’s as if it has to be a conspiracy since, to their thinking, they should be the center of the universe.

Well, a far more constructive and profitable view exists. The March 30 posting entitled “Wall Street doesn’t run the world” points out that not being the center of the universe creates investment opportunities. In fact, it used a GS recommendation to illustrate the logic. Yet, instead of capitalizing on not being the center of the universe, people persist in believing that if it hurts their ego, it must be hurting their pocketbook. They hurt their pocketbook in the process of protecting their egos.

To see how absurd it can be and to identify some investment opportunities in the process, consider the logical inconsistencies people will tolerate in order to retain their predisposition.

“What are the inconsistencies and how can one make money off of them?” you ask. For starters, in the most generic terms, ignoring information that is inconsistent with a predisposition violates a basic of good investing. Behavioral economists refer to this as looking for confirming information and minimizing non-confirming information. The investment saying is “when your reason for getting in looks wrong, get out.” I prefer: “always question your assumptions” and would add “question other peoples’ assumptions, too.”

That’s all very generic; let’s get to GS. Here’s the inconsistency and how to make it pay. GS received TARP funds, was converted to a commercial bank, borrowed from Warren Buffet at some pretty high rates, and took a pretty big balance sheet loss. All the while, people persisted in believing the “GS runs the world” conspiracy nonsense. Now that’s pretty darn inconsistent unless you think GS was intentionally conspiring to make others rich. In fact, it makes it pretty silly to persist in believing that the financial industry is a game that’s rigged in GS’s favor.

So, here’s the investment theme: “even if you buy into a conspiracy theory, don’t pay money to do it.” A disclosure is in order. About three to six months ago quite a few people were advising to buy GS stock: “they run the world, after all.” Since then, numerous alternatives performed better including the indexes. This isn’t the first time not buying stocks that were the supposed beneficiaries of conspiracy theories facilitated relative performance. Some time after Chaney became VP, it became fashionable to believe that he would conspire with his ex-coworkers to enrich Halliburton. I don’t remember the exact dating, but in that case investing in Halliburton as a trade would have been a disaster. Conspiracy theories are entertainment, nothing more.

Now, consider Gregory Zuckerman’s reporting on John Paulson’s trading. As is making headlines currently because of GS’s role, he made billions by betting that the growth of sub-prime mortgages was a bubble. For a relevant example of Zuckerman’s reporting, consider this item:

What does this item tell us about erroneous conspiracy theories and investing? First, it certainly should put to rest the idea the GS ever ruled the world. Second, the investigation and evidence collection began under one administration and the civil complaint was filed under another. That should call into question efforts to couch the entire issue in partisan political terms. The investment implication is that changes in administration have very little impact on investment risk. Finally, it should raise some questions about the nature of the relationship between politicians and Wall Street. It isn’t always easy to tell who is using whom. That implies that avoiding situations with Washington-based headline risk is an effective risk reduction strategy for most investors.

Truth is, to really get the full benefit of the issue’s ability to provide guidance on investing one should read Zuckerman’s book, THE GREATEST TRADE EVER: THE BEHIND-THE-SCENES STORY OF HOW JOHN PAULSON DEFIED WALL STREET AND MADE FINANCIAL HISTORY. Note that just from the title the basis for one conspiracy theory gets shot down. Wall Street can be profitably “defied.” More importantly, implied by that, and as described in the book, Wall Street isn’t a monolith. Wall Street’s counterparty is often Wall Street; hardly the chummy bunch of insiders populating many conspiracy theories. So, when stocks in Wall Street firms move in lock step, especially as a result of a scandal, somebody is being painted with too broad a brush.

There’s another potential idea for traders. If the investor is willing to take on the risk associated with an investment with a carry-cost (e.g., a short sale or analogous derivatives) or to make a time-dependent trade (e.g., an option), betting against a conspiracy theory is usually a winner. Put differently, one should consider shorting the supposed beneficiary of the conspiracy. But remember, one has to get the timing right as well as to be right. Being proved right after having lost your money may gratify the ego, but egos and investments are two different things. The Zuckerman book was written in late 2009. It took over six months, close to a year, for the impact of the events documented to really hit GS, thus this posting’s preference for avoiding the long rather than initiating a short.

Zuckerman’s book actually goes well beyond just Paulson in describing people making the trade. One thing comes through load and clear: not all the people making the trade could have been a part of any feasible conspiracy. They are just too diverse and scattered a group. Some were secretive about the trade; others were quite proud of it; some viewed others making the trade as a competitive threat; others seemed to sympathize with them as soul mates struggling to make the same trade. Almost all of them viewed their counterparties with suspicion, not as co-conspirators. For investors, the book is a pleasant reminder that when investing one has to think about seller verses seller competition, buyer verses buyer competition, seller verses buyer competition, and buyer verses seller competition.

But more than anything else, the book highlights how difficult it can be to successfully be a trader even when one’s forecast is on target. At this detailed level, the book makes the notion that all successful trades are based on insider information look as foolish as it is. Having the right information failed to be enough for many investors trying to make the trade.

It’s at that detailed level where the book is particularly informative because it highlights some of the skills required to turn good ideas into good investments. To illustrate, getting over-leveraged and consequently not being able to carry the position brought down some traders. When considering shorting a bubble, investors should remember that bubbles often go exponential before busting. Others just initiated the trade too soon. Then they got discouraged and took the trade off just as it started to make money.

Still other people were scared off the trade by dreaming up conspiracies to explain why their trades weren’t working out when they thought was appropriate. It’s dangerous to attribute motives to participants in a trade. It’s foolish to think there is a conspiracy, stupidity, malicious intent, or anything else explaining the entire market. You just don’t know and don’t need to. There’s probably some of each happening as well as differences in objectives and outlooks.

The only example of where understanding motives contributed to successful trades was a motive that’s usually overlooked in conspiracy theories. All of the investors realized that the transaction fees were driving behavior, not the resulting investments. However, that wasn’t necessarily counterparty’s motive; more often it was the middleman’s. Further, they put effort into understanding whether their immediate trade was with a counterparty or a middleman. Conspiracy theorists often overlook, misinterpret, or confuse the distinction. It’s not a good idea for investors to do the same.

Once the people making the trade understood who their counterparty would be, their primary concern wasn’t motive. Their concern was solvency. Getting a commitment to be paid and getting paid are two different things. It’s informative that successful investors worried more about ability to pay than intent. One suspects they relied on the contract to manage intent leaving ability as the open issue and primary concern. Not a bad approach in general.

Counterparty solvency is particularly important when considering investments in derivatives, especially things like synthetic CDOs where collateral is questionable, some would say non-existent.

Finally, the biggest lesson for investors is that all the people making the trade didn’t bother dancing on graves. Rather, they focused on what they could control.

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