Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM EST Wednesday, January 30, 2008:
I continue to not like stockmarkets. The little bounce we've had anticipates
another Fed rate cut. I suspect that that rate cut (scheduled for today) won't
be sufficient. As a matter of principle, one should never trade in front
of a potential Fed rate cut, or a company earnings report. You'll be wrong
far more times than you'll be right. This market and the economy remain weak.
When in doubt, stay out. Don't fell compelled to trade, as Wall Street obviously
did (and probably still does). Keep reading.
Stein believes traders control the stockmarket. Several
readers claim they don't. I'm semi-dubious. I don't know precisely how
much traders "control" the market. But I've heard figures for traders
and computer trading to be as high as 70% of daily volume. And we do know (from
his first book) that Cramer contacted the press and badmouthed or extolled stocks
he had positions in. The era of the trader may be waning, as this piece from
of VaR (Value at Risk) Evoked as Risk-Taking Vim Meets Taleb's Black Swan
model that emboldened Wall Street to trade with impunity is broken. Everyone
from Merrill Lynch & Co. Chief Executive Officer John Thain to Morgan
Stanley Chief Financial Officer Colm Kelleher is coming to the realization
that no algorithm or triple-A rating can substitute for old-fashioned due
Value at risk,
the measure banks use to calculate the maximum their trades can lose each
day, failed to detect the scope of the U.S. subprime mortgage market's collapse
as it triggered more than $130 billion of losses since June for the biggest
securities firms led by Citigroup Inc., Merrill, Morgan Stanley and UBS AG.
The past six
months have exposed the flaws of a financial measure based on historical prices
that securities firms use idiosyncratically and that doesn't anticipate every
potential disaster, such as the mistaken credit ratings on defaulted subprime
debt. "Finance is an area that's dominated by rare events,'' said Nassim
Taleb, a research professor at London Business School and former options trader.
"The tools we have in quantitative finance do not work in what I call
the 'Black Swan' domain.''
"The Black Swan,'' published last year by Random House, describes how
people underestimate the impact of infrequent occurrences. Just as it was
assumed that all swans were white until the first black species was spotted
in Australia during the 17th century, historical analysis is an inadequate
way to judge risk, he said.
Merrill, Morgan Stanley and UBS took steps in the past six weeks to overhaul
their risk-management groups after internal models failed to foresee the first
annual decline in house prices since the Great Depression that eroded five
years of trading gains.
Group Inc., the firm with the highest nominal VaR, was the sole investment
bank to report record earnings in the fourth quarter, while New York-based
Merrill, which had the second-lowest nominal VaR of the five biggest U.S.
securities firms, posted a $9.8 billion loss for the last three months of
2007, the biggest in its 94-year history.
Thain, who replaced
the ousted Stan O'Neal last month at Merrill, said Jan. 17 that the largest
U.S. brokerage should stop making trades that have the potential to wipe out
profits. He revamped the unit overseeing trading positions and hired former
Goldman executive Noel Donohoe as co-chief risk officer.
UBS CEO Marcel
Rohner told employees two weeks ago that Europe's biggest bank will scale
back risk taking after reporting a $15 billion writedown last year for subprime-infected
investments. As part of the plan, Zurich-based UBS shut a U.S. fixed-income
At New York-based
Morgan Stanley, which disclosed a $3.56 billion fourth-quarter loss after
writing down mortgage-related and other securities by $9.4 billion, the risk
department will now report directly to Kelleher instead of to the trading
heads. The firm said it plans to hire more risk managers.
was a result of an error in judgment that occurred on one desk in our fixed-income
area and also a failure to manage that risk appropriately,'' Morgan Stanley
Chief Executive Officer John Mack said on Dec. 19. "We're moving aggressively
to make necessary changes.''
might help protect firms against rogue employees. Societe Generale SA, France's
second-largest bank by market value, said last week that unauthorized trades
caused a $7.2 billion loss, the biggest in banking history. The trading wiped
out about two years of pretax profit at the Paris-based company's investment-banking
said the trader was Jerome Kerviel, 31, who joined the bank's trading division
in 2006 after working six years in the company's back office. He had "intimate
and perverse'' knowledge of the bank's controls, which enabled him to avoid
detection, Co-Chief Executive Officer Philippe Citerne told reporters on Jan.
a whole other side of risk management,'' said Benjamin Wallace, who helps
oversee $850 million at Grimes & Co. in Westborough, Massachusetts, which
owns shares of Morgan Stanley and Merrill. "That's not the modeling,
that's making sure that people are overseen properly.''
managers and giving them more power won't alter the mistake that led to last
year's slump and that was Wall Street's dependence on statistics to quantify
risks, Taleb said.
had dismal failures in quantitative finance in measuring these risks, yet
people hire quants and hire risk managers simply to back up their desire
to take these risks,'' he said. "There are some probabilities that
you cannot compute.''
Banks and securities
firms increased the size of their trades during the past decade on interest
rates, stocks, commodities and credit. Trading revenue for the five largest
securities firms -- Goldman, Morgan Stanley, Merrill, Lehman Brothers Holdings
Inc. and Bear Stearns Cos. -- climbed to a combined $71.1 billion by
2006 from $29.1 billion in 2002. The higher profits added to the firms'
capital, enabling even bigger trading bets.
scale your value at risk relative to your book value,'' said Wallace. ``It
was a self-reinforcing part of the cycle.''
daily VaR more than tripled to $151 million in the fourth quarter from $46
million five years earlier, according to company reports. Goldman's VaR was
almost twice as high as Merrill's in the third quarter.
third-quarter daily average VaR was $76 million, compared with Goldman's $139
million, Morgan Stanley's $87 million, Lehman's $96 million and Bear Stearns's
All the New
York-based firms base their calculations at a confidence level of 95 percent,
meaning they don't expect one-day drops to exceed the reported amount more
than 5 percent of the time.
differ in part because every firm uses their own methodology and data. For
instance, Lehman uses four years of historical data to calculate VaR, with
a higher weighting given to more recent time periods, while Morgan Stanley
provides VaR calculations using both four years and one year of market data.
compare what peoples' values at risk are versus what their losses were in
the third quarter or fourth quarter, the numbers are astounding,'' said David
Einhorn, president and co-founder of hedge fund Greenlight Capital LLC in
New York. "There are a lot of things that probably the value-at-risk
model said would have trivial losses 95 percent of the time or 99 percent
of the time but are now having a huge loss.''
one-day value at risk in the third quarter was $92 million, indicating that
the firm's maximum expected cost during the 63-trading day period would be
$5.8 billion. In fact, the firm wrote down $8.4 billion from the value of
collateralized debt obligations, subprime mortgages and leveraged finance
commitments, 45 percent more than the worst- case scenario.
All of the risk-measurement
tools failed to prepare Merrill for the unforeseen declines on triple-A rated
securities backed by subprime mortgages, according to the company's third-quarter
filing with the U.S. Securities and Exchange Commission. The firm's writedowns
related to the highest-rated portions of CDOs backed by pools of home loans,
which plunged in value as defaults on the underlying mortgages soared.
tests and other risk measures significantly underestimated the magnitude of
actual loss from the unprecedented credit market environment,'' Merrill's
filing said. "In the past, these AAA ABS CDO securities had never experienced
a significant loss in value.''
developed statistical models during the early 1990s to better quantify risks
as the trading of bonds, stocks, currencies and derivatives increased. J.P.
Morgan & Co., now part of JPMorgan Chase & Co., helped popularize
the use of value at risk as the primary measurement tool in 1994 when it published
its so-called RiskMetrics system.
Four years later,
two events helped demonstrate the drawbacks in using statistical analysis
based on historical market movements to measure risk. Russia's bond default
sent fixed-income markets into a tailspin and Long-Term Capital Management
LP, the Greenwich, Connecticut-based hedge fund run by former Salomon Brothers
trader John W. Meriwether, had to be bailed out after $4 billion of trading
risk was underestimated because value-at-risk computations used by investment
banks depended on market events of the preceding two to three years, when
nothing similar had occurred, according to Wilson Ervin, who's now chief risk
officer at Zurich-based Credit Suisse Group, Switzerland's second-biggest
bank after UBS.
Management, which amplified its risk by relying on borrowed money for most
of its trading bets, blew up in part because it didn't anticipate that investor
panic after the Russian default would cut the value of any risky debt, whether
it was issued by a country, sold by a company, or backed by mortgages.
Russian and Brazilian bonds owned by the fund plunged far more than the safer
Russian and Brazilian bonds that it had bet against as a hedge, according
to "When Genius Failed,'' the book written by Roger Lowenstein.
"In a market
stress event, some individual sectors that previously appeared unrelated do
move together, and as a result, the organization could take losses on both
of them or even on positions that were previously deemed to be a hedge,''
said Ed Hida, the partner who runs the risk strategy and analytics services
group at Deloitte & Touche LLP in New York.
The other risk
tool commonly used by securities firms, known as stress testing or
scenario analysis, also failed to prepare the industry for the plummeting
value of AAA-rated securities that had previously been deemed the most creditworthy,
tests are only as good or as predictive as the scenarios used and in many
cases the scenarios that played out were much more severe than people anticipated,''
Hida said. "One lesson learned is that these stress tests should be broader,
should consider more scenarios.''
became Morgan Stanley's CFO in October, explained the flaw in the firm's stress
testing in a Dec. 19 interview, the day the company reported its first unprofitable
quarter. "Our assumptions included what at the time was deemed to be
a worst-case scenario,'' he said. "History has proven that the worst-case
scenario was not the worst case.''
banks will continue to take unsafe risks as long as traders are rewarded for
making profits, leaving shareholders, bondholders and sometimes taxpayers
to shoulder the consequences, Taleb said.
traders "make an annual bonus and get an annual review based on risks
that don't show up on an annual basis,'' Taleb said. "You (as a trader)
have all the incentive in the world to take these risks.''
off automatic updates: From Computerworld magazine comes word
that the latest Office 2003 service pack update from Microsoft won't
let you open some older files, including some in Excel, Word and PowerPoint
formats. This blocking of old file formats is for "security purposes,"
according to Microsoft. But it's a huge pain in the tushy for you and me.
recommendation: Turn off ALL automatic updates to any programs -- Microsoft
or any other vendor. Do not assume that the latest is the greatest. It
often isn't. Harry's inviolate computer rule: If it works, don't mess with
it. For Computerworld's article, click
got to be really dumb to be in financial trouble. Regularly I get
emails from organizations and "experts" telling me that "Many
Americans continue to bury their heads in the sand, ignoring the fact that their
credit card balances are growing, their savings account balances are diminishing,
and a recession is possibly on the economic horizon." Yesterday The National
Foundation for Credit Counseling (NFCC) emailed me a that my readers should
take. The results will reveal whether or not they need professional help to
avoid a deeper financial quagmire. Questions include:
+ I normally pay
only the minimum amount due on my credit card bills.
+ My credit card
balances increase each month.
+ I have begun
using cash advances to meet my obligations.
+ Most of my credit
cards are near the limit, so I've begun applying for new lines of credit.
Maybe I'm stupid,
I can't imagine that anyone reading this column doesn't know that paying their
credit cards bills in full every month is the absolute best investment
around today. If you can't pay in full, spend less. What am I missing?
the stockmarket works.
Once upon a time in a village, a man appeared and announced to the
villagers that he would buy monkeys for $10 each.
seeing that there were many monkeys around, went out to the forest, and started
The man bought
thousands at $10 and as supply started to diminish, the villagers stopped their
effort. He further announced that he would now buy at $20. This renewed the
efforts of the villagers and they started catching monkeys again.
Soon the supply
diminished even further and people started going back to their farms. The offer
increased to $25 each and the supply of monkeys became so little that it was
an effort to even see a monkey, let alone catch it!
The man now announced
that he would buy monkeys at $50 ! However, since he had to go to the city on
some business, his assistant would
now buy on behalf of him.
In the absence
of the man, the assistant told the villagers. "Look at all these monkeys
in the big cage that the man has collected. I will sell them to you at $35 and
when the man returns from the city, you can sell them to him for $50 each."
rounded up with all their savings and bought all the monkeys. Then they never
saw the man nor his assistant, only monkeys everywhere!
Now you have a
better understanding of how the stock market works.
favorite New Yorker cartoon:
After their baby was born, the panicked father went to see the Obstetrician.
"Doctor," the man said, "I'm a upset because my daughter has
red hair. She can't possibly be mine."
the doctor said. "Even though you and your wife both have black hair, one
of your ancestors may have contributed red hair to the gene pool."
possible," the man insisted. "This can't be, our families on both
sides had jet-black hair for generations."
said the doctor, "let me ask you this. How often do you and the wife have
The man seemed
a bit ashamed. "I've been working very hard for the past year. We only
made love every few months."
you have it!" The doctor said confidently. "It's rust."
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
is . You can't
click on my email address. You have to re-type it . This protects me from software
scanning the Internet for email addresses to spam. I have no role in choosing
the Google ads on this site. Thus I cannot endorse, though some look interesting.
If you click on a link, Google may send me money. Please note I'm not suggesting
you do. That money, if there is any, may help pay Michael's business school
tuition. Read more about Google AdSense, click
here and here.