Tag Archives: wall street

Why is Wall Street Confused?

In my previous post I argued that the valuations on some of the growth tech stocks that have recently tumbled were overpriced and that a correction in the market was necessary. As this correction has occurred over the past week its affects have trickled down to the entire equity market. Today the Nasdaq dropped 1.3% and the total loss for the week was 3.1%. The S&P 500 and the Dow each dropped 0.9% as well today. (WSJ – Stock Bloodbath Hasn’t Hurt Other Assets)

Despite the recent selloff impacting all equities, riskier asset classes that are often negatively affected by the US stock market selloff reacted adversely in the market today. Whenever the stock market takes a negative hit historically oil prices have fallen as well. This trend did not occur this week as oil prices rose.

 

 

As you can see in the graphs depicted above the price of oil has not moved in correlation with the falling stock market. This trend was also witnessed in emerging markets. As the market fell today the South Korean Won hit a new five year high and the Brazilian Real hit another monthly high.

This unique market movement shows that the dominant market force is currently the Fed’s commitment to maintain low interest rates. This new Fed view comes as opposition to January’s consensus that rates would be immediately hiked due to the strength of the domestic economy. New thoughts about the Fed have caused investors to reinvest into emerging markets and thus create a capital inflow into emerging markets, thus strengthening emerging market currencies such as the Won and Real. The new belief regarding domestic interest rates is also the factor that has pushed up oil future prices.

The current trend in the market is a signal that many investors don’t see this broad equity selloff as a long-term correction. After a high yielding year for tech stocks, many investors are using this correction as an opportunity to cash in profits and diversify their portfolios. Furthermore, the changing treasury rates has created an overall market confusion that has left many investors trying to find ways to make their portfolios more risk-neutral until further guidance.

According to Palisade Capital Management CIO, Dan Veru, “Money isn’t leaving the market, it’s just being reallocated.” (WSJ – Nasdaq Closes Below 4000) With no specific news affecting the market it would appear that this is the current sentiment on the street. With this all being said it would appear as if Wall Street is stuck in a bit of confusion. As the Fed continues to give contradictory forecasts and China continues to waiver, it is difficult for anyone to really know what exactly is going on in the market. For this reason, we may start to see a lag period where investors move their portfolios in order to mitigate as much risk as possible.

Revised: A Random Walk Down Wall Street Today

According to Burton G. Malkiel, there are two types of valuations used to price a stock. The first is the firm-foundation theory. Often credited to S. Eliot Guild and John B. Williams, the firm-foundation theory is a stock valuation approach that is based on dividend income. The valuation technique argues that by using the present value of all future dividends of a stock you can find the intrinsic value of an asset. Once you calculate the intrinsic value of the asset, the technique by theory should become profitable when the investor purchases the asset as it falls below the intrinsic value and sells the asset when it rises above the intrinsic value. This is because under this theory it is believed that the market will undergo irrational corrections, but will always converge to its intrinsic value in an infinite time period.

The second valuation theory highlighted by Malkiel is more relevant to many of the new high profile stocks in today’s “growth focused” market. Malkiel calls the second valuation method the castle-in-the-air theory. This theory, developed by the economist John Maynard Keynes, focuses on the psyche of the market rather than the intrinsic values. Keynes likened the market to a newspaper beauty-judging contest where a prize is given to the person who selects the six prettiest women based on the medium consensus of all the judges. The most effective strategy for this game is to select the faces that others would find most attractive, rather than yourself. In this game, the six prettiest woman in the contest will conform to the consensus of the masses rather than the tastes of each individual man. To put it in terms of the stock market, Keynes believed that the price of an asset in relation to its intrinsic value is absolutely meaningless as long as one can sell the asset to someone else for a higher price.

By highlighting examples of famous market crashes, such as the tulip-bulb craze in 1637, the South Sea Bubble in 1720, the Great Depression, and the tech bubble in 2000, Malkiel warns of the risks of the castle-in-the-air valuation method due to the risk of mob mentality investing. My takeaway from the reading was that the markets became vulnerable when a small group of investors are able to conform the investments strategies of a mass by convincing them that fundamentally dangerous market conditions are the norm and that price valuations will always continue to rise. This dangerous and irrational market philosophy was best explained by Jack Dreyfus, of Dreyfus and Company, when he said,

“Take a nice little company that’s been making shoelaces for 40 years and sells at a respectable six times earnings ratio. Change the name from Shoelaces, Inc. to Electronics and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are worth 15 times earnings. However, the real play comes from the word “furth-burners,” which no one understands. A word that no one understands entitles you to double your entire score.”

In today’s market we are seeing more and more instances of castle-in-the-air valuations, especially when it comes to hyper-growth technology companies. Investors have become accustomed to companies with absorbent price to earnings ratios or even companies with negative earnings, in order to place emphasis on pure growth. For example, Facebook has a P/E ratio of 104.91 and Twitter and Tesla both don’t have P/E ratios due to their negative earnings, yet these stocks are considered by many institutional investors as the top growth stocks to own. Analysts argue that these valuations can be justified based on the future earnings and monetization of the technology in years to come, but these valuations are based on the assumption that consumer demands don’t change. For example, the consensus on Wall Street agrees that the steep valuation on Facebook can be justified based on future earnings, yet the idea of Facebook potentially being a fad is not thrown entertained often. By basing valuations on future earnings, these companies are exposed to extreme risks, such as the risk of their user base declining.

Despite all these additional risks, many investors continue to move their money into these stocks as Wall Street becomes more optimistic about the prospects of these companies and valuations continue to rise. At some point someone must beg the question somewhere in Wall Street, what price is too high for these companies with little or no earnings? We will likely not know the answer to this question until it is too late, but Malkiel made it quite clear that historically stocks that grow faster in price than in earnings are eventually doomed to fail.

A Random Walk Down Wall Street Today

According to Burton G. Malkiel, there are two types of valuations used to price a stock. The first is the firm-foundation theory. Often credited to S. Eliot Guild and John B. Williams, the firm-foundation theory is a stock valuation approach that is based on dividend income. The valuation technique argues that by using the present value of all future dividends of a stock you can find the intrinsic value of an asset. Once you calculate the intrinsic value of the asset, the technique by theory should become profitable when the investor purchases the asset as it falls below the intrinsic value and sells the asset when it rises above the intrinsic value. This is because under this theory it is believed that the market will undergo irrational corrections, but will always converge to its intrinsic value in an infinite time period.

The second valuation theory highlighted by Malkiel is more relevant to many of the new high profile stocks in today’s “growth focused” market. Malkiel calls the second valuation method the castle-in-the-air theory. This theory, developed by the economist John Maynard Keynes, focuses on the psyche of the market rather than the intrinsic values. Keynes likened the market to a newspaper beauty-judging contest where a prize is given to the person who selects the six prettiest women based on the medium consensus of all the judges. The most effective strategy for this game is to select the faces that others would find most attractive, rather than yourself. In this game, the six prettiest woman in the contest will conform to the consensus of the masses rather than the tastes of each individual man. To put it in terms of the stock market, Keynes believed that the price of an asset in relation to its intrinsic value is absolutely meaningless as long as one can sell the asset to someone else for a higher price.

By highlighting examples of famous market crashes, such as the tulip-bulb craze in 1637, the South Sea Bubble in 1720, the Great Depression, and the tech bubble in 2000, Malkiel warns of the risks of the castle-in-the-air valuation method due to the risk of mob mentality investing. My takeaway from the reading was that the markets became vulnerable when a small group of investors is able to conform the investments of a mass by convincing them that fundamentally dangerous market conditions are the norm and that price valuations will always continue to rise. This dangerous and irrational market philosophy was best explained by Jack Dreyfus, of Dreyfus and Company, when he said,

“Take a nice little company that’s been making shoelaces for 40 years and sells at a respectable six times earnings ratio. Change the name from Shoelaces, Inc. to Electronics and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are worth 15 times earnings. However, the real play comes from the word “furth-burners,” which no one understands. A word that no one understands entitles you to double your entire score.”

In today’s market we are seeing more and more instances of castle-in-the-air valuations, especially when it comes to hyper-growth technology companies. Investors have become accustomed to companies with absorbent price to earnings ratios or even companies with negative earnings, in order to place emphasis on pure growth. For example, Facebook has a P/E ratio of 104.91 and Twitter and Tesla both don’t have P/E ratios due to their negative earnings, yet these stocks are considered by many institutional investors as the top growth stocks to own. Many investors continue to move their money into these stocks as Wall Street becomes more optimistic about the prospects of these companies and valuations continue to rise. This market mentality must be begging the question somewhere in Wall Street, what price is too high for these companies with little or no earnings? We will likely not know the answer to this question until it is too late, but Malkiel made it quite clear that historically stocks that grow faster in price than in earnings are eventually doomed to fail.

Bonuses at Work

Today, I came upon an article about HSBC’s earnings report, where they have missed the expected revenue by about 5.7% from 68.3 billion to 64.6 billion dollars. This caused HSBC’s stocks in London to sink 4% and the final dividend for 2013 fell to $0.19 to $ 0.21. I could go on about which branches in some regions gained for what reason, while other regions lost for some other reasons. However, I would like to focus on HSBC’s CEO Stuart Gulliver’s new outline of pay for senior executives (about 670 in number) in the midst of this stumble.

With the EU’s new regulation limits that prohibits firms to pay out bonuses more than 100% of workers’ base salary or 200% with shareholders’ approval, Gulliver has came up with the new “fixed pay allowance” which would turn some of the bonuses into base salary. I wonder whether this new outline was announced at a right moment where HSBC’s earnings has been tumbling (10% fall in year-to-year pre-tax profit).

Bonuses at work has been very controversial–highlights had been especially shed on the finance sector ever since the melt down of financial services in 2008 that caused recession not only in the US, but around the world. Movements like occupy Wall Street that called out for more regulation in the finance sector, or numerous movies that ridiculed the moral-hazardous life style of bankers at the Wall Street. The most recent movie “The Wolf of Wall Street” – setting aside its vulgarity – is based on a true story of biographical account written by Jordan Belfort, and he acknowledges that general life style of spendthrift drug abuse and prostitutes depicted in the movie is quite correct.

Of course, I would not want to fall into the mistake of generalization fallacy. Most bankers are hard working spending 80+ hours per week. Some extreme schedule would even come to about 100 hours per week with weekend works too. Ironically, many recent college graduates crowd into the finance industry even after the 2008 recession.

To put things more objectively, Wall Street is not the only place that pays enormous amount of bonuses. Silicon Valley is also one of the cities that emerges higher income disparity in the US. Computer science engineers’ average base salary in recent years have been unparalleled across many industries. And the executives also gets paid equal if not higher pay than what is paid on the street.

Many argue that there is a fundamental difference between two sectors of business that one creates value that contributes to the society while the other is just number crunching jobs that does not do too much for the betterment of the society. My argument for this is that you cannot compare this from the same perspective. Yes, the finance industry had been in trouble for its moral hazardous act, but think about the tech bubble in 2001. There were not much value created through the hands of technology sector. Ultimately it was the fault of people’s greed.

In my opinion, bonuses can be a great motivator for marginal efforts, but there should be somewhat standardized measures. I call it the communist approach that if the wage / salary disparity were not extremely large, many people would choose occupations not simply on how much money they can make, but what they would enjoy doing more — increasing efficiency, fully utilizing human resource and reducing the mismatch of worker-employer relationship. However, this is only my fantasy in the capitalistic world where marginal case for higher pay actually do dictate decisions of most workers.

Why is Wall Street high paying? Lets give them less!

 

Wall Street, the eight block long financial district of New York City, has become a metonym for the American financial sector. Some have come to know it as a place where all the cleverest and greediest individuals go to make a profit off of economic inefficiencies. Because of the growing trend of Financialization (yes that is a word) in the US, the financial sector has been increasing its share of US GDP and has led to even higher pay and benefits to those in successful businesses.

 But why is it that middleman are churning huge profits? Where does this fit into the efficient economic models of capitalism we’ve learned in our introductory economics courses?

Traders:

 Traders can quantify there worth to the company, based on a number of the profits they bring in through their transactions. They can justify a reason to simply take a slice of their contributions and compensations, which can become quite a lot.  A good trader can argue (not to say they should) that if he/she left, the company would make $E[X] less that year. When he/she asks for $Y strictly less than $E[X] in return for their efforts, the company would accept $E[X] – Y as opposed to $0 (Its simple game theory: Nash equilibrium).

Venture Capitalists:

 What about Venture Capitalists? VCs fund projects they believe might become profitable, in exchange for ownership. When a venture becomes profitable. A lot of money grows to a lot more money and the cycle continues. Imagine a startup asking for and getting approved for a million dollars. The interest of the VCs might be to see the startup’s value increase and look for a potential acquirer. This doesn’t include the startups interests and my concern is a deal could be reached without adequate compensation for the original founder ‘building up’ an idea and going through the hurdles.

 So what about theses people doing the work and ‘build things’ per say. Those who build things should arguably be paid the most. But this is clearly not the case. I would personally like to see a shift. A difficult rewarding process for one’s ideas and the ability to churn huge profits off of arbitrage (high frequency trading) don’t sound like the capitalistic economy that the US should be. If markets would be optimized for further efficiency and not determined on a technological arms race, we’d see a country closer to capitalism.