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Wall Street Is #Winning In Full-Blown Charlie Sheen Fashion

We interrupt this financial blog for an important political message:

First of all, let me say I haven’t read the actual bill but I’m sure none of the folks in the house who voted for it haven’t either. What I do know is that Wall Street’s too-big-to-fail banks have basically held the federal government hostage by inserting their own provision into the latest spending bill that allows the government to avoid shut down.

The banks are essentially saying, ‘let us keep trading what Warren Buffett calls “financial weapons of mass destruction” with an explicit bailout backstop from the FDIC or else… [the government will cease to operate].’ To be clear, this is one way banks are allowed to play the heads I win (and keep all the trading profits), tails you lose game (and American taxpayers pick up the tab) in the markets.

What I find especially disgusting about this is that Citigroup lobbyists, not congress, wrote the entire provision that has been inserted into the spending bill. Then Jamie Dimon, CEO of JP Morgan, made personal calls to key players in the house to ensure the bill would pass.  What’s more, another provision in the bill allows for congresspersons to receive 10X as much money from lobbyists, like those from Citi who wrote the provision, in the future as they do already today.

Now I know this isn’t about ‘did we learn nothing from the financial crisis’? We certainly did learn something and the Dodd Frank reforms, with critical insight and input from Paul Volcker, went a long way toward rectifying the problems. No – this is more about the banks paying people off to put their interests above those of the American people.

And I, for one, am utterly ashamed of our political process at a time like this.

Full Disclosure: I have not been registered Republican or Democrat for over a decade because, in the words of Richard Jeni, it’s just too much fun to, “bitch no matter who wins.” 

Now back to your regularly scheduled market insights.

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5 Reasons You Should Avoid Bank Stocks Right Now

Josh Brown, blogger extraordinaire, wrote a post the other day about the breakout in the financials which argued that investors should overweight them. All due respect to Josh (who I think highly of), here’s 5 reasons why I think that’s a bad idea, especially in regards to the bank stocks:

  1. The yield curve has been falling all year and lately more like a brick. Because banks borrow at the short end and lend at the long end this always leads to pressure on profit margins. That’s why, until this year, banks’ share prices were so sensitive to changes in the curve. I don’t know why their share prices haven’t noticed yet this time around but I’m thinking it’s just a delayed reaction:sc-14
  2. The default cycle is about as low it can possibly get and now looks to be turning upwards again. The 40% crash in the price of oil over the past few month raises the real prospect of rising defaults in the energy sector. Canadian and Texas banks are especially vulnerable and their share prices have taken a hit recently. But if there’s one thing we’ve learned from the financial crisis it’s that these things are never isolated. They are all closely and inevitably intertwined.
  3. Everyone and their mom is overweight the banks and has been for quite some time. And if everyone already owns them where’s the incremental demand going to come from to push prices even higher or at least faster than the broader market? That’s a tough question to answer.BAML Allocations Nov 14
  4. What if these breakouts everyone is watching are nothing but a head fakes? False breakouts are one of my favorite chart patterns to trade because they are visual evidence of the crowd become overly euphoric for something. They are a text book example of price getting ahead of fundamentals (exactly where I think the banks are today). The resulting fall back to reality of sentiment usually brings with it a pretty dramatic price reversion, as well. (JPM, C, WFC all look vulnerable to me and BAC is merely working on a double top.)sc-15
  5. They are impossible to value. If the companies themselves can’t even determine how much money they made or lost in a given quarter how can anyone else be expected to? In fact, since FAS-157 was repealed (or “relaxed”) who knows if they’re even solvent? You just can’t possibly “invest” in something you can’t begin to understand (but speculate away; that’s your prerogative).

Ultimately, I think the banks might be the most vulnerable sector to a cyclical downturn and there are plenty of signs (global economic weakness, interest rates, commodities and bond market risk appetites) we could be headed in that direction fairly soon.

Disclosure: I am short financials.

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Over A Barrel

A local craft brewer announced recently that they’re being bought out by Anheuser Busch and at first I thought, ‘Cool. Good for those guys.’ But then there was a fairly large customer backlash that got me thinking a bit more about it. Why does everyone get pissed when a company like this “sells out”?

The 10 Barrel guys say they sold because AB gives them opportunities they wouldn’t otherwise have. They obviously get better distribution but they also get access to used brewing equipment and ingredients that are hard to come by in today’s booming craft beer market.

That’s all fine and good but every company goes through these sort of growing pains. Surely Deschutes Brewery and Sam Adams went through these very same problems as they grew from small town craft brewers into two of the largest in the country. They managed to overcome these very same hurdles without selling out.

Ultimately, it’s easier to solve these problems by selling to a buyer like AB or even just to any buyer and then letting them figure it all out. But is it the right thing to do for your brand, for your customers, for the long-term health and vibrancy of your business?

I think the main reason people get pissed is because when a company sells out it sends a clear “show me the money” message. It tells people that profits are your top priority. And in the capitalism capitol of the world you’d think, ‘well, what’s wrong with that?’

What’s wrong is people want their companies to stand for something more than just profits. Look at the companies that have the greatest brand loyalty. Why do people love them so much? Apple, Twitter, Amazon. And smaller companies, like Ben & Jerry’s, In-N-Out Burger, Patagonia. What makes their customers so loyal?

It comes down to the company’s mission. Truly – don’t laugh. I know Twitter got some flack for the their mission statement last week but it’s precisely because the company puts their users first that they remain loyal. It’s simple, really. A company has to stand for something more than just profits for it to engender any sort of loyalty.

Apple has consistently told Wall Street that their top priority is creating amazing products. Period. Profits are an afterthought. Amazon clearly prioritizes their customers over profits. I don’t think they’ve made a dime of profit over the past decade. Ben & Jerry’s and Patagonia are both about doing social good while you sell top quality products. In-N-Out sells fresh, quality burgers at low prices.

Nowhere will you find any of these companies talking about how maximizing profits is their reason for being. Sure, they think about it but it’s not the reason they do what they do. They have a passion that goes totally above and beyond.

And I purposely left out Facebook in the list companies above because I believe they have a sellout problem similar to 10 Barrel. They sold out to Wall Street when they went public. They started prioritizing profits above their users and that’s why a little site like ello, with an inspiring “manifesto,” can come in and begin to steal Facebook’s users (whether they do on a grander scale is yet to be seen). I don’t have the data but I’d be willing to bet almost any amount that ello users are significantly happier with and more loyal to the site than Facebook’s. Because Facebook is a sellout.

So when you sell out, you’re effectively telling your customers that nothing really matters as much to you as making a buck and that’s just a bummer. It’s also why people hate Wall Street. Because Wall Street’s whole reason for being is to make a buck. There is no higher purpose.

Disclosure: I own Apple for myself and for clients. I’m short Facebook for myself and for clients.

UPDATE: My friend Lee notified me that Ben & Jerry’s sold to Unilever back in 2000. Looks like they setup the deal in a way that allowed them to maintain their mission (see: “Ben & Jerry’s to Unilever with Attitude“). Who knows? Maybe 10 Barrel will find a way to do the same.

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Obscene Risk Hidden In Plain Sight

Recently there have been numerous major economic agencies warning of the growing and severe risks in the debt markets. Investors have shrugged them off as they seem to think that their bond fund is immune as are equities. They’re not.

The Geneva Report, released last month, revealed that there has been no progress made in reducing debt levels around the world in the years since the financial crisis. In fact, debt levels have only grown over that time, even here in the US. This should be worrisome, they report, because, “there is considerable evidence that a high stock of debt increases vulnerability to the risk of a financial crisis.”

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Chart via Geneva Report

Clearly, the BIS is looking at the same research because back in July they warned these growing debt levels could kick off ‘another Lehman.’ BIS General Manager, Jaime Caruana, told the Telegraph, “We are watching this closely. If we were concerned by excessive leverage in 2007, we cannot be more relaxed today.”

This week, the IMF joined the chorus:

…Prolonged monetary ease has encouraged the buildup of excesses in financial risk-taking. This has resulted in elevated prices across a range of financial assets, credit spreads too narrow to compensate for default risks in some segments, and, until recently, record-low volatility, suggesting that investors are complacent. What is unprecedented is that these developments have occurred across a broad range of asset classes and across many countries at the same time.

For all of these bankers, economists and regulators, there’s just too much debt for their liking and much of it carries too much risk – and it’s spread beyond the debt markets to a broad variety of other asset classes. That’s funny because even the Fed has been warning about the very same thing lately! And they’ve pointed their finger directly at the leveraged loan market.

There’s not really one definition for these things but leveraged loans are typically floating-rate loans made to companies that carry an above-average amount of debt and, for this reason are labeled, “high-yield” or “high-risk.” The “high-yield” might actually be a misnomer because lately these things have been issued at a rate of around 5%. Many of these loans are used for leveraged buy-outs and the “high-risk” label is right on the money.

Back in 2012, the volume of these sort of loans rebounded to a new all-time record as investors, hungry for yield in a zero-interest rate environment, couldn’t get enough of them. Last year blew 2012 away and this year is on track to do even more than last.

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Chart via Dallas Fed

What’s more troublesome than just the sheer volume of these loans is the quality. Although the Fed has advised bankers not to loan an amount greater than 6 times EBITDA to any given borrower, in the third quarter of this year new LBO debt levels ran 6.26 times EBITDA. This amount of leverage would normally be very risky but it is especially troublesome today because current EBITDA for these companies is based on record-high profit margins. Should margins contract at all, it would make these borrowers less likely to be able to service their debt. In other words, a simple reversion in profit margins closer to their historical average level would probably mean rising defaults, maybe dramatically so.

With yields currently at 5%, investors in these loans currently don’t need to worry about defaults hovering around the 2% level (unless you think a net 3% return is silly for the amount risk you’re taking, as I do). But prior to the financial crisis, before the s*** even began to hit the fan, default rates were nearly twice that level. At the height of the crisis defaults soared to nearly 13%. Now consider that these companies are more highly leveraged than ever and a huge portion of their debt floats at rates that are now near record lows.

On top of that, the share of “covenant-lite” loans has soared. These are loans that place fewer restrictions on the borrowers and give lenders less recourse in the event of a default. So when (not if) defaults rise again lenders will feel more pain in these sorts of loans than they ever have before.

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Chart via Dallas Fed

Richard Fisher summed it up fairly well recently saying, “the big banks are lending money on terms and at prices that any banker with a memory cell knows from experience usually end in tears.” And this time it will be more than just bankers’ tears. Shadow bankers will be affected, too. And by “shadow banking,” I mean your bond fund (among other things).

From the IMF:

While banks grapple with these challenges, capital markets are now providing more significant sources of financing, which is a welcome development. Yet this is shifting the locus of risks to shadow banks. For example, credit-focused mutual funds have seen massive asset inflows, and have collectively become a very large owner of U.S. corporate and foreign bonds. The problem is that these fund inflows have created an illusion of liquidity in fixed income markets. The liquidity promised to investors in good times is likely to exceed the available liquidity provided by markets in times of stress, especially as banks have less capacity to make markets.

This may be why the Fed has been chastising the banks so much lately. Maybe they know how much more difficult a “shadow banking” crisis would be to deal with than just your run-of-the-mill “banking crisis.”

Anyhow, what is troublesome right now is that it looks like profit margins might have already begun to revert. This  puts pressure on all of these highly leveraged companies and makes the prospect of defaults more likely. This is probably why credit spreads have recently widened to their highest levels of the year, breaking the multi-year downtrend that inspired the boom in the first place. All in all, this could be the beginning of the end of the “reach for yield” in this cycle.

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Chart via St. Louis Fed

What I find most fascinating about the whole thing, however, is that the demand or appetite for leveraged loans is so closely correlated to the stock market. The black line in the chart below tracks the PowerShares Senior Loan Portfolio, a leveraged loan ETF with $6.5 billion in assets, relative to the 5-Year Treasury Note price (roughly the average weighted duration in the ETF portfolio). The S&P 500 Index is also overlaid. Clearly, the risk appetite for leveraged loans is nearly perfectly mirrored by the stock market.

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Chart via StockCharts.com

Now I don’t know if this correlation will hold up going forward but it sure looks like risk appetites across asset classes are currently dancing to the same beat. And if this credit cycle is going to end in tears then it may be hard for equity investors to avoid a similar fate.

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Two Similes

A couple more thoughts on “The New Wolves of Wall Street“:

  • The main reason for using index funds is to reduce costs. If that’s the case then why add a high-cost advisory fee on top? Doesn’t that defeat the entire purpose?! If asking your stock broker if you need to trade something is like asking the barber if you need a haircut (to steal a Buffett line), then an adviser pitching index funds with a fat advisory fee is like a barber telling a bald guy, “okay, you can shave at home but keep the regular checks coming, okay?”
  • Many of these advisers will say that just because they’re using index funds doesn’t mean they’re not providing valuable advice. It’s true that some are but some will argue that you pay them to close the “behavior gap.” In other words, “you pay me to protect you from yourself.” To me this sounds a lot like, “I’m the wiseguy who provides protection in this neighborhood. If you don’t pay me how can I keep you safe?”
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On The “Sioux And The Buffalo”

My recent piece, “The New Wolves Of Wall Street,” struck a nerve. I think it taps into both advisers’ insecurities and investors’ worries about not getting what they pay for. Good. That’s what I was going for.

Before I follow up on that piece, though, let me make a couple of things clear. First, there are some truly wonderful advisers out there. My experience, however, tells me they are more the exception than the rule. As WSJ’s Jason Zweig tweeted this morning many, “treat clients like Sioux treated the buffalo.”

Second, I’m not criticizing either the RIA model or index funds right now (though these aren’t without their own problems). All in all, they are a net positive for individual investors because they reduce conflicts of interest and bring down costs. I’m focused on the problems that arise when you put the two together.

Ultimately, this discussion is focused on the massive underperformance individual investors experience in their own portfolios on a consistent basis:

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Most pundits like to blame this on the fact that individual investors are just “dumb money.” Indeed, there is a “behavior gap” that causes investors to become euphoric with the crowd and buy at the wrong time and then panic in the midst of a bear market and sell at precisely the wrong time. This is human nature.

What the wolf doesn’t want you to know, however, is that he’s just as much to blame for your underperformance as your caveman brain is (see “Where’s Wall Street’s Blame In The Buy High Sell Low Game?“). In fact, even if he does a perfect job managing your natural instincts along with his own, he’s going to cost you big time – like half of all of your profits over the long run, big time.

So the problem as I see it two-fold. Both the “behavior gap” and obscene fees are significant contributors to the problem of massive underperformance. Addressing the first part is a good start. But ignoring the second part or – even worse – pretending, as an adviser, to pursue a low-cost approach while charging predatory fees is counterproductive, at best.

In fact, I’ll take it a step further. An adviser who is recommending passive index funds should not charge a “management fee” at all. Management fees are just that – fees for managing investments. If you’re not managing investments – you’re just overseeing a passive portfolio – you don’t deserve a management fee. Period.

Investment advice like this is valuable, though. Investors deserve to be educated about how their biases screw up their investment plans. And I think there’s a huge opportunity for advisers interested in doing this the right way.

Investment advice like this should be compensated just like all the other “advice” given by professionals out there – attorneys, accountants, therapists, etc. – on an hourly rate. Get paid for the advice you’re giving. Nothing more – nothing less. What would you say to your CPA if, instead of his hourly rate, he asked you for 2% of all your money every year for the rest of your life just for doing your taxes?

Too many “advisers” simply gather assets, charge their management fee for a one-time recommendation and then just ride the gravy train. And can you blame them? Under a management fee structure this is the overwhelming financial incentive. They maximize their profits by bringing in as much money as possible to charge a perpetual management fee on and then do as little management or advising as possible.

If advisers were compensated for the time they spent actually advising rather than the amount of assets they gathered then that’s how they would spend their time. This would much better align investor needs with adviser incentives. And it would also help keep human advisers relevant in the era of the robo-adviser. Somebody’s going to see the light here and seize this opportunity, I’m sure.

Still, I believe that the vast majority of investors are capable of overcoming the “behavior gap” on their own. They certainly don’t need pay an annual tithe to have it managed for them. My hope is that this helps inspire them to help themselves. And there are some wonderful role models out there like Stephanie Mucha.

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