life in financial markets: it was a dash to trash

I just came across this very insightful story at asianinvestor.net. Here it is:

asianinvestor.net/print.aspx?CIID=128414
Risks were ignored, but crisis wasn't unexpected
By Nick Ferguson
17 November 2008
SocGen's head of strategy arefers to the current crisis as a predictable surprise that rewarded those who had invested in prescient collapse products.

Most people describe the happy days before the crisis as a bull market, but not James Montier. Societe Generale's plain-speaking global head of strategy calls it the "dash to trash" – a period when the madness of crowds led market participants to ignore risk in almost every way.
The collapse that followed this orgy was not an example of one of Nassim Taleb's black swans – a massive and unpredictable event – but a clearly predictable consequence of what was going on in the markets. Indeed, plenty of economists and market watchers did see it coming. Bob Shiller, for example, a Yale economist who prodded Alan Greenspan into making his "irrational exuberance" comment in 1996, first warned of a housing bubble more than three years ago.
He made the following prediction in an interview with the New York Times in August 2005: "A very plausible scenario is that home-price increases continue for a couple more years, and then we might have a recession and they continue down into negative territory and languish for a decade." But Shiller and his fellow sceptics were in a minority.
Montier says there are several reasons why the market consensus was so wildly over-optimistic, despite the alarm bells. First, he argues, many modern risk management techniques helped give senior bankers a misplaced sense of confidence. "Things like value at risk give an illusion of being able to quantify risk," he says. "And yet we can neither quantify nor control risk in any meaningful sense."
To make matters worse, the financial industry also tends to have a self-serving bias towards happy thoughts, because most participants generally tend to do better when markets are rising – so it doesn't serve anyone's interests to draw attention to flaws in markets, accounting models or the banking system, which is why practices such as mark-to-model valuations didn't come under closer scrutiny. "It's like asking a school kid to mark his own homework," says Montier. "Don't be surprised if he gives himself 100%."
Finally, most of us are not good at spotting change. To illustrate, Montier gives the example of a popular study in which test subjects are asked to watch a clip of a basketball game and count the number of passes. Halfway through the video a gorilla walks on to the court and beats his chest, yet when asked about the clip 80% of subjects say they didn't notice anything unusual.
This is a phenomenon known as change blindness, and Montier says it can apply to markets too. "We're not inclined to look for what we don't expect to see," he says.
But some people were, in fact, expecting to see a collapse. Strategists like Montier, who are happy to work outside the consensus, were tracking the bubble as it moved through the stages described by economists Hyman Minsky and Charles Kindleberger. The key stage in the progression is commonly known as a Minsky moment; when financial distress flips into all-out revulsion, asset prices collapse and liquidity evaporates.
Back in June, Montier and the SocGen global strategy team had some particularly strong views that several markets were due to reach their Minsky moments, and his analysis prompted the bank's structurers to create a series of structured products aimed at hedge fund clients that would take advantage of the coming collapse.
At the time, crude oil was at $135 a barrel, the US dollar was at $1.56 to the euro and the S&P500 was at 1,350 points, but Montier was confident that all those values were toppish and the structurers, led by Stephane Mattatia in Paris, calculated the best way to express his views and were ready to go out and sell the products by early September.
Mattatia's so-called collapse-put was a straight forward one-year bet against 10 stock indices and crude oil. The pricing models put a very low probability on the bet coming off, based on the assumption that markets as diverse as Turkey, China and South Africa, as well as those in the developed world, are not likely to fall in tandem. With the odds apparently stacked against him, Mattatia was able to price the option cheaply with a strike of 110, meaning that investors have the right to sell the best performer in the basket at a 10% premium to the early September price.
Of course, as it turned out, the bet came off almost immediately. Right now, the best performer in the basket is South Korea's Kospi 200, down 21% since September 1, which means the option has an intrinsic value of 31% today. The option was priced at less than 3%, so investors are currently sitting on a return of more than 10 times their capital.
Even so, investors who bought the collapse-put may be worried that their bet came off too soon, but Montier is confident that equities are yet to hit rock bottom. Valuing stocks by looking at their price-to-earnings ratio is fine, he says, but only if you discount the effects of the business cycle. One way to do this is to use a 10-year moving average, and by this measure US stocks are not yet "super cheap", he says – they are at roughly 20-times right now, compared to a long-term average of about 15.
Current P/E ratios also support a gloomy outlook. Compared to average P/E levels, markets are signalling a 23% earnings decline in the US, 33% in Asia and 40% in Europe.
The second bet combined Montier's three main predictions: stock markets and crude prices would fall, and the dollar would rise. The triple European digit had a premium of roughly 20% and will pay back 100% after six months if the euro-dollar rate is down by more than 1%, the Euro Stoxx 50 is down by more than 2% and crude oil is down by more than 3%.
That looks like a safe bet today. The euro-dollar rate is down about 13% since early September, the Euro Stoxx 50 is down 28% and the price of a barrel of crude has fallen 47%.
Another of Montier's observations is that the bubble was biggest in the emerging markets, where over-optimistic investors overpaid for the hope of growth. His cyclically adjusted P/E for the emerging markets shows that valuations are still way above long-term averages and have considerably further to fall.
To capitalise on this view, Mattatia's team structured an outperformance trade that pits the two worst performers in a basket of developed market indices against the two best performers in an emerging indices basket. Investors bought a call on the spread between the two with a strike price of 110, and paid a premium of 3.5%.
At the moment the spread is zero, which means that the call is 10% in the money. The S&P500 and Nikkei 225 are down a combined 65%, which is exactly the same as the combined fall of the JSE Top 40 in South Africa and the National 30 in Turkey.
Ironically, the heart of Montier's investment philosophy is that nobody knows very much about what is going to happen in the short term – he describes his prescient call on the collapse as lucky timing – and that the only sensible way to invest is to have a longer time horizon.
By far the biggest contributor to returns during a one-year time horizon are changes in valuations, which, he says, are essentially random. But over a five-year horizon dividend yield and growth in real dividends account for as much as 80% of real returns – and these are things that fund managers should be able to analyse and understand.
Unfortunately, the market is biased against letting fund managers do that. "Good long-term performers underperform in the short-term," he says, which, in effect, means that people who get rewarded on the back of short-term performance are incentivised to underperform in the long term. Or as Montier puts it: "Doing what I say will generally get you fired."

life in financial markets: hypocrites' anthem: "privatise gains, socialise risks"

It does not come as a surprise to me -- the hypocrisies of soon-to-be-nuclear-superpower India's so-called capitalists. The last week-end's death of Lehman Brothers and the takeover of a in-great-distress Merrill Lynch, and the the bullying cry for help to the government by AIG (that the Fed has now succumbed to) has once again exposed the hypocrisies of the top-level executives in the financial and corporate sector.
The Indian media has been seeking views from Indian Inc and Indian banking & financial sector about the implications of the global financial crisis on India and generally. As usual, a majority of those who give their views want the US government to bail out the distressed AIG like it did with Fannie Mae and Freddie Mac recently.
I can give two examples from what I remember watching on business news channels the last 3 days. Goverment bailouts of private organisations when they go into financial distrees was rigorously defended by Anil Ambani-owned Reliance Money's CEO Sudip Bandyopadhyay and similarly, though not rigorously, by State Bank of India's chairman, O.P. Bhatt.
Companies like AIG will never price their products and services cheap to their customers (for instance, when I took out my pure-term life insurance policy 3-4 years i was checking out the pure-term policies of all insurance companies and found that Tata-AIG's one was the most expensive... i finally went for HDFC Standard Life's offering). It is ludicrous, therefore, for them to expect themselves to be treated by kid gloves (= bail out) by public taxpayers' money.
Some good reading material can be found at recent blog posts at globaleconomicanalysis.blogspot.com.
Meanwhile, the hypocritical Indian-&-international capitalists can continue to loudly sing their anthem "Privatise gains, socialise risks."
this below part of the post was added on 21 Sep:
The one good thing about the US markets that is misearbly lacking in Indian and all other markets is the level of transparency. It is high even though it is not great in the US but in the rest of the markets it ranges from low to very low. Another thing is that many American analysts are refreshingly bold in criticising their governments and regulators for doing regressive things. I have got most of my understanding of why the government bailouts in the US or anywhere is regressive from American analysts and commentators themselves. Here, in India, barring an occasional voice or two, most of the analysts and commentators are cowards and support almost every regressive step that finance minister, Chidambaram, or the commerce minister, Kamal Nath (notorious for his devious obsession in pusing for more and more sops for SEZs) RBI or the Sebi takes with regard to the economy or the financial markets.
Here are some examples of some American analysts/commentatos' telling it like it is:
1) After the nationalisation of Fannie Mae and Freddie Mac, CNBC, on 8 September, quotes an investor and former partner to George Soros in Quantum, Jim Rogers, as saying "... America is more communist thatn China is right now. You can see that this welfare of the rich, it is socialism for the rich... its just bailing out financial institutions... This is madness, this is insanity, they have more than doubled the American national debt in one weekend for a bunch of crooks and incompetents. I'm not quite sure why I or anybody else should be paying for this..."
2) Mike Shedlock, an investment advisor, says openly in his 21 September post that the Bush administration is seeking unreviewable dictatorial power by pressurising Congress to hand over power to him to buy $700 billion worth of in-deep-loss mortgage investments that financial companies are stuck with.
3) The ludicrous ban on short selling by SEC has be ripped apart by many in the US -- Peak Insanity, Peak Insanity--Comments, Short Sellers Targetted, Short Sellers Targetted--Comments, Paulson's Shorting Ban Needs Revisions Already, Paulson's Shorting Ban Needs Revisions Already--Comments. From the comments sections, here are some interesting ones: (a) "... These are supposedly the bureaucrats that champion the wisdom of the free market and the market's ability to correct itself over time. Now they seem drunk with the taxpayers dime rushing from one billions of dollars fix to the next. All this plus two (and possibly more) land wars in Asia financed with borrowed money. It is nuts." (b) "UNBELIEVABLE! I didn't buy a house when I could have because I believed it to be prudent to wait til the market dropped. I didn't get into debt because I knew we were on our way to the greatest credit crisis the world has ever seen. Because I have been prudent and saved my money and waited to short the Sh*t out of this market, I lose and those that were spending like there was no tomorrow, that took out loans bigger than what they could pay, that levered themselves to the skies....they win! This is not a free market and I am fed up with those running the system and this country!" (c) "... Now Paulson and Bush and Bernancke stand before the country and declare they are taking steps to save the country... including unlimited powers for Paulson, and Congress can't wait to say yes...exactly the way the Iraq war was sold. Just freaking say no...is there anyone with an integrity in Congress...we are of course being sold down the river. No pain, no gain. Let the freaking markets work."