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Vol 1, 1 May 2010 www.amphora-alpha.com
IN THIS EDITION
HOW WOULD EINSTEIN VALUE FINANCIAL ASSETS?
Naturally, Einstein would have valued financial assets in relative terms. We use the classic children‘s tale, Puss n‘ Boots, to explain what this means.
THE ASSET PRICING IMPLICATIONS OF THE GREAT BAILOUT
By way of unconventional monetary policy and other extraordinary policymaker actions, the global financial system was successfully stabilised in early 2009. But how has the great bailout impacted relative asset prices? Which have become overvalued? Which still offer value? In this edition, we answer these questions in some detail while offering some practical investment strategy.
HOW WOULD EINSTEIN VALUE FINANCIAL ASSETS? In summer 2005 the Head of European Capital Markets at a bulge-bracket US investment bank asked me, in my role as the Head of European Interest Rate Strategy, to deliver a presentation to that year‟s new Associates on the topic of international interest rate markets. Those who have gone through a typical Wall Street Associate training programme know how challenging and demanding these are. (For those who have not had the benefit of experience, Michael Lewis devotes much space to the Salomon Brothers training programme in his classic, Liar‟s Poker.) However, they are not only challenging and demanding for the Associates. Those giving presentations are running businesses that need new Associates and there is always competition to attract the best. During the 1990s and 2000s, as investment banking became a more and more quantitative discipline, largely due to the explosive growth in derivatives markets, investment banks increasingly sought out graduates in physics and engineering, as the maths they required were similar to those used in building derivatives pricing models. So no surprise, the 2005 Associates class was chock full of physics and engineering graduates from the best universities, including Oxford and Cambridge in the UK, Ivy League institutions in the US and the IIM institutions 1 in India.
For those not familiar, the IIM‘s are business schools with a strong and growing reputation for turning out immensely bright, highly numerate graduates. They are arguably the most competitive business schools in the world, with some
As such, I decided to prepare a presentation that would demonstrate how certain key principles of physics are reflected in various ways in the financial markets. A central part of the presentation was a demonstration that all financial assets, be they bonds, stocks, swap contracts or various derivatives thereof, cannot be properly priced without reference to interest rate markets. Also, I made the effort to inject a bit of humour, by reading from a famous children‟s tale, Puss ‗n Boots, and then asking the class how they would go about pricing some of the various „assets‟ described in the story, including the Puss. Some of the answers were quite sophisticated in their application of various mathematical techniques. But none was quite what I was looking for. This is because, in all cases, they implicitly assumed that the asset values were based on some notion of absolute value independent of the other assets in the story. Finally, I dropped a big hint: “How many of you are familiar with Einstein‟s Theories of Relativity?” Most hands went up. I continued, “How do you think Einstein would go about pricing these assets?” Most hands went down. Of those remaining, I called on one particularly eager Associate who then said something along the lines of, “Einstein would argue that assets have value only in relation to other
230,000 students competing for a mere 1,200 places. Most major financial institutions now regularly recruit a portion of their annual Associate training classes from these schools.
taken by the US Federal Reserve. In those cases where there has been a specific government bailout or explicit guarantee it may appear rather straightforward to determine the impact of such action on the share prices of the firms in question. consider the impact of the US federal guarantee on money-market funds generally. although given the leverage ratios involved. For example. primarily banks. These include the following: 1) A decline in short-term interest rates from around 5% to effectively zero 2) An increase in the size of the monetary base from $800bn to over $2tn 3) The outright purchase of federal agency (Fannie/Freddie/etc) and non-agency mortgagebacked securities now approaching $1. only in relation to something else. However. for example. By implication. Assets are nothing more than legal claims on future cash flows of varying degrees of certainty. including General Motors. and that which is uncertain cannot be valued in an absolute sense. we find it hard to imagine that spreads would remain mostly unchanged. as represented by the term structure of interest rates. the current market value of the equity represents the apparent value of the bailout for shareholders. Had the government not stepped into to provide this guarantee. We disagree. it will misvalue assets. Second. 1 May 2010 www. free-market value. But then what of the bondholders? What would the recovery rate have been on the bonds of failed financial firms? It is difficult to make precise estimates. Estimating the impact of the Great Bailout on financial asset prices becomes only more difficult as one broadens focus. if a central bank sets interest rates at an inappropriate level. in particular those that the central bank has demonstrated are essential to its ―lender of last resort‖ role. It is hard to estimate what the residual (postdefault) value of such paper would be but given that residential property values are down some 40% from their highs.com assets. Had such support not been forthcoming it is quite possible that both agencies would have defaulted on their debt in the face of rising interest costs and declining residential mortgage collateral values. the signal this would send to the market—that the Fed is no longer the ―buyer of last resort‖ for such paper—would force a qualitative reassessment of the Fed‘s willingness to provide a liquidity backstop in future. While moral hazard of this sort is difficult if not impossible to quantify. probably low indeed. illiquid assets associated with certain failed financial firms. shareholders would have been wiped out. 02 . yield spreads between US Treasuries and other fixed income assets —primarily mortgage-related—held on the Fed‟s balance sheet are tighter than they would otherwise be. Also important in this regard is that the government decided to outright nationalise the federal mortgage agencies Fannie Mae and Freddie Mac. a 60% recovery rate would be a possible 2 It could be argued that. asset prices will become distorted and resources misallocated. Not only would spreads need to widen to help to absorb the supply. and even non-financial firms.amphora-alpha. given the 2 substantial relative changes in holdings. what we can do is look around and locate certain distortions in relative prices which are the direct result of policymakers‟ actions. rather than in absolute terms. the level of interest rates generally is lower than it would otherwise be had the Fed not acted as above. that does not mean that it does not exert a huge influence on financial asset prices. far lower than they are today. the only constant is the time value of money. such as Bear Stearns and AIG 5) Various temporary liquidity facilities which have now largely been wound down The probable effect of these actions has been twofold: First. The bottom line is that it is an impossible exercise to quantify the overall impact of the Great Bailout on the level of asset prices generally. none probably have had greater impact on relative asset prices than various measures. Of all the actions that comprise the Great Bailout. had firms been allowed to fail. as the Fed has now ended its scheduled programme of purchasing non-US Treasury securities. no matter how mathematically sophisticated a pricing model may be. In a few cases there have been outright nationalisations of financial institutions.” Bingo! That was what I was waiting for. In financial markets. The Great Bailout of the global financial system in 2008-09 may be comprised of many different parts — some of which are still being withheld from the public in whole or in part—and the specific government interventions taken may vary somewhat by country but in general they all represent various forms of fiscal and monetary stimulus and also state guarantees for certain financial assets and institutions. After all.3tn in total 4) The acquisition of a comparatively small amount of highly risky. Were the Fed to sell back into the market its holdings of some $1. Equally difficult would be to quantify the impact of the implied bailout for financial institutions that almost certainly remains in place should the financial system find itself facing another such crisis in future. spreads for such securities now reflect a fair. So in these cases. Some of these distortions are large enough to have significant implications for investment strategy and asset allocation. Looked at from a different angle. if it contains incorrect or unrealistic interest rate assumptions. only that they would be far. with potentially severe economic consequences. then an incipient run on these funds in November 2008 would most probably have resulted in a failure of the entire financial system.THE AMPHORA REPORT Vol 1. both conventional and unconventional. All we can know for certain is that the prices of securities issued by such firms are somewhat higher than they would otherwise be. What that would have done to financial asset prices is impossible to know. Einstein showed that the speed of light was the only constant in the universe against which all else could be measured. Everything else is necessarily relative.3tn in these securities.
from the certain to the highly uncertain. in particular when the cash flows are a) relatively far out in the future. Not only is the cash flow only one day away—not enough time for interest to accrue—it is also unknown. alternatively. although it may appear so from time to time. As such. For a 10-year maturity bond. It might look something like this: Certain GBs = CBs = VEs = GEs = VC Uncertain flows become gradually less sensitive to the term structure of interest rates. 03 . E(Rm) is highly uncertain. notice that. Henry Markowitz and Merton Miller jointly received the 1990 Nobel Prize in Economics for the CAPM. GEs = growth equities. Regardless. investments in equities and venture capital might seem to be relatively insensitive to interest rates. Financial asset valuation models are therefore sensitive to interest rate assumptions. In other words. the risk-free rate also becomes less relevant. even a large change in interest rates will not have much impact on the value of the lottery ticket. The 2008-09 credit crisis is just the latest example that this is not the case. Rf is the risk-free interest rate.THE AMPHORA REPORT Vol 1. is the universal point of reference for discounting the future cash flows on which financial assets represent legal claims. E(Rm) is the expected return of the market for comparably risky assets. As the cash flows accruing to the government bond are known in advance and extend far out into the future. 1 May 2010 www. Applied to 3 Where GBs = government bonds. risky assets in general will become fundamentally overvalued. the expected return on the asset becomes a function entirely of the risk-free interest rate. that would imply a fair spread to Treasuries of over 5%. just because they are relatively uncertain. the expected return on the asset becomes less dependent on the risk-free interest rate. Imagine now that the relative certainties of financial asset cash flows are laid out on a spectrum. consider two financial assets.com estimate. While it is obvious that the interest rate Rf plays a role here. note how the model is based entirely on the concept of relative value: Assets are being valued relative to a risk-free asset and relative to the market for comparably risky assets. what we are left with today is. quite clearly. the time value of money. perhaps even a decade or more. although several others also did essential work in this area.amphora-alpha. Half a century ago. William Sharpe is also well known for his eponymous measure of risk-adjusted returns. CBs = corporate bonds. CAPM has come under increased scrutiny in part because it assumes that financial market risk is normally distributed. it is frequently the case that when it comes to investments in growth equities and venture capital. a long-term government bond and a lottery ticket for tomorrow‟s $10mn draw. far wider than the current spread of Fannie/Freddie bonds of only about 0. Due to the long duration of these cash flows. Now given that interest rate assumptions are going to have at least a modest impact on relative risky-asset valuations. the payoff is so uncertain —a binary outcome of either zero or $10mn—that the actual value of the ticket is really just a function of pure uncertainty independent of the term structure of interest rates. VEs = value equities. But as Bi and E(Rm) rise. as the measures of risk Bi or E(Rm) approach zero. normally assumed to be that on government bonds. Bi is the sensitivity (risk) of the asset relative to the market for comparably risky assets. the price of the bond will be highly sensitive to changes in the term structure of interest rates. as represented by the term structure of interest rates.5%. it would be a mistake to conclude that. The shorter the time and the more uncertain the cash flows. If. Taken together. what does this imply about financial asset prices generally? THE TIME VALUE OF MONEY AS THE UNIVERSAL REFERENCE FOR ASSET PRICING The time value of money is to financial asset pricing what the speed of light is to Einstein‟s theories of relativity: While not a “constant” in the physical sense. the impact on both the level of interest rates and the spread between US Treasuries and agency securities implies that the term structure of interest rates generally is nowhere near where it would have been had the Fed and the Treasury simply sat on the sidelines and allowed nature to take its course. these assets should not nevertheless be somewhat sensitive to interest rate assumptions. and VC = venture capital. artificial. However. the present values (prices) of the cash William Sharpe. As you move from left to right and the uncertainty as to the realised size of the cash flows becomes ever greater. In recent years. In its simplest form the CAPM model calculates the expected return of a financial asset according to the following equation: E(Ri) = Rf + Bi(E(Rm) – Rf) Where: E(Ri) is the expected rate of return. and b) relatively certain. note that. then this will have the effect of increasing the expected returns on risky relative to risk-free assets. if the risk-free rate Rf is being held artificially low by the monetary authority. To illustrate this point. the less sensitive a financial asset price will be to changes in the term structure of interest rates. But if the term structure of interest rates for Treasury and mortgage securities is to some extent artificial. Probability theory can estimate the value of the lottery ticket but. in practice. several economists working independently developed the key elements of the Capital Asset Pricing Model (CAPM) which has provided the theoretical basis for risky-asset 3 valuation models up to the present day. the cash flows that really matter—that determine whether the investment is going to outperform or not—are those at least a few years out in the future. However. As a result.
Leaving the fundamentals aside for the moment. 1 May 2010 www. If speculators rather than value investors are the primary force behind stock price trends. spreads to government bonds will become too tight to compensate investors for the fundamental risks they are taking. INVESTMENT STRATEGY FOR A WORLD OF DISTORTED FINANCIAL ASSET PRICES For those who are concerned that the dramatic recoveries in risky asset markets over the past year are largely the manifestation of unsustainable. value assets and also to underweight nominal vs. the question then becomes. speculators became even more aggressive. If the stock market becomes overvalued. it all came crashing down and the malinvestments were exposed for what they were. for any given level of earnings. By making it more difficult to value risky assets properly and by generally inflating the value of such assets beyond what fundamentals can justify. As tech stock prices rose and rose. Recall that whereas in theory all financial asset valuations are potentially distorted by artificial manipulations of the term structure of interest rates. there were real economic advances that had taken place but valuations. as they divert resources from other. financial history may not repeat but it certainly rhymes. This implies that. But the stock market does not exist in a vacuum. stimulus-fuelled bubbles of varying magnitude. companies are liable to overinvest in their operations. over time. in a word. As we have written before. Eventually. then economic resources generally are being allocated in an inefficient. these strategies require investors to underweight those assets which have the most potential to be distorted in value and to overweight those assets for which valuation metrics have been left reasonably intact. it is the actions of the speculators which move prices to levels that are fundamentally unjustified which creates the very opportunities that value investors such as Warren Buffett seek to exploit. with the entirely predictable consequence that new bubbles would form elsewhere. after-tax earnings. valuedriven determinations of sensible. these strategies require investors to underweight growth vs. Consider the tech bubble for example. Notwithstanding the very real technological advances taking place in the 1990s. leaving it more open to speculators. leading to even greater malinvestments which have subsequently been exposed as such by a commensurately greater bust. were interest rates allowed to adjust to their natural equilibrium. And risky equities will become overvalued relative to bonds and to low-beta (low risk) equities. reducing the attractiveness of emerging markets. Investment flows will become increasingly dominated by those who are really just speculating and chasing trends rather than making reasoned judgements about which companies offer the best potential long-term value. When the Fed bailed out LTCM in 1998 and also eased monetary conditions briefly going into Y2K. In general. Sure.amphora-alpha. As for where the next bubbles are now forming. more productive activities. to grow. To compensate for that bust. equity P/E ratios will be higher than they would otherwise be. Indeed. More specifically. Such malinvestments will. with some help from the Fed. But Warren Buffett would probably be among the first to acknowledge that a substantial portion of stock market transactions represent the whims of speculators rather than the careful. value-oriented investors. value investors will be less willing to invest in the market generally. such that investors end up paying more for shares than they can reasonably expect to get back (someday) in the form of actual.THE AMPHORA REPORT Vol 1. In the wake of the Asian crisis in 1997. this implies that. have the effect of reducing the overall economy‟s potential growth rate. to acquire other companies through M&A. systematic. haphazard way which leads to malinvestments. corporate credit spreads would most likely rise and share P/Es fall. the Fed eased policy even more aggressively than it had in the wake of the LTCM failure. by 1997 the stock prices of tech firms began to rise out of line with any reasonable assumptions of economic reality. these companies spent more and more on various expansion plans. of course.com corporate bonds. the greatest distortions are likely to manifest themselves in those assets with relatively long-dated but also relatively certain nominal cash flows. we believe that the Fed and economic policymakers generally have spun a vast web of financial market distortions and systemic moral hazard that facilitates asset misallocations just about anywhere. even absent any explicit or implied government support. By implication. these speculators moved more aggressively into tech stocks. to compensate their employees with shares or options thereon. Value investors began to retreat from the market. how does the defensive investor go about investing? Or merely go about preserving wealth? We think there are several investment and wealth preservation strategies worth considering. HOW DISTORTING INTEREST RATES CAUSES REAL ECONOMIC DAMAGE This leads us to another way in which the actions of the monetary authority can become so detrimental to the economy at large. In this 04 . had become so stretched that a bust become inevitable. this time in residential and commercial real estate and in credit markets generally. real assets. Warren Buffet and other successful value investors would beg to differ. some might argue that stock market investment is not necessarily investment at all but rather a form of speculation and that what stock-market “speculators” are after is short-term capital gains rather than valuebased long-term earnings growth. The valuations placed on stocks represent the abilities of companies to raise capital in the form of new shares or debt issues.
amphora-alpha. Historically. costs or expenses nor for any loss of profit that results from the content of this report or any material in it or website links or references embedded within it. A problem then arises in that these assets are traditionally regarded as the standard. John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London. AMPHORA: A lateral-handled. JOHN BUTLER john. While conditions are certainly somewhat different today. such as in the 1930s. DISCLAIMER: The information. Essentially all western government bond markets are at risk. Nothing in this report shall be deemed to constitute financial or other professional advice in any way.THE AMPHORA REPORT Vol 1. investment products or other financial instruments. rather than to invest or speculate. ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. having worked for European and US investment banks in London.com regard. there are enough parallels to make gold.butler@amphora-alpha. they have held their value particularly well during periods in which central banks have chosen to follow unconventional policies. All express or implied warranties or representations are excluded to the fullest extent permissible by law. silver. such as during the 1970s. investors should be particularly concerned about recent developments in sovereign debt markets and not only in the weaker euro-area members. where he was responsible for the development and marketing of proprietary. what are the alternatives? We would argue that gold and other precious metals are attractive as substitute stores of value. New York and Germany. For those simply looking to protect wealth. tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities. quantitative strategies. where he and his team were voted #1 in the Institutional Investor research survey. © Atom Capital 2011 Amphora is a registered trading name of Atom Capital Ltd which is authorised and regulated by the Financial Services Authority 05 . and also when there have been major rebalancings of the global economy. benchmark long-term stores of value.com John Butler has 18 years' experience in the global financial industry. 1 May 2010 www. This report is produced by us in the United Kingdom and we make no representation that any material contained in this report is appropriate for any other jurisdiction. Investors should thus be particularly wary of longer dated government bonds but also other highquality fixed income assets. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London. other metals and commodities generally attractive alternatives as stores of value. and under no circumstances shall we be liable for any direct or indirect losses. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences. Prior to joining DB in 2007. The growing perception that government bond markets are not necessarily reliable stores of value given exponentially rising sovereign debt burdens is almost certain to weigh on the prices of sovereign obligations generally in the coming years. These terms are governed by the laws of England and Wales and you agree that the English courts shall have exclusive jurisdiction in any dispute.
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