Agora Financial’s Rude Awakening

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Laguna Beach, California

• Wall Street Implodes – Now, Who’s Next?
• Where to Run When There’s No Place to Hide,
• “Avarice, Meet Consequence,” and plenty more…

Eric Fry, reporting from Laguna Beach, California…

What separates an epic financial crisis from a merely ordinary one is the scale of the resulting destruction. The current credit crisis is epic in almost every imaginable way. Very few investors have managed to escape its fury.

For most of the last 14 months, some wary investors managed to escape harm, simply by avoiding financial stocks…and/or by hiding out in the commodity sector. But as the crisis has intensified, reliable hiding places have all-but-disappeared. In fact, many hiding places are starting to feel a bit like tombs.

As recently as the end of August, many commodity-focused investors were savoring modest gains for the year-to-date. But the first two weeks of September have demolished those gains, along with the comfortable illusion that commodities would provide a reliable hedge against stock market losses. Even gold has failed to provide any refuge – slumping more than 5% in September alone.

Therefore, many of us resource investors are feeling more chagrin than satisfaction. We sidestepped the financial sector 18-wheeler, only to step in front of the commodity sector bus. But at least we’re still flinching on the pavement…unlike our bank-stock-investing counterparts. We should remember that Merrill Lynch stock has delivered a total return of MINUS 45% during the last 10 years! Commodity prices have nearly doubled over the same timeframe. So all of you commodity investor who gravitate toward self-flagellation might want swing the whip a little more gently. Your misery is not entirely your fault. These are very unusual times in the financial markets.

Typically, stocks and commodities move in opposite directions. Therefore, the investor who feared a selloff in the stock market could usually protect himself by loading up on commodities. But not in September of 2008! During the recent stock market selloff, commodities have provided no protection whatsoever. In fact, they have performed even worse than stocks.

A hypothetical portfolio that contained half S&P 500 stocks and half commodities would have lost 9.75% during the month of September, so far. That performance would rank as the fourth worst monthly performance of the last 50 years. In other words, these are strange times indeed.

But even though commodity prices have retreated substantially from their all-time highs, they will rebound eventually. By contrast, the financial sector has wiped out more than one trillion dollars of investor wealth…and that wealth is gone for good.

So at the risk of repeating ourselves, we will repeat ourselves anyway: we like commodities, at least for the long haul, if not also for the short haul. We like commodities because supplies are limited and demand is not. But we also like commodities because they lack CEOs and executive management teams. We like commodities because greed and stupidity cannot destroy their value.

“Looking back, what was the cause of this credit crisis?” CNBC’s Maria Bartiromo asked Bank of America’s CEO, Ken Lewis, during an interview yesterday morning. “What caused this whole mess?”

“Excessive leverage and greed,” Lewis responded.

Even six months ago, very few investors feared these two financial toxins – and even fewer Fed chairmen, Treasury Secretaries or banking regulators feared them. “Wall Street is full of smart guys,” the advocates of leverage and greed explained. “They know what they’re doing and they deserve their pay.”

Unfortunately, this dangerous myth did not simply fade away with the passage of time, it detonated…and the shrapnel is claiming millions of victims. Thousands of mid- and low-level Wall Street employees will lose their jobs, while millions of investors will suffer multi-billion-dollar losses in one way, shape or form.

Therefore, to rephrase Maria Bartiromo’s question: Could America have avoided this mess?

Answer: Only if we could have contained both the leverage and the greed that have been greasing the Wall Street money machine for the past decade.

To provide a more complete response to Ms. Bartiromo’s question, we would refer to the January 18, 2007 edition of the Rude Awakening: “Bonus Envy,” in which we suggested, “Greed is one reason why brokerage stocks might be dangerous stocks to own at their current lofty valuations…No automatic connection exists between greed and poor stock market performance. But bad things just seem to happen to the common shareholders of companies that greedy managements oversee.”

This simple observation seems even more timely today than it did in early 2007…and the lessons this observation contains seems even more valuable.

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Bonus Envy
By Eric J. Fry

The rain falls on the rich and the poor alike. That’s symmetry. But after the rain lands, the rich receive a much larger share of the water than the poor. That’s asymmetry. Indeed, some of the rich funnel as much water as possible toward their own personal reservoirs…even though they have more than enough water already. That’s greed.

…And some of the rich drain the wells of their neighbors and clients to water their golf courses. That’s Wall Street.

Greed is one reason why brokerage stocks might be dangerous stocks to own at their current lofty valuations.

No automatic connection exists between greed and poor stock market performance. But bad things just seem to happen to the common shareholders of companies that greedy managements oversee. Names like Enron, Tyco and Worldcom come to mind.

In this context, names like Merrill Lynch and Morgan Stanley do not yet come to mind. But the big brokerage firms of Wall Street have veered perilously close to the shoals of excessive greed. And this course endangers shareholders because it squanders capital that could be funding productive activities, or providing a balance sheet buffer against future unanticipated “adverse outcomes.”

As long as the financial markets remain robust, however, no one will care how many billions of dollars might slosh into the brimming bank accounts of elite traders and top Wall Street insiders. But financial markets are not always robust. The same Citigroup that is today lavishing billions on its top employees was once the Citibank that flirted with bankruptcy in the early 1990s.

Bank and brokerage stocks are already risky enough, thanks to the perennial risks of falling financial markets, rising interest rates and exploding derivatives books. Avaricious management teams do not lessen these risks.

The owners of brokerage shares, therefore, do well to remember that Wall Street is forever and always about money. It is about making as much money as humanly possible, in as many different ways as legally defensible. Wall Street is not about charity or altruism or the “greater good.” Wall Street is also about survival of the fittest – the “fittest” being those who maneuver themselves into obscenely overcompensated positions. Do these alpha-bankers and alpha-traders deserve their millions? In a primal sense, yes…just like a great white shark deserves a slow-moving harbor seal…or a falcon deserves a hapless bunny…or a coyote deserves the neighbor’s dozing Pomeranian.

But these metaphors become a bit sinister when one realizes that the “hapless bunny” and the “dozing Pomeranian” are the common shareholders.

The big brokerage firms make most of their money by speculating with capital that does not belong to them, or by levying fees and commissions on capital that their clients put at risk in the financial markets. In other words, shareholders and clients bear most of the risks. Yet whenever any form of success arrives, Wall Street’s elite always garner an outsized share of the rewards. That’s asymmetry. And in this case, asymmetry might just be another word for “greed.”

Consider the case of Morgan Stanley. The firm posted net income of $7.4 billion in 2006 – an impressive $3.7 billion more than 2003 earnings. But at the same time, total compensation at Morgan Stanley last year topped $14.3 billion – a whopping $5.8 billion more than in 2003. Does it not seem odd that employee compensation is nearly twice the firm’s net income? And does it not seem odd that employee compensation has jumped 60% more than net income since 2003, even though the number of employees has barely increased at all? In fact the employee count has DROPPED since the end of 2002.

Most of the individual recipients of year-end bonuses are not to blame, of course. They are simply blessed. And as blessed individuals, they enjoy the privilege of sharing their wealth in altruistic and charitable ways…or not. Likewise, the stockbrokers who toil for these firms deserve no scorn. They earn their keep like entrepreneurs, and must conduct their activities in a very open and competitive marketplace.

But the leaders of Wall Street – those who perpetuate the status quo – might consider taking a minute of “quiet time” to consider the propriety of their practices. Do these folks honestly believe that they deserve their multi-million-dollar bonuses, simply for presiding over bull market trading activity? And do they honestly believe that “star” traders deserve their multi-million-dollar bonuses, simply for speculating with someone else’s capital.

To re-phrase the question: Isn’t it possible that Wall Street’s elite employees should receive a somewhat smaller share of corporate cashflows than they do currently…and that the common shareholders should receive a somewhat larger share?

“Nobody who is hired help and who plays with other people’s money ‘deserves’ to earn $100 million,” gripes Steven Pearlstein in a terrific article for the Washington Post. “That’s certainly true in a moral sense. But it is also true economically…Let’s start with the fundamental asymmetry of risk in the investment business.

“If you were putting your own money at risk,” Pearlstein continues, “there’s the possibility of making lots more, but there’s also the possibility you could lose it all. The same, however, can’t be said if you are an investment banker, a hedge fund manager or a trader in credit default swaps. In that case, if you do well, you get a percentage of the winnings or the value of the deal. But if you do poorly and your clients lose money, the worst that happens is that your bonus is zero. You never have to give back anything from the bonus you earned last year. And you still get a base salary comfortable enough to keep up payments on the Upper East Side townhouse, the summer place on Nantucket and the tuitions at Brearley.”

No one cares about over-the-top compensation schemes when business is booming…and when share prices are rising. But on the downside, everyone cares. During the Great Bull Market of the late 1990s, almost no one bothered to question the exorbitant option grants that Silicon Valley companies lavished on their employees (and on their board members!)

But once the Great Bull Market ended, and the Nasdaq imploded, a new bull market in recrimination and litigation began. Class-action shareholder lawsuits erupted from the smoldering remains of former Wall Street darlings, as desperate shareholders tried to recover some small fraction of their losses.

Would it not have been much better for these abused shareholders to sell when the selling was good? Would it not have been better to have raised a skeptical eyebrow toward the questionable corporate practices of the era and headed the other way…even though questionable corporate practices were producing rising share prices?

“Excess compensation in one area leads to excess compensation in others, “Pearlstein concludes. “And that, in the end, is how this arms race in executive pay comes about. It’s more about envy than economics. The corporate executives complain they should make as much as the investment bankers, the bankers are upset if they don’t make as much as the private-equity guys, the private-equity guys demand to make as much as the traders, and the traders won’t sit still until they are paid like hedge fund managers.”

Excess compensation also leads to sub-optimal shareholder returns. Greed and capital preservation just don’t seem to mix very well, especially when the greed belongs to someone else and the capital belongs to you.

[Joel’s Note: A while after this column was published, our own resident short seller, Dan Amoss, recommended buying puts on Lehman Brothers. A few months later, he gave readers the heads-up to cash out…for a 462% gain. Those that braved it until the very end could have cashed in for over 700% after Lehman filed Chapter 11 over the weekend.

Every trader is different, of course – risk tolerance, available capital, stomach for volatility – so Dan often issues two ways to play the ideas he presents in his Strategic Short Report; one for high risk traders and one for the more conservative type. Right now, Dan’s got his eye on another Wall Street giant – one that hangs on precariously after yesterday’s market mayhem.

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Continued Here

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[Rude Endnote: One way to avoid a painful “I told you so” is to first heed the “I warn you thus.” The market yesterday suffered its ghastliest day since September 11, 2001. Wall Street is unraveling at the seams…giants are toppling every other week…global indexes are again under the pump again today (as we write, the Hang Seng is off over 1,000 points…Japan’s Nikkei is under water more than 600)…and many commentators believe this is going to get a lot worse.

In short, if you don’t have an adequate bear market strategy, you’re really leaving yourself open to a deserved “I told you so”…and nobody likes that. Seriously, get yourself on board with the Ultimate Bear Market Strategy. As this thing really gets going, you’ll be glad you did.

Until tomorrow…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com