Sunday, February 20, 2011

That Was The Week That Was

  • NYSE deal demonstrates derivatives are more important than equities in the business
  • FICC is volume-reliant
  • G-20, markets manipulator
  • Advice for Equity Investors

Many years ago the British, the masters of satire, produced a television program that parodied the weekly news. A similar program developed in the US. The title of both shows was "That Was The Week That Was." I was reminded of that title early in the week when finally the announcement was made of the Deutsche Böerse deal with the New York Stock Exchange. As usual, most of the press coverage was focused on the wrong topics: control of the board, loss of national pride, and even the name of the new multinational collection of exchanges and clearing houses. What was generally missed by the popular press is that the key to the future profits of the new group would come from market making, settlement and clearing of derivatives. Already derivatives contribute more profits to the NYSE/Euronext than trading of listed stocks. In the art of investment analysis, one of the key tenets is to follow the profit trail. With rare exceptions, the perceived future decisions of management will be made to favor where the profits are being derived. With this announcement, whether or not this deal is consummated, a tombstone should be erected to the slowly dying equity business. The political powers within the investment banks and exchanges do not come from a stock culture. This deal is only attractive if one sees their future and profitability will come from derivatives.

If you think that I am being unrealistic, try to enter a brokerage firm and tell them that you would like to invest in 30,000 shares of General Motors or about $1 million dollars, and see how quickly the order-taker will dispatch you to a salesperson who will suggest that one or more packaged products would do you much better than your chosen investment. Perhaps it would, but what is definite is that the brokerage firm would make much more money now (and probably in the future) from the sale and/or management of various products and services than executing an equity order. To further buttress this analysis, ask the best and brightest candidates from our premier universities where on Wall Street they want to work. You will largely find they want to work as investment bankers, traders, or hedge fund managers. Few, if any, have a long term objective of analyzing and selling individual equities. If future brains and talents follow the profit trail, the outlook for equities is severely diminished. As a former president of the growing New York Society of Security Analysts, I can see our membership shifting further and further away from the analysis of individual equities and more into the study of derivatives and packaged products (wealth management and hedge funds).
  • Are the prices of your stocks impacted by derivatives?
  • Has that changed your trading techniques?
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For those of our blog community members who do not follow the investment banking stocks the way I do for our own hedge fund, FICC stands for Fixed Income Currencies and Commodities, the product areas which have been the largest sources of profits for most major investment banks for a number of years. FICC is the magnet that attracts firms’ capital and talent banks. What are the attractive characteristics of these diverse markets? Disclosure and regulation are less rigorous, the majority of dollars are traded privately in an over-the-counter format, market making allows a proprietary profit opportunity, and clients are likely to use leverage with borrowed money from the house, generating net interest income. Supplemental reading on this topic can be found in my earlier blog entitled: "Too much Reliance on FICC Could be Dangerous."

Almost all activities in the financial community have a certain level of fixed costs and variable compensation. Even with the multiplication power of leverage, there is a need to find new participants to reach the desired level of profitability, or in large organizations the desired share of overall profits. The development of the currency market is a good example. Initially, foreign exchange transactions were needed to support cross border physical trading. As orders were placed for goods in advance of shipment and collection of proceeds, producers needed to protect themselves against unfavorable shifts in the value of the contracted currency. Thus they began to hedge the currency just as farmers did with commodities. The trade in “invisibles” such as intellectual properties and debt service payments only magnified the need for trading and hedging currencies. Remember, most hedging involves borrowing which creates net interest income for the provider. Thus, a robust, in-depth daily market in currencies was created centuries ago. (The Rothschild family was expert in the use of its family network in currencies and the ultimate currency of the time, gold.) Pure financial traders without an interest in shipping goods and services recognized that a wonderful trading market was created that encouraged private trades at undisclosed prices. Over time, the trading of currencies has grown to be much larger than the level of goods shipments. One of the key profit elements for most large commercial and investment banks has become currencies. There are at least two profits, trading profits and net interest earned. Within these banks, the head of currencies is politically important but not disclosed.


As with the currency markets, the commodity markets have been in existence ever since farmers sold off their excess crops. As with currencies, the natural market has been multiplied by financial players. Investment banks and others have long discovered the same twin profit streams of trading profits and net interest income. While commodity revenues can be extremely volatile in some years, they can be an important part of the firms’ overall profits and thus their leaders can be richly rewarded and politically important.

Up to the Minute

This weekend, the G-20 finance ministers and central bankers are meeting in Paris at a time of currency instability and sharply rising food prices. The President of France is the host for the meeting, and as he is in fashion, he is calling for restrictions on commodity “speculators,” just as he unwisely called for controlling hedge funds a year ago. I am not able to solve the problem of an increasing number of people going hungry who can not afford to buy enough food to sustain themselves and their families. (I only wish that I or anyone else could.) Most of the current problem is due to changing weather conditions which has produced both droughts and floods. Whether these are cyclical or secular weather changes, I will let others debate. What I do recognize is that many of the affected countries suffer from inadequate physical and financial infrastructure. Further, in many cases past foreign aid from the developed world was surreptitiously exported to private accounts out of their country.

Who are the culprits?

To some degree, those who are responsible both for currency instability and some of the rising food prices are the people sitting around the Paris table (or their predecessors). These days, almost all governments are attempting to manipulate their currencies up or mostly down through either “dirty floats” or more likely, excessive money supply growth and inducing inflation. The nasty, venal speculators and hedge funds only wish it would be legal or proper to manipulate the markets as those in Paris have done and are likely to attempt to do in the future.

What Should Equity Investors Do?

First, we need to recognize that we will get less support from the “best and brightest” from the sell-side of the investment community. In turn, this can create opportunity for numerous stocks around the world. Even with increased disclosure, we will find neglected prices and opportunities. In the near term this could be enough for us, but the lack of historic selling efforts at our near term peak prices may not be as high as they would have been using the past markets' valuations. So we need to be careful.

On a longer term basis I envision capital returning to equities that has been diverted to currencies and commodities. I suspect at some point in the future we will achieve currency equilibrium, as many market forces will be applied to keep hard currencies hard, and these will, in effect, set the exchange rates for most of the weaker ones. Eventually much of the capital devoted to commodity speculations will return to the equity market. Most commodity prices are priced to recognize the current level of scarcity. In almost all cases there are long term forces at work to reduce these scarcities. South African gold mines will dig deeper to bring to the surface more low grade gold that can be milled and mined at today’s prices, new copper mines will produce more silver as a bi-product, new agricultural machines and crop management will be more productive, etc. All of these trends will be incomplete and take time. However, I believe that eventually investors will realize that well chosen equities and equity managers will produce the highest reasonably sustainable results. Endowments and family fortunes please note.

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