CFA MN Book Club (St. Paul) Notes: The Physics of Wall Street.

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Earlier in the month the CFA Book Club (St. Paul group) met to discuss The Physics of Wall Street, by James Owen Weatherall. The book featured biographies of some famous, and not so famous, physicists that used their knowledge of physics systems in nature, such as chaotic systems, and how they were able to translate those theories into actionable strategies in the financial arena. Additionally those biographies were interlinked so you could see how one person’s work influenced others.  Some of those names would be familiar to those in the financial industry, such as Scholes, Black, Merton and others.

Overall, the book received good-to-mixed reviews. About half of our group would have recommended the book to a friend, while the other half had reservations. Here were some of the observations from the group:

What people liked about this book:

  • This would be a good book for undergraduate Finance and Economics majors to read to see why it is important to understand quantitative analysis and calculus, because sometimes as a student it’s not easy to see how those disciplines are used in finance every day.
  • It was a good lesson on how we all need to talk to others in related disciplines to gather insights that we would not have gotten otherwise.
  • It was interesting how the people in the biographies intertwined and utilized each other’s ideas to build upon their own theories offered a nice insight on how quantitative analysis in finance and trading strategies came into existence and evolved over time.

What people did not like about the book:

  • Sometimes the biographies dwelled too much on the subjects’ academic background and how those people became physicists in the first place.
  • The book dwelled too much on historical information and background and less about the interpretations of the theories and how it influenced today’s financial world.

Our next book for the St. Paul group will be Dark Pools: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market, by Scott Patterson. Our next meeting is at Sweeney’s Dale Street Room on Wednesday, February 26 from 5:30 to 7:00.

Living on the Edge, Part II—Make Mine a Large (Cap)

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Late last month, we asked if you can get a real edge on individual equities in general. This week we ask if you can get an edge on large cap stocks in particular. We think yes. We think there are lots of ways to get an edge on large cap stocks—more ways than we can fit in here. So we’ll discuss just one of our favorites: Looking beyond the next handful of quarters in earnings estimates.

One of the toughest parts of an analyst’s job is deciding whether to use a short-term or long-term outlook as he or she develops an investment thesis. Often—perhaps too often—the shorter view wins out for less-than-the-best reasons. Because analysts usually are judged on quarterly performance, for example. Or because there are so many voices chattering about the same issues concerning a particular security.

Those short term perceptions are often what drive a stock, but in our experience, short term noise and thinking can create biases in analysts’ financial models—particularly in forecasting next year’s earnings estimates.

For instance, if an analyst is convinced that shorter-term factors are going to have a negative influence on a particular stock, chances are that perception will bias his-or-her longer-term estimates. Such a bias can keep estimates artificially low, as the analyst may have a difficult time explaining to clients a negative thesis on a stock with accelerating longer-term forecasts.

Simply being aware of the potential for such a bias can be a powerful tool, especially when an analyst believes the longer term potential of a stock outweighs the short-term risks.

So when we hear that most investors are waiting for that “one last negative factor” to subside before getting more constructive with a security, we get interested.  Usually, with well-known products and names, the negative factors are already well-known and anticipated—and factored into short-term forecasts.

But longer-term recoveries from those negative factors in subsequent year’s numbers are often overlooked. The result is a potential edge for the investor willing to cultivate the long term perspective.

There is, of course, the risk that those shorter term factors will drive down the price after one purchases a security. But if your long term investment thesis is unchanged after those events such a price dip often is a great time to add to a position.

Indecision Time

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In spite of the much-heralded cold snap over the past week, credit markets have not cooled off. Maybe market sentiment is just frozen in place along with everything else, but 2014 has started on a positive note.  Or did it? We find ourselves going back and forth between the good and the bad.

On the good side, the new issue calendar was active, which was expected after a holiday hiatus of several weeks. $50 billion priced this week, about $20 billion of which came from sovereign issuers, and the rest from corporate issuers. Bank and finance dominated, which is typical to start the year, including deals from GE, Toyota Motor Credit, and a number of Yankee banks. They were joined by industrial issuers Mondelez, American Tower, Union Pacific, and French oil producer Total. Demand was solid, with deals generally pricing inside of guidance, and performing well once they were free to trade. Spreads have also remained firm – intermediate bonds are a few basis points tighter, and longer duration corporate spreads unchanged so far this year. Not a bad start to the year for Credit.

On the other hand, we are starting to see some weakness in a few areas. Long duration industrials are a little wider, following an unusually strong performance in December. CDX spreads are a few basis points wider (CDX are indices based on Credit Default swaps of a set group of issuers), also following a generally strong December. Investors began selling bank/ finance and telecom paper after the first couple of trading days, and spreads there also moved a little wider. There haven’t been any big cracks yet, so maybe we can chalk up some of the movement to profit-taking.

There are a few worries still in the market, like the never-ending budget battles in Congress. But we have sailed through taper from the Fed, new rules from Dodd Frank, and we are no longer concerned about the collapse of any European Banks. It looks like we’re set up for a solid year with low volatility and good performance from credit.

My mind is going to keep me up at night. Crisis in credit just wasn’t that long ago.

Husker Du?

Rebuilding Trust in the Financial System

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Tom Brakke, CFA

The CEO of Barclays recently acknowledged the damage to the firm as a result of its transgressions and said:  “Trust is a very easy thing to lose, and a very hard thing to win back.  In my view it will take several years – probably five to ten – to rebuild trust in Barclays.”

Meanwhile, J.P. Morgan has been on a treadmill of settlements, resulting in tens of billions of dollars of costs to the firm (or, if you will, to its shareholders).  Once viewed as having skated through the financial crisis relatively unscathed, its reputation has been tarnished by subsequent revelations.

The list could go on but, given the performance of bank stocks over the last few years, you might ask, “Who cares?”  Many observers have come to the belief that the firms are specifically in the business of stepping over the legal and regulatory lines – and that fines and damaged reputations are just a cost of doing business for them.

Surveys show that trust “in the financial system” has collapsed over time.  But that “system” is very complex and involves a wide range of firms and professionals.  Those in research and asset management, for example, might feel that they have been tarred unfairly with the same brush as the banks.  But we are all in this together.

The natural governors on the investment banks are the large asset management firms.  But they have been missing in action – in fact, they tend to exacerbate destructive trends rather than impede them.  Consider the subprime mess.  Had there been a buyers’ strike when underwriting standards deteriorated, we wouldn’t have had much of a crisis.  An absence of buyers would have meant that the paper-making machines would have shut down well before reaching the level of insanity that was attained. Continue reading →

Who Spiked the Eggnog?

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Christmas arrived a little early in the credit markets. Spreads have been grinding in for most of the fourth quarter, but over the past week are tighter by a solid 7 or 8 basis points. That may not sound like a lot, but for the whole market to move that much tighter in such a short span of time is pretty extraordinary, and is the biggest weekly move tighter we’ve seen in the past couple of years. The market closed yesterday at a spread of 116, feels like it’s moving tighter again today, and all sectors are participating.

Long credit is having an especially good month. In fact, it’s had a great year. Excess returns in long corporate bonds are 128 basis points this month, and 377 for the year. It looks like the great rotation out of bonds into equities is not happening on the long end. If anything, it’s the other way around, driven by pension funds. They started the year underfunded, and given the move in rates and equities, we’re guessing many are now close to fully funded, which allows them to de-risk. That means selling equities, and buying long bonds, including investment grade credit.

There are also some good fundamentals underpinning the move in credit. Stronger economic growth, a rebound in housing, and a masterfully orchestrated taper announcement from the Fed all contributed to the positive sentiment.  We’ve had a modestly-more-benign-than-expected announcement regarding the Volcker rule, at least around dealer market-making. There was some concern that corporate bonds would face another decline in liquidity depending upon what restrictions were placed on dealers under Volcker, and so the market is breathing a sigh of relief on that front. Finally, with the new issue market shut down for the rest of the year, and virtually no supply this week, there has been little paper to buy if one did feel like going long credit all of a sudden.

All of these factors have contributed to a downright jolly party in credit. No one feels like playing Scrooge at this bash, everyone just wants to belly up to the eggnog punch bowl. So raise a glass to toast a great year in credit….and let’s hope we don’t all have a massive headache on January 2nd…