What Will The "Wizards of Wall Street" Think Up Next?

image credit: ZeroHedge.

Well, that was fun!

The largest point drop in the Dow Jones Industrial Average (DJIA) in history on Monday February 5, 2018.  Of course, the financial news media had a ball reporting on this historic day, regardless of the fact that when prices go higher, the impact of a higher price movement is, of course, relative (the percentage drop was not even close to historic).  Nonetheless, even we, who have been watching market moves for decades now, were somewhat taken back by the violent swing in the DJIA when at one point we observed about a 1000 point swing in a matter of mere seconds!

We have come to virtually ignore such actions despite the awe they inspire in the moments when they are happening.  Frankly, such events have become great "educational moments" for those of us who adhere to a discipline of considering the investments we make in publicly traded companies as investments in businesses.  Yes, we mean investments!  Does anybody remember that word?  Webster's defines it as follows: the outlay of money usually for income or profit : capital outlay; also : the sum invested or the property purchased.

We suggest that this is somewhat limiting because it does not give any reference to time.  We have always viewed investment in a business as something that requires time, some length of time, maybe years, to fully reap "income or profit" with any level of certainty.  At least Webster references "property" in the definition as this can in some way be connected to time.  Does anyone invest in property for a few seconds, even days, weeks, months, quarters?  Surely, years?  Of course it is possible to invest in property, and in this instance we mean "real property", or what is commonly known as "real estate" for any amount of time, even seconds, we suppose.  But in reality, most "investors," when investing in property, think of it as "long-term," measured in years, usually, as the time frame for which they will be invested.

How does this discussion of property ownership relate to Monday's wild stock volatility?

Well, referencing back to the action of the market on Monday past, it occurs to us that investing in businesses should be considered similarly to the way people invest in property.  But this is not the case in the stock market today.  And this lack of patience is exacerbated by the financial engineering that has been propagated by the illustrious "Wizards of Wall Street," who dream up complex "financial products" which have little to nothing to do with the allocation of capital to actual businesses.

In this recent article in the Wall Street Journal, "Born To Die: Inside XIV, The Busted Volatility ETN" author Charles Forelle describes the Credit Suisse creation called "VelocityShares Daily Inverse VIX Short-Term Exchange-Traded Note".  Huh?

This derivative instrument is a way for traders to "invest" in the lack of volatility in the market.  This does not sound like anything remotely resembling investing in businesses -- more like speculation or even gambling.  Especially when you follow the path of progression for this instrument that ultimately ensured that it would race to "zero" value in the future. Forelle notes that the instrument's prospectus even noted that it would ultimately result in zero value. However, along the way, it appears to have created a level of volatility in the shares for real businesses which happen to be traded on the public markets, and can therefore be connected to the reason we witnessed such wild swings in the market on February 5, 2018.

This is just the latest culprit.  There have been plenty of others over the years.  We recall the infamous "portfolio insurance" products of the 1980s that aided in the over 20% drop in the market averages on October 19, 1987.  Forelle references that disastrous day in his article as well.

When and where does this stop?  Perhaps nowhere and never.  As long as the focus is short-term in nature, and purports to give people better mouse-traps for making money (particularly the financial industry), then this stuff will continue.  We can only plead with those that care about their asset value over time that they avoid getting caught up in such schemes.  That they recognize there is no magic to making good returns investing but disciplined, hard and tenacious due diligence in choosing companies in which to invest.  And that the best way to invest is to stick as close to "real" investing as one can.  We have preached about this, and we have delivered this as professionals over the decades.  But we are often lone voices in the morass of the financial world in making this case.

Hopefully, days like Monday February 5, 2018 and follow up articles like the one Charles Forelle has written, will teach the world a lesson!

Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

Active vs. Passive Redux

As investment managers who have espoused the value of actively managing a portfolio to try to beat average market returns, we have consistently brought investors' attention to those arguments in favor of such an approach.  We are particularly attentive when we see others making the arguments for us.  We have referenced the topic in many posts such as this one and this one.

The active vs. passive debate can be complex for the typical investor to adequately evaluate.  Nonetheless, the bias towards passive investment as a superior strategy has grown dramatically in recent years, particularly since the 2008-9 financial crisis.    Financial media pundits have wholeheartedly embraced the passive form of investment, and both individual and institutional  investors have voted with their funds in pouring assets into passive strategies. 

Interestingly, it appears that the almost decade-long march towards more passive strategies is changing.  In a recent article in the Financial Times, "Hungry Funds Look To Switch To Active Equity", the case is made that many institutional investors are looking to reverse that trend in the coming years.  While the article suggests that more than simple equities are on the radar of these institutions, the point is clear that a change in trend may be happening.

Frankly, we believe the rush to passive over the years has become a major danger for the market and economy, in general, because of the affect such strategies can have on adequate price discovery.  Essentially, if everyone were passive, how can companies be appropriately valued?  What does such lack of reliable valuations mean for the economy?  How can capital be effectively allocated in an environment where investors can't clearly determine value, ie., where are the good companies who deserve capital allocations?

We are proud that in this desert of active managers, our equity strategies have outperformed their benchmarks over the long term.  So, apparently, we have bucked the trend.  Yet, it doesn't give us comfort that the impact of passive investing may be much more significant than the effect the phenomenon has on the active investment management business.  In the December 7th, 2017 article in   "Chief Investment Officer" magazine entitled "Back to the Future", the author Vishesh Kumar gives a general overview of markets and touches on a number of investment trends.  However, we found the key point in the article was a reference Kumar made to a Neuberger Berman research piece that discussed the type of market we have been in since the financial crisis of 2008-9 (a largely passive-dominant market) and what has driven it:

“Fueled by extraordinary global central bank intervention, equity markets have soared since their 2009 trough, leading to conditions unsupportive of traditional capitalism and active management, including high levels of correlation and low levels of dispersion,” Joseph Amato, Peter D’Onofrio, and Alessandra Rago from Neuberger Berman wrote in an October research report. “Stock correlations within the S&P 500, for example, have spiked nearly 20% since May 2009, depriving active managers of the opportunity to distinguish winners from losers through fundamental research. Post-crisis market conditions also suggest that the past decade is not an ideal timeframe over which to gauge an investment’s potential for long-term success across market cycles. We think central bank policy normalization could inspire a normalization in market dynamics."

Setting aside the change in trend back towards active management, it should concern every investor who believes in free enterprise capitalism and bases their investment decisions on finding the best companies in which to invest that recent government policies have served to stultify "traditional capitalism." It underscores what we have been saying for years about the heavy hand of government and its effects on the economy and capital formation.  Too much government starves the economy and markets from the capital it needs to expand and redirects it towards, most often, inefficient government projects (a "Bridge to Nowhere" anyone?).  Is it any wonder the number of public companies has been almost cut in half?

We really don't concern ourselves with whether or not the "trends" are in favor of active management or passive management: we will continue to seek out great businesses in which to invest capital.  However, if the trends favoring passive over active are symptomatic of damaging policies which impede the proper allocation of capital, then we all should be concerned, professional investor or not.

Disclosures: Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.  A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.