One of the reasons we moved from the academic world to the investment world was the potential for profiting from widely-held misperceptions. Such situations abound in the current political and market environment. Investors who understand this can have a field day.
In the study of economics, political science, and public policy formation there is a body of work supported by evidence. There are also areas of disagreement. A student entering the first course in these subjects comes without knowledge, but with plenty of biases about "how the system works."
It is easily demonstrable (and the subject for more articles) that those who study these subjects find agreement on a wide range of topics. The experts may seem to disagree, and they do on many theoretical offshoots and specific implications. It is more interesting for them to debate the disagreements.
Meanwhile, the average reader (or investor) did not take these classes, or long ago forgot what they learned. This provides an interesting opportunity for the Internet age, where bloggers and mainstream media alike are hungry for content.
One simply takes some plausible "everyman" idea, then takes some development in the news, and spins it to the lowest common denominator of understanding. Since most people share the underlying value bias, they uncritically accept the conclusion. Your blog or column is popular. You get acclaim and high ratings. Life is good!
The Case in Point
Yesterday we wrote about the SEC opinion letter, which attempted to improve both accuracy in valuation of assets and visibility to the investor. If anyone takes the time to read the entirety of the letter, it is obvious that whatever method chosen by a company and its accountants must be revealed and described in full. There is complete visibility of method and conclusion. Those with a value bias do not quote the key parts of the letter, as follows:
If you conclude that your use of unobservable inputs is material, please disclose in your MD&A, in a manner most useful to your particular facts and circumstances, how you determined them and how the resulting fair value of your assets and liabilities and possible changes to those values, impacted or could impact your results of operations, liquidity, and capital resources. Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:
- The amount of assets and liabilities you measured using significant unobservable inputs (Level 3 assets and liabilities) as a percentage of the total assets and liabilities you measured at fair value.
- The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2.
- If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:
- the significant inputs that you no longer consider to be observable; and
- any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded.
- With regard to Level 3 assets or liabilities, a discussion of, to the extent material:
- whether realized and unrealized gains (losses) affected your results of operations, liquidity or capital resources during the period, and if so, how;
- the reason for any material decline or increase in the fair values; and
- whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views.
- The nature and type of assets underlying any asset-backed securities, for example, the types of loans (sub-prime, Alt-A, or home equity lines of credit) and the years of issuance as well as information about the credit ratings of the securities, including changes or potential changes to those ratings.
An objective reader of this letter might well question a pundit who suggests that something in this process reduces visibility to shareholders. The idea that it encourages fraud is just silly.
The Value Biases in Place
There are several easily identifiable biases:
- Markets always yield the correct valuation, regardless of liquidity. Anyone with actual trading experience knows this to be false. There can be many reasons for buyers to step back, often based upon a lack of information or guessing that others will not buy either. The Fed, through a number of measures, and the SEC, have both recognized this, attempting to stabilize markets until there is more visibility and more trading.
- The SEC and the Fed are trying to fool people. One should recognize this as an assumption, not a conclusion based upon evidence. Try doing a critical reading of those taking this viewpoint. What evidence is there that this is what these agencies actually do? We might add that our own study of government (based upon forty years of experience) yields a quite different conclusion. Most of the participants are non-partisan, senior officials who are attempting to get it right. Unlike the pundits playing to an audience, they are genuine experts in their field.
- Companies lie. Accountants back them up. This value bias stems from the 1999-2000 bubble experience. Wall Street pundits can invoke these examples and everyone can remember them. Did any of these pundits note the passage of Sarbannes-Oxley? Did they notice the death sentence delivered to Arthur Andersen? Do they believe that these changes have had no effect upon corporate and accounting behavior? Our own experience as a member of the board of a public company and as a reader of many corporate reports suggests a very different conclusion.
This article from Accrued Interest provides some great information about the liquidity in many bonds and the issues in marking to market (although the author may not share our conclusions). The CDO liquidity is even worse.
Tonight's discussion on Kudlow has an interesting exchange (starting at 4:15) between Barry Ritholtz, who believes that the SEC opinion promotes fraud, and Vince Farrell who makes an insistent rebuttal. (Both are colleagues on RealMoney, and frequently offer valuable insights). Vince invokes the example of AIG and their accountants as refutation, an example we have cited at "A Dash."
One might also compare the conclusion with Barry's take on home prices. He seems to feel that this market, despite millions of trades, does not accurately reflect pricing because some homeowners are unrealistic in their offers. The implication is that distressed trading in CDO's, based upon few trades, is valid, while home prices, based upon many trades, are not.
There are many investors who are currently acting out their biases. In a world where one is free to reject any piece of data as somehow flawed, the initial value biases govern behavior.
At "A Dash" we have attempted to show a powerful and ongoing effort by various parts of government to deal with the relevant issues. We expect each of these initiatives to have an effect, with a strong cumulative effect.
Meanwhile, investors and managers rejecting stocks and going to cash are not just fighting a Fed that is cutting rates, something we warned about. They are fighting a creative Fed that is willing to employ new tools never before considered. They are fighting the stimulus package, the SEC, expansion of Fannie, Freddie, and the FHA. The Frank/Dodd legislation will be the next battleground. If the Bush Administration agrees to a compromise, it will be another significant effect on housing supply and demand.
It is so easy to point out problems, and so difficult to see the solutions.