• K Squared Capital

Weekly Edition #63

In this edition:

Top Nomura Trader James Im Admits Lying to Clients But Says Everyone Did

There was a high profile case a couple of years ago in which a bond trader was convicted (later it was overturned) for lying to clients about how much he had paid for certain bonds. Basically, Jesse Litvak was a bond trader for Jefferies, he bought and sold bonds to the bank’s clients. In his trading with clients, he would often tell clients how much he had paid for a bond in order to establish a floor which he would not sell below. Therefore, he might tell clients that he had paid $80 for a bond so he was cutting the client a deal by selling it to them at $80.5 or $81 or whatever. However, he often lied about what he had paid for the bonds. So, in the previous example he might have paid $65 or $70. He kept a spreadsheet with the actual prices he had paid and mistakenly sent it out to a client one day which then confronted him and informed the SEC.

The SEC has been cracking down on this type of behavior and a trader from Nomura recently took the stand in his own trial and said that type of behavior was common in the industry. The argument is that the firm’s clients are sophisticated investors which rely on bond pricing models to price bonds and don’t rely on the traders’ representations of how much they paid. This type of lying is made possible because of the structure of the bond market. The bond market is relatively opaque and it isn’t always possible to look at every trade that has happened with a particular bond. Something like this is impossible for stocks, since stocks trade on centralized exchanges and all transactions are reported. Why the bond market hasn’t evolved into a centralized exchange platform is beyond us. But we guess there are a lot of entrenched interests that don’t want it to change much since it would disrupt their business.

The Postpandemic Normal Is Here and It Isn’t That Special

When the pandemic hit in 2020, there was a large shift in the stock market. In the beginning the market got crushed, dropping around 30% in a matter of weeks. This was the fastest crash in US history. After the Fed announced all their different programs to help out markets and the economy, most markets shot back up. However, some companies did much better than others. Airlines, hotels and cruise stocks were hammered. But technology companies such as Zoom, Amazon, Microsoft, Google, Netflix, etc. shot up in price as they were the main beneficiaries of the lockdowns and having to work from home. ETFs like ARKK which invests in speculative growth stocks had record years in terms of returns and asset flows. However, it seems that many of those stocks got way ahead of themselves. Stocks like Peloton, Robinhood, Zoom, and Netflix are down big and are way off their all-time highs. It seems that with the economy gaining steam and things reopening (at least in the West), things are returning to normal and many of these high-flying stocks are coming down.

There is a famous quote that in the short term the stock market is a voting machine and in the long term the stock market is a weighing machine. This basically means that in the short run, investor emotions and sentiment matter more to stock prices than fundamentals. However, over the long run these emotions wash out and fundamentals matter more. We have mixed feelings about this. No doubt fundamentals are important, but we think investor sentiment plays a huge role in both the short and long term. Even if two investors agree on what future fundamentals for a company will be, the prices they’re willing to pay might be wildly different. In order to determine how much you’re willing to pay for a stock, there are many variables unrelated to the fundamentals of a company. For example, it matters what you think the economy will do and how interest rates will behave, what are your liquidity needs, your other investment options, your risk tolerance, etc. Therefore, we think investor sentiment is one of the most important variables in determining stock prices; unfortunately, it is one of the hardest things to predict since oftentimes we are unpredictable beings.

SEC warns 80 more Chinese companies of impending U.S. delisting

There have been a lot of claims about fraud and shenanigans going on with US listed Chinese companies. Many Chinese companies have become US listed by what is called a reverse merger. A reverse merger is when a private company merges with a public company in order to become public. Similar to how SPACs work. Typically, these reverse merges happen with public companies that don’t really do anything but are listed on US stock exchanges. It may be bankrupt companies that are just limping along or companies like the New Jersey deli which we spoke of a couple of months ago. This process is attractive for many Chinese companies since the scrutiny for reverse mergers is much less than for an initial public offering (IPO). Therefore, if they didn’t do it this way, they probably wouldn’t be able to go public. Oftentimes these Chinese companies are very opaque, they have very lax auditing standards, and many are outright frauds. The SEC has been cracking down on these lax auditing standards and now require that any company listed on US exchanges meet US auditing standards. If they don’t meet them 3 years in a row they will be delisted.

We’ve written several articles about investing in Chinese stocks. Investing directly in China has its complications. There are restrictions of foreign ownership, capital controls, and there’s always the risk that the Chinese government decides they don’t like certain companies and destroys their business model (like with after school education companies) or sanctions their founders (like Jack Ma and Alibaba). If you invest in large Chinese tech companies listed on US exchanges, you don’t really own any shares in the Chinese company. What you own are shares in a Cayman entity that has a contract with the Chinese company to share part of the profits; however, this workaround could be closed by the government at any time, and you have no protection. Finally, if you invest in US listed Chinese companies you run the risk of not having transparency into the company’s operations or buying into an outright fraud. Since there are many complications investing in China the easiest way would probably be through a fund or ETF that deals with all these issues.

Elon Musk and Cathie Wood Say Passive Investing Has Gone Too Far in Twitter

The first passive fund was invented in the 70s when Wells Fargo managed an equal weighted version of the S&P 500 for the Samsonite pension fund. They did equal weights instead of market capitalization weights because it was easier to calculate, and they didn’t have the computational power we have now. However, it proved to be very hard to run because it required constant rebalancing to keep equal weighting. Jack Bogle then launched the Vanguard 500 Index Fund which was the first passive S&P 500 mutual fund. This was run just like the S&P 500 in market capitalization weights, which doesn’t require rebalancing to maintain, as the weights drift naturally with the up and down of stocks.

Passive investing has grown tremendously since the 70s and by some measures 50% or more of all investments are passively indexed (we have our issues with the definitions of passive, but we’ll leave that for another day). In theory passive investors don’t affect market prices since they are price takers, they essentially just buy at whatever the market price is. Active investors are trading in and out of securities adjusting their relative prices based on what they think each stock is worth. However, there is an increasing body of literature that goes against this theory. Evidence is mounting that passive flows do impact markets and not in a good way. Passive investing may create certain dynamics which push prices upwards when people are investing and may create some sort of a doom loop which will crash prices if there is a large withdrawal from passive funds. We’ve heard convincing arguments on both sides but have been moving more towards the theory that flows to affect market prices.

Jim Grant: 'Rising Interest Rates Are the Kryptonite of Financial Assets'

Inflation is an interesting subject. Pretty much everybody universally agrees that inflation is bad, the more inflation there is, the less your money can buy. However, a policy goal of almost every single central bank in the world is stable and positive inflation. How can it be that they are all trying to create something which we can all agree is negative? It’s basically because the alternative is much worse, if we were to have sustained deflation it would crater economies (or so the theory goes). Therefore, central banks prefer to have a little bit of inflation in order to minimize the risk of going into deflation. Ideally we would have 0% inflation but that is an impossible goal to meet.

The key here is low and stable inflation, high inflation is also terrible for economies and asset prices in general. The last period we saw high inflation was in the 1970s which was sparked by an oil shock. This oil shock essentially pushed prices up for many goods and services in the economy and stopping it was very difficult. Paul Volcker (the Fed Chairman at the time) had to raise interest rates to the mid-teens and drive the economy into recession to stop the inflation. Central banks typically raise interest rates to slow demand and cool inflation (this is the mainstream theory of how to fight inflation, some in the Modern Monetary Theory camp argue that high interest rates actually spur inflation since asset owners have more money to spend). What is clear though is that high inflation is bad for asset prices. In the 1970s bonds and stocks both did poorly in real terms (adjusted for inflation). There are relatively few assets that perform well in inflationary periods, such as commodities or TIPS. Most portfolios have very small allocations to these types of assets and are concentrated in assets that tend to perform very poorly in inflationary periods. 2022 has been a perfect case study with both stocks and bonds down. In these types of environments there is no hedging between stocks and bonds. For these types of environments we need to think about including other assets or strategies that should perform well.

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