Wall Street on the way to becoming a bit player in world finance? The real meaning of the Goldman Sachs resignation letter.

March 17, 2012


Investors are wanting transparent yield not murky promises. Aivars Lode

“Greg Smith’s letter adds fuel to an idea going mainstream that the markets are a rigged game,” says Chris Mayer of the Goldman Sachs exec who not only burned his bridges, but poisoned the river below the bridges by publicly resigning in The New York Times.

“In the world of professional baseball,” Chris explains, “the worst crime you can commit is against the integrity of the game. Baseball banned Pete Rose for life because he bet on games while he was a manager of the Reds. Baseball banned ‘Shoeless’ Joe Jackson and seven other White Sox players for throwing the World Series in 1919.”

“You could be a druggie or a rapist and still play ball. But do something to damage the perception that what people are watching is a legitimate athletic contest and not a rigged game and you are out — for good. It is a stiff penalty because the game knows that without that perception, it is out of business. Fans won’t come to the ballpark or watch games if it is all a farce.”

“I think the storm around Greg Smith has touched a similar chord. Goldman Sachs is almost synonymous with Wall Street. If people widely believe Goldman is actively trying to screw its clients, then the game is up. No one wants to play. The public markets suffer. The ability of the nation’s companies to raise large amounts of capital is impaired. And Wall Street’s role in the world is much diminished.”

“This is already happening, as the world’s financial axis spins now not only on New York, London and Tokyo, but also Sao Paulo, Dubai, Mumbai and other market hubs. Greg Smith and Goldman Sachs just hasten that process along.”

[Ed. Note: The process Chris describes is a central theme in his new book, World Right Side Up — wealth and power shifting away from the West back toward China, India and other places that dominated trade for the better part of recorded history.

"Watchman, What of the Night"

Why investors need transparency in their investment’s and yield. Aivars Lode

SATURDAY, MARCH 17, 2012

By STEVEN M. SEARS

In an excerpt from his new book, Barron's Options Editor Steven M. Sears explains why new financial regulations do little to improve the lot of individual investors. How to use history to get a leg up on the market.

In 1953, John Kenneth Galbraith was finishing his history of the 1929 stock market. He needed a title for the final chapter of his book, The Great Crash. Somehow he came across verse 11 of Chapter 21 in Isaiah: "Watchman, what of the night?" It was a fitting title. In less than eight pages, Galbraith described how new laws, including the Securities Act of 1933 and the Securities Exchange Act of 1934, would better regulate Wall Street. But the chapter mostly detailed how politics and other realities would insure those rules fell short of their promise, and their spirit.

Galbraith likely never imagined just how far short those rules would fall. Those depression-era laws, forged when Franklin Delano Roosevelt was President, now loom like monuments immune to the technological and financial innovations that have changed the fundamental nature of markets and Wall Street. The stock market of 1929 bears no resemblance to the stock market of 2012, which will not resemble the stock market of 2052.

In 2011, in the shadow of a financial crisis that rivals the Great Crash in scope and destruction, but lacks a suitable poetic sobriquet, the federal government once more enacted laws to rid the market of self-destructive behaviors that nearly led to its destruction. The watchman has seen this before. His answer to the eternal question, as contained in Isaiah, offers as little solace as Galbraith's conclusion: "Morning is coming, the watchman replies, but also the night."

History always repeats in the financial markets, and individual investors need to be aware of that history.

The market will, of course, recover from its excesses, and it will, of course, fail again. The birth of every bull market will always occur in every bear market. Laws will always be passed. And those laws will fail to prevent another crash while burdening businesses with the expense of complying with massive regulatory requirements destined to be circumvented, if not outdated, shortly after they are passed.

The laws will do little to improve the lot of the individual investor. The primary beneficiaries will be law firms and management consultants, who will reap huge profits helping corporate America implement, interpret—and likely step around—more than 2,000 pages of new laws passed after the credit crisis. By 2011, Debevoise & Plimpton, one of Manhattan's top law firms, was charging $100,000 to write a 17-page letter that explained the meaning of "bank-owned hedge fund."

Davis Polk & Wardwell, another top law firm, that hired top SEC market regulators before and after the crisis, charged clients a $7,500 monthly online subscription fee to track the Dodd-Frank amendment's progress. The amount of money expected to be spent on technology to comply with new rules is simply stunning. From 2011 to 2013, the Tower Group, a technology consulting and research firm, estimated firms would spend more than $3.8 billion.

This is a dim view of Washington's regulatory response more than cynicism. It is warranted by history. The Sarbanes-Oxley Act of 2002, passed in reaction to corporate accounting frauds at companies—including Enron, Tyco and WorldCom—failed to prevent or anticipate the subprime credit crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010, will similarly be humbled, and perhaps even embarrassed, by the extent of its own shortcomings, despite the bombastic vow in the act's 16-page executive summary to "Create a Sound Economic Foundation to Grow Jobs, Protect Consumers, Rein in Wall Street and Big Bonuses, End Bailouts and Too Big to Fail, Prevent Another Financial Crisis."

BUT EACH NEW CRISIS SHOWS that the regulatory regime is permeated with gaps. "Money is like water; it will find its way to those holes," says Pippa Malmgren, who served as President George W. Bush's special assistant on economic policy—and is now president of Canonbury Group, a London-based consulting firm that advises financial firms on the impact of political policies on the markets.

The Bottom Line

An estimated $3.8 billion will be spent be spent on technology to comply with the new Dodd-Frank regulations. The big winners are law firms and consultants, not investors

Perhaps the next financial crisis will occur in the foreign exchange market that is increasingly trying to lure investors with promises of quick riches. Maybe the next crisis occurs in the futures market, where some brokerage firms are trying to persuade investors to invest in gold and silver futures to diversify into different asset classes. Maybe the next crisis occurs in the municipal bond market or in the fast growing exchange-traded fund industry—or in some area of the financial market that has yet to be invented by Wall Street's financial engineers.

All that is certain is that another crisis will occur. It will occur someplace unexpected. It will hurt many people, many of whom can ill-afford to be hurt again by another financial crisis. Those people will be hurt the worst. They will be lured to buy just before the game ends. They will hold on throughout the worst of decline, hoping for the stock market to bounce higher so they can at least break even. But that will not happen when they most want it, or need it. This will panic them, and they will sell right at the bottom just as the stock market readies to advance.

From The Indomitable Investor: Why A Few Succeed In The Stock Market When Everyone Else Fails, by Steven M. Sears. Copyright 2012 by Steven M. Sears. Excerpted with permission of the publisher, John Wiley & Sons (www.wiley.com).

California Sounds Retreat in War on Arithmetic

March 15, 2012

California is staging a limited retreat in the war on arithmetic—but it’s vowing to fight on.

Just like in New York, where the state legislature recently vetoed a plan to put the state’s wobbly pensions on stable footing, California is facing a crisis borne out by numbers. The problem bedeviling California is the gap between the money it has promised to pay retirees and the money it has—or expects to have—to pay the claims, estimated at about $500 billion late last year. For years, California politicians and union leaders rallied around a lie: They promised big benefits to employees while telling taxpayers that it wouldn’t cost a lot of money. They took less money out of current tax receipts than required to honor the pensions, and they assumed unrealistically high rates of return on the assets they did sock away. The wood fairies and the forest elves were going to make up any shortfalls.

The trouble with math, of course, is that it is so implacable. You can tell it anything you want; the numbers don’t change. If you don’t put enough money away, and it doesn’t grow as fast as you tell yourself it will grow, you won’t have enough money when the time comes to write the checks.

That is where California is today.

Despite the best efforts of public unions and government planners to deny the hard truth, in some combination, payouts will need to drop and other contributions will need to rise to keep the funds from running out of dough.

Calpers, the most important California retirement fund and one of the largest pension funds in the country, is responding to the crisis with a partial recognition of reality. For the first time in nearly a decade, it is lowering its estimates for return on investments to 7.5 percent.

This will be an extremely painful adjustment for a state where budgets are already strained to the breaking point. The Wall Street Journal reports that state workers will likely see layoffs and increases in their pension contributions. New pension obligations are expected to cost the state an additional $303 million per year, and many local governments face price increases of two to three percent.

Yet this may not even be the worst news for California. One Calpers actuary believed that the penion plan only had a 50 percent chance of achieving a 7.5 percent return and suggested that a more realistic number should be 7.25 percent, which would place it among the lowest in the country. The only reason these estimates weren’t lowered further were concerns at Calpers about the government’s ability to pay. Clearly, something is wrong, and as much as California employees would like to ignore it, the arithmetic doesn’t lie.

Wars on arithmetic never end well.

http://blogs.the-american-interest.com/wrm/2012/03/15/california-sounds-retreat-in-war-on-arithmetic/

We have exactly the opposite model as we partner with all stakeholders at every level to deliver transparent yield. Aivars Lode

Why I Am Leaving Goldman Sachs

By GREG SMITH

Published: March 14, 2012

TODAY is my last day at Goldman Sachs. After almost 12 years at the firm — first as a summer intern while at Stanford, then in New York for 10 years, and now in London — I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it.

To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money. Goldman Sachs is one of the world’s largest and most important investment banks and it is too integral to global finance to continue to act this way. The firm has veered so far from the place I joined right out of college that I can no longer in good conscience say that I identify with what it stands for.

It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization. I am sad to say that I look around today and see virtually no trace of the culture that made me love working for this firm for many years. I no longer have the pride, or the belief.

But this was not always the case. For more than a decade I recruited and mentored candidates through our grueling interview process. I was selected as one of 10 people (out of a firm of more than 30,000) to appear on our recruiting video, which is played on every college campus we visit around the world. In 2006 I managed the summer intern program in sales and trading in New York for the 80 college students who made the cut, out of the thousands who applied.

I knew it was time to leave when I realized I could no longer look students in the eye and tell them what a great place this was to work.

When the history books are written about Goldman Sachs, they may reflect that the current chief executive officer, Lloyd C. Blankfein, and the president, Gary D. Cohn, lost hold of the firm’s culture on their watch. I truly believe that this decline in the firm’s moral fiber represents the single most serious threat to its long-run survival.

Over the course of my career I have had the privilege of advising two of the largest hedge funds on the planet, five of the largest asset managers in the United States, and three of the most prominent sovereign wealth funds in the Middle East and Asia. My clients have a total asset base of more than a trillion dollars. I have always taken a lot of pride in advising my clients to do what I believe is right for them, even if it means less money for the firm. This view is becoming increasingly unpopular at Goldman Sachs. Another sign that it was time to leave.

How did we get here? The firm changed the way it thought about leadership. Leadership used to be about ideas, setting an example and doing the right thing. Today, if you make enough money for the firm (and are not currently an ax murderer) you will be promoted into a position of influence.

What are three quick ways to become a leader? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.

Analysis: Slow, steady tops fast trading on Wall Street

Interesting article showing that rapid trading and hope for the next big thing is not necessarily better than holding.  Supports  our view of the paradigm shift in the industry from growth & dump to hold & yield. Guenter Krauss

March 10, 2012

By Herbert Lash

(Reuters) - Today's coda for investing in the market calls for rapid-fire trading and an eye for the next hot sector. The investing heroes in this world are hedge funds such as Renaissance Technologies, which made founder James Simons a billionaire with its computer-driven, high turnover trading.

And yet, an informal study of U.S. mutual funds shows that managers who churn through their portfolios are underperforming those who hold investments for longer periods.

The hair-trigger trading strategies used by a number of hedge funds ran into trouble last year, when worries over the U.S. budget, European debt crisis, Japanese tsunami and North Africa unrest whipsawed markets and left investors frustrated over when to get in and out.

The mutual fund study, from Thomson Reuters' Lipper Inc, examined about 75 categories of funds over various lengths of time, finding that longer-held portfolios outdo about 70 percent of the time those funds holding stocks for only a short period.

Low turnover - less than 30 percent a year, or far below the historic average - often beats turnover that is four times greater or more, the data showed.

A longer holding period is a surprising antidote to the poor returns that plagued hedge funds last year. Many hedge funds are driven by fundamentals, but their holding periods are typically short - at times three days or less.

Hedge funds over the past decade turned over an average 35 percent of their positions every quarter at an annualized rate of nearly 140 percent, according to Goldman Sachs research.

SECRET SAUCE FOR ALPHA: LENGTHEN HOLDING PERIOD

Data from the New York Stock Exchange shows annual turnover has steadily increased for decades, peaking at an annualized 138 percent in 2008 during the financial crisis. It has since retreated to an annualized 74 percent in January.

A look at U.S. mutual funds found that portfolios with low turnover outperformed those with high turnover 70 percent of the time over various periods, according to data from Lipper.

About 75 categories of funds were examined at one-, three-, five- and 10-year periods, and at turnover ratios of 30 percent or less, 60 percent or less and 110 percent, a level now considered typical in the mutual fund industry.

Increased transaction costs and the selling of losers for tax purposes often drag on the performance of portfolios with high turnover, said Tom Roseen, head of research services at Denver-based Lipper.

"Very seldom do you see high portfolio turnover actually totally outperform," Roseen said.

The HFRI Fund-Weighted Composite Index of more than 2,000 hedge funds last year fell 5.13 percent, only the third calendar-year decline since 1990, according to Hedge Fund Research Inc of Chicago. The reinvested returns of the Standard & Poor's 500 Index .SPXTR gained 2.1 percent in 2011.

Lengthening the investment time frame in choppy markets will improve the results of investments, advocates say, but it requires a strong stomach to wait for the strategy to pan out.

"To actually add value to alpha, to outperform, you have to have a long holding period," said David Pearl, co-chief investment officer at Epoch Investment Partners Inc.

Epoch is unusual in that it typically holds stocks for about three years, far longer than most money managers. Pearl and co-CIO Bill Priest, with 76 years of experience between them, practice a dying art on Wall Street - security analysis. Fundamental analysis gets overlooked, but can outdo rapid-fire turnover when adhered to with patience.

The New York firm is wary of price-to-earnings or price-to-book metrics trumpeted on Wall Street, as they can easily be manipulated or hide value traps.

Epoch instead scrutinizes free cash flow - the amount of money left over after capital expenditures and all the bills are paid - to gauge a company's growth prospects.

Many investors prefer a story that promises future riches. But Pearl finds free cash flow remains the best measure for determining a company's health.

"When we see businesses that are growing but keep losing money, keep having to raise equity or borrow money, we know, eventually, they're going to be in trouble," he said.

Amazon.com Inc (AMZN.O), for example, trades at a P/E ratio of 130, far exceeding the average of 20.2 for Internet retailers, even though it is growing only twice as fast as the e-commerce sector has as a whole in recent years, according to Thomson Reuters data. Amazon is spending heavily to expand and warned in January that it may post a first-quarter operating loss.

And analysts have panned Microsoft Corp (MSFT.O) for a lack of new ideas, yet operating income has grown by double-digits the past two years.

"They're not getting credit for being technologically up-to-date," Pearl said of Microsoft, which Epoch holds. "It's a cash cow, and we argue they do know what they're doing."

Amazon's stock has gained about 35 percent since the end of 2009 after flat-lining for years. It's off about 26 percent from an all-time high in October. Microsoft rose 4 percent over the three-year span, but is up about 30 percent since October lows.

The market will eventually reward fundamental analysis if a company's profitability is improving and management rewards shareholders through buybacks, increased dividends or debt reduction, Pearl said - but only if cash flow is positive and growing.

Epoch's returns have consistently beat its benchmarks. The biggest fund - Equity Global Shareholder Yield with $6.5 billion in assets - has beaten MSCI's all-country world index by 5.3 percentage points before fees since its inception six years ago.

Epoch's assets under management rose to $19.2 billion as of December 31, up one-third from a year earlier.

After the subpar returns in 2011, hedge funds have outperformed so far this year in what has been an eerily quiet market. But many analysts warn uncertainty is likely to return with China's growth slowing and the still-unresolved euro-zone debt crisis encumbering the developed world.

"We definitely expect high-volatility, risk-on risk-off going forward because a lot of the big macro uncertainty has not been resolved," said Eric Weigel, director of research at the Leuthold Group in Minneapolis.

A high volatility environment that favored less risky assets snarled the timing of entry and exit points in 2011, making it difficult for thematic bets to pay off.

Since the financial crisis hit, the number of days with large swings has been greater than any time since the Great Depression. Swings of 2 percent or more occurred once in every seven trading sessions in 2011, data from research firm Crandall, Pierce & Co show.

"A greater proportion of players in the markets have really shortened their time horizon because it really is risky to make long-term bets, even though they may prove to be very rewarding in the long term," Weigel said.

"But nobody has the patience to wait that long."

(Editing by Padraic Cassidy)

Deeper Dive: NYSE Volume Cut in Half, in Three Years

If they had not tried to support the Specialist system, and supported the technology improvements that we all encouraged them to do, they would still be the premier exchange in the world. As a result, they are just another exchange ---           Case study for other industries.  Try to protect your old model/proprietary technology footprint, when its time has passed - and you will pass into history as well. Ted Baker

March 9, 2012

Tom Steinert-Threlkeld

NYSE Euronext said its dive in trading volume has deepened, in both stocks and derivatives.

Globally, its average daily volume in derivatives contracts was 7.0 million in February, down 21.4 percent from a year ago. Europe was down 35.7 percent and U.S. equity options down 9.2 percent.

The operator of the New York Stock Exchange, NYSE Arca and NYSE Amex said its trading in stocks in the United States was down 21.0 percent from a year ago.

In Tape A, which tracks trading of stocks listed with the NYSE, its market share and trading volume is down pointedly.

In the past year, its market share in matched orders on Tape A has fallen 4.5 percent, from 34.5 percent to 30.0 percent.

Most notably, the number of shares that it traded in the month of February in NYSE-listed stocks fell below the level of activity of 2004 – and is half what it was three years ago, when the credit crisis roiled financial markets.

Activity in NYSE’s “group share” of NYSE-listed stocks was 23.7 billion shares in February 2012.

That compares to 29.3 billion a year ago, 32.7 billion two years ago and … 50.3 billion in February 2009.

February 2009 was the month when, among other things, President Obama signed into law the "American Recovery and Reinvestment Act of 2009", which included a variety of spending measures and tax cuts intended to promote economic recovery. The U.S. Treasury Department, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Office of Thrift Supervision, and the Federal Reserve Board issue a joint statement that the U.S. government stands firmly behind the banking system, And the U.S. Treasury Department announced its willingness to convert up to $25 billion of Citigroup preferred stock issued under the Capital Purchase Program into common equity.

The 23.7 billion shares in February 2012 compares to 28.2 billion in February 2004, according to statistics kept by NYSE Euronext on nyxdata.com.

In a given day, NYSE Euronext handled 1.8 billion shares of all listed stocks in the United States in February. That was down 21 percent from a year ago and 2.2 percent from January.

The exchange operator and technology supplier also said its European stock trading showed a decrease of 8.7 percent from a year ago, to 1.6 million transactions a day in February. But that was up 7.1 percent from January.

Its European derivatives products daily volume of 2.8 million contracts was down 35.7 percent from last year and 11.9 percent from last month.

Four Things Entrepreneurs Can Learn From Warren Buffett

We stick to our knitting...software only, for the long term. Aivars Lode

March 3, 2012

by Glenn Solomon

Warren Buffett’s Berkshire Hathaway 2011 annual shareholder letter was just published this week. For years, Buffett has provided a glimpse into his strategies for success through these letters. I look forward to reading the letter each year. Never fails, I learn from Buffett’s insights and am reminded of fundamental business concepts that never go out of style.

The other day I was with an entrepreneur, and I mentioned I had just read this year’s letter and found it full great insights. She asked me to summarize a few of the gems that are relevant to entrepreneurs. I’ve shared some here:

Identify and nurture your competitive advantage. Buffett is famous for finding businesses with “a competitive moat” to allow them runway to grow fast for a long time and protect them from competition.

Coca Cola is one of the best examples in the Berkshire portfolio. The brand is iconic and powerful, and the competitive hurdles are high for any other players attempting to encroach on Coca Cola’s turf. Some similar examples of competitive advantage from technology include Apple, where product quality and brand seem to reinforce each other, creating rabid loyalists that virtually lock out other contenders from large swaths of market; Google, where core intellectual property led to a demonstrably better user experience, enabling the company to dominate the search marketplace; and Facebook, where network effects have made life very difficult for other players aspiring to build general purpose social networks.

Building and motivating your team is a top priority. In this year’s shareholder letter Buffett begins by gloating about the addition of two new investment managers,Todd Combs and Ted Weschler. He also singles out several of the CEOs in his portfolio for doing a great job such as James Hambrick at Lubrizol, Jordan Hansell at Netjets, Vic Mancinelli at CTB, and Grady Rosier at McLane.

Buffett clearly takes the time to get to know his team well and views the prospects for his various businesses as a function of the strength of these managers. The current breed of top entrepreneurs in technology, regardless of focus area, all seem to echo this sentiment – build a top quality team and great things can happen. Successful public companies like Google, and private ones like Palantir, are well known for their incredibly selective screening processes, and the correlation between great people and value creation is clear.

Measure your performance consistently and don’t be afraid to admit mistakes. Buffett starts this year’s letter with a bunch of good news, but he quickly offers counter-examples and mistakes. He exclaims that his purchase of bonds in a Texas utility a few years earlier was “a big mistake” where he committed “a major unforced error.” He also tells us that he was “dead wrong” when he predicted a year earlier that a housing recovery was set to begin.

It’s human nature to sugar coat mistakes, but like Buffett, the best entrepreneurs are quick to point out challenges and decisively address them. In late 2008 when the market for enterprise software slowed abruptly, Successfactors CEO and founder Lars Dalgaard, reduced staff by one-third immediately. While painful to dismantle much of the growth investments he had made, Lars didn’t hide from the challenge. Three years later, Lars was rewarded with a $3.4 billion price for his company by SAP.

Buffett has reported change in Berkshire’s book value and compared this with the S&P 500 for the past 47 years. That’s consistency! Like Buffett, the best entrepreneurs seek to consistently measure their own performance and those around them as well.

Play the long game and stick to your vision, even if it’s out of style. Buffett reminds us that the key to his success has been to focus on investments in “productive assets,” those companies that can grow without the need for significant additional capital. These companies efficiently deliver goods and services that are consistently in demand, through good times and bad.

He avoids “unproductive assets,” things that don’t produce anything else but that are purchased in the buyer’s hope that someone else will pay more for it in the future (such as gold). He points us to the Internet stock bubble as a similar example, where “extraordinary excesses [were] created by combining an initially sensible thesis with well-publicized rising prices.” Because he knows that “bubbles blown large enough inevitably pop,” he’s missed the opportunity to invest in several companies where he could have made a quick buck, but this strategy is to focus on “productive assets” only and he’s stuck to it successfully for nearly 50 years.

Similarly, great entrepreneurs don’t look for validation from the outside world too often, rather they trust their own instincts and don’t stray from their ultimate vision. Steve Jobs is a terrific example. He was kicked out of the company he started, re-joined when it was down and out, and never lost sight of his vision for what Apple would become.

There you have it. Thanks for another year of great teachings Warren!

[Image Credit: Asa Mathat, Fortune]