High IQ = Genius Investor?

“Investing is too difficult! I’m not smart enough.” If I had a dollar for every time I heard that I’d be writing this post on the deck of Roman Abramovich’s yacht! I took some time to think over the reasons as to why so many people feel this way.

The first reason that I came to almost immediately are the images that are commonly broadcasted out to the general public from the financial services industry. Scenes of traders yelling at each other, two phones at their ear, while flashing exotic hand gestures dominated the popular perception of investing for decades. Now in the 21st Century these images have morphed into scenes of traders calmly sitting at a station of eight screens, each filled with numbers and graphs and newsflashes. These images overwhelm and discourage those who may be ready and willing to invest money on their own terms, and thus enlarges perceived barriers to entry into the world of investing.

After thinking it over a bit longer I then came to a much more substantive answer. There is a general misconception held by many of what investing really is. Investing at its core is putting aside money now, in order to return an excess to what you originally put down at sometime in the future. This requires no multi-tiered charts with layers of technical analysis, no Ph.D in physics, and no money manager you pay fees to.

The key to investing, which has been missed by so many brilliant people, is that you are in fact investing into a business. By buying a share of a company, you are buying a piece of the underlying business. No matter how commoditized the market has become, with double and triple (long/short) levered ETFs, this fundamental principle will always be true.

So what does that mean for you, the average investor? It means that you are in luck! The keys to making a good investment are thorough and holistic analysis of a company, and conviction. A holistic analysis of the company will make you familiar with not just its finances and projected growth, but of other aspects, such as cultural and environmental impact, perception, and internal culture, all very important to the health of the company. Conviction, which cannot be numerically gauged, is equally important. If someone after extensive research of a company decides to buy its stock, but has no conviction, they will almost always prove to be fickle. When adverse market conditions occur (and they will), they will be prone to dumping shares, even if the decline in price had nothing to do with the underlying business. More often then not, moderate dips in the price of a stock actually present a opportune time to buy more of the stock at a relative discount. By selling into a market full of sellers, you end up losing in the long run.

So why are the smartest people often the dogs of the market? It’s because the market within the last decades has smiled upon added complexity. There is an almost endless offering of financial products today. With more complexity comes more risk, with more risk comes higher potential rewards. Over the last several weeks the price of crude oil has taken a serious hit. In the midst of its decline, several traders I talked to mentioned that they planned on “fading” the market. Fading is contrarian trading strategy in which you sell in a rising market and buy in a declining market, it requires you to have an extremely high risk tolerance. Their big, grand thesis came from a series of technical analysis they had conducted on levels of support and resistance, as well as chart patterns and volume. Skeptical, I warned them not to ignore the macroeconomic and political factors regrading crude. Dismissing my objections, they decided to go big and invest in a triple levered crude ETF. A couple weeks went by and oil continued to drop, and several days ago they decided to cut their losses and sell out of their positions in the red more than 40%.

Were these people stupid? No! They are some of the smartest people that I know. However, sometimes people can be smart to their detriment, as they become enamored with their own theories and convince themselves of its inevitability.

If you want the best shot at being successful in the market, keep it simple! It takes time and dedication, and at certain times the market will test your mettle and determination. But if you do your homework, apply your principles, and hold to your convictions, there is a very good chance you could beat those who break their necks looking for the next wave of market momentum to ride. Work smarter, not harder!

Chasing Yield

“Every reaction has an equal and opposite reaction.” The words of Sir Isaac Newton could not be more true when addressing the fixed income market.

When the Federal Reserve decided to lower interest rates to nearly zero percent several years ago it affected the market in two very distinct ways. First, it eventually revived the housing market (albeit sluggishly), in relation to it ghastly state of the late 00s. When interest rates are low it encourages those with mortgages to refinance, and an uptick in home buying. This was great, as a recovering housing market is vital to the heath of the broader market. But low rates also had another effect: treasury yields reached very low levels (bond prices and yield have an inverse relationship). The unattractiveness of treasuries was compounded by the bull market in equities, in fact some point out that capital flows from the bond market into equities (stocks) is one of the main catalysts of the multi-year bull market.

So what does a fixed income investor do when treasuries cannot generate a desirable return? The simple answer is they start buying lower rated, but higher yielding corporate or sovereign debt. This means that these investors became creditors to companies or countries whose ability to meet its debt obligations was in question, their variable levels of yield serve as an barometer of creditworthiness (higher yield=higher risk). High yield and distressed debt offerings have been oversubscribed in recent years, as the desire for higher yields intensifies.

Not only have investors been piling into riskier corporate debt, but they have increasingly been engaging in structured finance transactions. Structured finance deals are very complex in nature. Some structured finance products, such as the collateralized debt obligation (CDO) gained notoriety during the financial crisis. Without going into too much detail, the structure of CDO is as follows. Before a CDO is structured, fixed income assets, such as mortgages or car loans are first warehoused, this simply means gathered and set aside for eventual use. These assets are pooled, and then they are broken into components called tranches. Tranches are determined by risk profile of the assets within. The highest rated assets make up the “super-senior” tranche. In relation to the rest of the CDO, the super-senior tranche has the lowest risk profile, and thus the lowest yield. Depending on the CDO, after super senior comes the senior, then mezzanine, and then the eventual equity tranche, which is the most risky, but also provides the highest yield. The kicker in these deals is that typically the issuer of these products holds onto some of the initial super senior. That means that the criteria of super senior (and thus all proceeding tranches) may become porous. Some prime may become super senior, some mezzanine prime, and that cascades down the tranches. It’s easy to spot the risks in some of these deals, but clients play a heavy role in the selection of the underlying securities that go into CDOs, so whatever the final product becomes, it is meant to service their needs.

If one were to make the argument that this eventual search for yield was a function of free markets I would not argue, investors have every right to make any investment they see fit. However, investors aren’t receiving adequate returns for the risks they are incurring. More volume in the high yield/distressed debt markets leads to tighter spreads. Although higher volume leads to more liquidity, the crowded market diminishes the ability to generate the usual rate of return. When risk becomes discounted one must be even more watchful and examine whether they are really making the best choice of investment. Rates won’t be at such depressed levels forever, the dovish Fed looks to ready to raise rates (in 2015) for the first time in years. When that happens there will be a probable mass exodus from high-yield corporate/sovereign, and back into treasuries, and may even serve as the catalyst for a pullback in equities.

For more information on CDOs, checkout http://pages.stern.nyu.edu/~igiddy/articles/synthetic_cdos_illustrated.pdf