Tuesday, April 20, 2010

The Case Against Goldman Sachs

There is no doubt that the sentiment toward big banks is negative.  Many resent that these banks were bailed out during the financial crisis, when the individual citizen who suffered as a result of irresponsible lending practices, misrepresentation of the safety of securities backed by those loans and resulting falling home prices, paid for the bail outs with their tax dollars.  When, added to that, historic profits are earned by those very banks, and enormous bonuses are paid to their employees, while ordinary citizens battle near double-digit unemployment, that anger is understandably exacerbated.
Few news reports give details of this charge, describing it as "complicated, difficult to explain, and hard to understand."  I disagree.  I think that, when explained properly, this is very understandable. 
It's easy to vilify Goldman for bad  behavior.  Let's take a look at this case, and decide for ourselves.
In plain English, Goldman is accused of selling derivative securities to their clients in April, 2007.  Derivative securities are securities that derive their price from another asset. The assets on which the price of these securities was derived, were residential mortgages, which were rated BBB-, the lowest "investment grade" rating available, by ACA Management, LLC, a company with experience rating securities like these. 
A Goldman employee, Fabrice Tourre, allegedly led ACA to believe that a hedge fund, Paulson & Co., Inc., was investing in these securities, when in fact, Paulson was investing in the other side of the transaction, i.e., a "short" position, or an interest in the securities losing value.  The securities that ACA approved as investment grade were chosen from a list that Paulson had chosen to invest against.
The approved securities were described as "Selected by ACA Management" and were marketed, not to individual investors, but to "sophisticated investors,” like banks and pension funds.
When explaining the difference between what must be disclosed to such sophisticated investors, former SEC lawyer Jacob Frenkel, explains,“Materiality is a lot like a continuum.  The amount of information that needs to be disclosed to institutional investors at the highest level, where they’re doing their own research and analysis, is less. Their criteria for the investment decisions tend to be far more sophisticated than the individual investor’s.”
So, the case is this.  A hedge fund wants to bet against sub-prime mortgages, and brings a list of the mortgages it feels will go down to Goldman.  Goldman takes the list to a rating agency, does not tell that rating agency that it received the list from a hedge fund that thinks the securities will go down, and gets an investment grade rating for most of those securities from that rating agency.  It sold those securities to banks and pension funds without telling them that a hedge fund was betting against them.  The banks and pension funds lost money.  So did Goldman, by the way.  They received $15 million for structuring this deal, but they lost $90 million investing in it.
The SEC alleges that Goldman should have told ACA and its investors that Paulson was investing on the other side.
Here are some questions that may help you decide how you feel:
1.  Should rating agencies rate securities on their own merit (not by considering who may or may not be investing in them)?
2.  Since ACA chose the securities in this investment from a list given to them by Goldman (from a Paulson list), was it a misstatement that ACA was "Portfolio Selection Agent?"
3.  Since banks and pension funds are defined as "sophisticated" investors, should they analyze the investments they are considering on their own merit (not by considering who may or may not be investing in them)?
I understand the anger many people feel toward investment bankers.  That said, I also feel that the analysis of securities, particularly by those who buy them on behalf of institutions or pension fund participants, should be based on analytical evaluation, not by "who else is buying this?"
I believe this to be a fundamentally weak case, and cannot help but notice that it was made public during the Financial Regulatory Reform debate.
For the record, I am in favor of Financial Regulatory Reform.  While this case may increase the likelihood of the passage of such reform, I find it largely without merit.
I welcome your comments.

Saturday, April 17, 2010

An Issue of Trust

Who can you trust with your money? 
If you ask the individual investor, the answer is "no one."  Not after the likes of Bernard Madoff, Allen Sanford and, now, Goldman Sachs, the crown jewel of investment banks.  So, if you follow the thinking of the individual investor by measuring "Investor Sentiment," you would have drastically cut back in stock investments in December, 2008, and you would not have returned to the stock market yet. 
In other words, you would have sold near the market low.  No wonder Warren Buffett cautions, "Be greedy when others are fearful; be fearful when others are greedy."
I follow a proprietary investment model that measures twenty one economic indicators.  I've built this model over a period of over twenty years, and use it exclusively for two purposes:
  1. It is my model, and I use only data from apolitical, independent sources for analysis.  That keeps me protected from data that may have been skewed by someone who has a vested interest in whether I choose to invest or not;
  2. It removes all emotion from investment decisions.  If it says that I should be 70% invested, I'm 70% invested.  No panic.  No euphoria.  No need to trust anyone but me.
 When I invested money for other people, it was an invaluable tool.  If my clients wanted to sell low, I showed them that they were doing just that.  If they wanted to buy high, again, I showed them that was a less than stellar strategy.
Discussing each indicator, and how it relates to the overall decision was the subject of a semester's work in an advanced class at UCLA for professional financial planners who chose an emphasis in investment.  Mostly geeks.  I will, however, discuss one part of this analysis, Investor Sentiment, and tie that discussion to the general feeling of mistrust that is currently pervasive with the individual investor.
If you had followed Investor Sentiment as discussed above, you would have sold when the S and P 500 was at 888.61.  It is now at 1192.13.  As reflected above, you'd have sold low and, if you buy back in, it will undoubtedly be higher. 
If, on the other hand, you would have read Investor Sentiment as a negative indicator, i.e., you did the opposite of what it suggested, you would have enjoyed a 34% increase.   Hmmm.  I'm reminded of what my grandmother said when I based my plea to do something on, "Everybody else is doing it."  Her familiar response was, "If everybody jumped off a cliff, would you do it, too?"
So, now we have both Warren Buffett and my sweet little Meema advising us to think for ourselves, and even consider doing the opposite of what others are doing.  In the particular case of the last market correction, that would have been good advice.  But, does it hold true most of the time?
As it turns out, yes.  Investor Sentiment is the most predictive of all twenty one of my indicators, if you do the opposite of what it says to do.  And, I will add, that the stock market is nowhere near the bargain it was in March, 2008, when its cost (P/E)  was about its long term average of $15.82 for every dollar of S and P 500 earnings, but even though the market has come back 75% from its low (25% lower than its high), the individual investor is still not buying.
Back to trust.  Yes, Bernie Madoff is a thief.  Yes, Allen Sanford appears to have bilked thousands of investors out of their money, touting "safe" international CDs.  Yes, it looks like Goldman Sachs took both sides of the bet that the housing bubble would burst.  But does that mean you should keep your money in the bank?  Let's take a look at how that will work for you in the long term.
The best rate I could find for a two and one-half year insured CD was 2.1%.  To calculate your "real return," that is, your return after inflation and taxes, subtract from that 2.1% the current inflation rate, or 2.1%.  Now you're at zero, but you still have to pay taxes on your interest.  For most people,  your marginal tax rate is about 16%.  16% tax on 3% is .48.  So, tax of .48 plus inflation of 2.1 is 2.58.  2.1 - 2.58 = -.48  You're losing about 1/2% annually.
If you're a woman with $100,000 that must last you for 30 years, at that rate, this money will produce about $3100 per year.  On the other hand, if you were to invest in the stock market, using its long term average return of 9%, this money will produce about $9,700 per year.
We live longer.  Inflation hits us harder.  We can put our money in "safe" investments that are guaranteed to lose money over the long term, or we can listen to Warren Buffett and my sweet little Meema.
The choice is yours.

Wednesday, April 7, 2010

The Best Investor 2010 - First Quarter Results

Last January, I posed the question that buying shares in the S and P 500 may be just as effective as following professionals' stock market picks.  Some women who are participating in the Self-Invested Women Pilot Program are considering whether they are passive (people who buy an index, like the S and P 500) or active (people who buy individual stocks or types of stocks, like energy and health care) investors.  This may help you make that decision.
The S and P 500 Index
This index allows investors to buy 75% of the publicly traded companies in the US, many of which derive a significant part of their income outside the country.  While there are many indexes (Dow Jones Industrial, the Russell 2000, the Wilshire 5000), the S and P 500 is the index against which the vast majority of money managers measure their performance.
The Challenge
Last September, ten investment strategists gave their recommendations for which sectors of the market would outperform the total market in 2010 in Barron's magazine.  We chose six of these strategists, representing US Trust, Citigroup, JP Morgan, BlackRock, Deutsche Bank and Goldman Sachs.  We'll compare the S and P 500 index performance against the sectors recommended by each investment professional, assuming you were to invest equally in all sectors.
It requires no management fee to invest in an index like the S and P 500.  Investment advisers' fees range from 2% to 5%.  We'll use the lower figure, 2%, for this comparison, and deduct 1/2% every quarter from the recommendations by the advisers. 
Since there are trading costs for both individuals and money managers, we'll consider this a "wash."
Long Term Investing
We'll assume that we're in the stock market for long term investing, not short term "trading."  Therefore, one quarter's data is insufficient to make this decision.  We'll look at this performance all year, and discuss how relevant this little experiment is to your long term strategy.
First Quarter Performance
S and P 500
S and P 500 was up 6.04% in the first quarter this year.
US Trust
Technology + 10.45%
Materials + 6.89%
Energy + 5.04%
Industrials + 4.77%
Weighted Average performance +6.7875%, less 1/2% fee = +6.2875%
US Trust's recommendations beat the S and P 500 by about a quarter of one percent in the first quarter.
Materials + 6.89%
Financials - 3.68%
Software + 10.45%
Energy + 5.04%
Weighted Average performance + 4.675%, less 1/2% fee = +4.175%
Citigroup's recommendations lagged the S and P 500 by about 1.87% the first quarter.
JP Morgan
Energy + 5.04%
Industrials + 4.77%
Financials  - 3.68%
Technology + 10.45%
Materials + 6.89%
Weighted Average performance + 6.166%, less 1/2% fee = +5.666%.
JP Morgan's recommendations lagged the S and P 500 by about 3/8 of one percent in the first quarter.
Energy + 5.04%
Health Care + 8.53%
Weighted Average performance + 6.785%, less 1/2% fee = + 6.285%.
BlackRock beat the S and P 500 by just under 1/4 of one percent in the first quarter.
Deutsche Bank
Technology + 10.45%
Health Care + 8.53%
Energy + 5.04%
Industrials + 4.77%
Weighted Average performance + 7.1975%, less 1/2% fee = +6.6975%.
Deutsche Bank beat the S and P 500 by 3/4 of one percent in the first quarter.
Goldman Sachs
Energy + 5.04%
Materials + 6.89%
Financials - 3.68%
Technology + 10.45%
Weighted Average performance + 4.675%, less 1/2% fee = 4.175%.
Goldman Sachs lagged the S and P 500 by 1.865% in the first quarter.
So far this year, three underperformed the S and P 500 and three lagged behind its performance, with Deutsche Bank doing best, and Goldman worst.
Last year, only Deutsche Bank and JP Morgan beat the averages, and four lagged behind.
Another update after the second quarter.
We'd love to hear your thoughts.  Are you an active or passive investor - and why?