The Great Deformation

by David Stockman

  The reason for this ultra-skew to the very top lies in the subtle and convoluted manner in which monetary inflation deforms the financial markets. What happens is that cheap credit and market-pegging actions by the central bank foster an irregular and syncopated path of financial asset inflation. This bumpy rise is punctuated by sudden windfall gains in stocks and other risk assets which occur with increasing scale and frequency.

  These windfalls are heavily “event” driven, as in the case of 75 percent M&A takeover premiums, corporate announcements of giant stock buyback programs, and the huge short-term price ramps that periodically occur among so-called growth stocks. By providing opportunities for outsized rewards to agile traders, as distinguished from fundamental investors, such event driven windfalls recruit more and more speculators to the craps tables.

  During the first Greenspan bubble, these storied windfall events and episodes arose initially from the tech sector, such as when Cisco’s stock hit its red-hot stage and witnessed a $350 billion market cap gain in just eight months. In like manner, Intel once gained $250 billion in only four months; the stock price of JDS Uniphase tripled in three months; and, of course, tech IPOs were even more spectacular. Beginning with Netscape’s $14 to $78 per share ramp on August 9, 1995, these tech IPOs often produced massive gains in a single day.

  Moreover, while the 10X stock price gains in deal companies like Time Warner, Lucent, and Enron required a slightly greater time frame to unfold, they, too, embodied the principle of rocket-ship gains. So the turbulent financial asset markets which were endemic to the Fed’s money-printing campaigns fostered a growing posse of financial storm riders.

  In the fullness of time, this posse became an enormous swarm. The Greenspan Fed thus fostered the mother of all malinvestments; namely, the massive array of hedge funds, private equity firms, highly leveraged real estate partnerships and like venues that flourished around and about Wall Street and came to constitute the fast money trading complex.

  These financial vehicles were pleased to call themselves “investment” partnerships, but their game was speculative trading, frequently with leverage in all its forms. They pursued numerous strategies and techniques, but the common denominator was foraging in a financial arena that offered outsized returns based on inside information.

  To be clear, the implication is not that the fast money trading complex was involved in something illegal, such as trading based on the foggy concept of corporate inside information of the type proscribed by the SEC. Rather, the “inside information” at issue here was mainly legal; it was inside knowledge of what the Wall Street wise guys were chasing as the flavor of the week, or day, or sometimes even the hour.

  Stated differently, lightning fast triple-digit stock price gains or sudden $100 billion market cap demolitions do not happen much on the free market in response to fundamental investment research. In fact, genuine value-changing information capable of causing violent price movements can only rarely be kept secret and sprung on the market without warning; it is the vast exception, not the rule.

  By contrast, the stock market “rips” and “wrecks” that became chronic during the Greenspan era were signs that the financial system had been corrupted and deformed by a régime of credit inflation and easy money. After all, what causes asset prices to rise like greased lightning or plunge like a hot knife through butter is the whispered tips of speculators. And easy credit and an accommodative central bank are the mother’s milk of speculation.

  HEDGE FUNDS AND THE REGIME OF INSIDER TRADING

  Accordingly, as the Fed transformed Wall Street into a casino, the mechanisms and arrangements for insider speculation took on massive size. In 1990, hedge fund footings amounted to about $150 billion; by the turn of the century, they had reached $1 trillion; and by the 2007–2008 peak, they had soared to $3.0 trillion.

  The scale of hedge fund operations thus grew by twenty times in as many years. At the same time, the trading books of the Wall Street banks grew even more explosively, expanding by thirty times during this period to approximately $3 trillion. Together that formed the inner arena of speculative finance, the fast money complex.

  Moreover, the highest-value information inside this mushrooming fast money complex was not about the corporate issuers of the securities being traded; it was about the bets being made by other traders. Likewise, the most valuable corporate information was about tradable news events: quarterly financial results and financial engineering moves, not fundamental business trends and strategies which actually drive long-term value.

  Needless to say, the last thing hedge funds do is hedge, an economic service that might actually contribute some value added in a capitalist economy. What hedge funds actually do is churn, chase, pump, and dump. They play wagering games which extract economic rents but contribute little if any value added to the Main Street economy.

  Wall Street is the link between financial engineering in the corporate sector and the wagering games of the hedge fund complex. Wall Street originates financial engineering transactions in its investment banking departments; it then lubricates the hedge fund complex with information and trading services out of its prime brokerage operations. What washes from one side of the Street to the other is the high-powered trading tips and gossip out of which momentum surges arise.

  Thus Wall Street investment bankers advise corporate boards about the size and timing of stock buybacks. Educated guesses leak out. Significant corporate M&A transactions are only undertaken with the good-housekeeping seal of a Wall Street “league table” advisor. More hints leak out.

  Leveraged buyouts are even more Wall Street centered because they encompass multiple sets of M&A advisors and also activate the vast machinery needed to underwrite and syndicate junk bonds and leveraged loan facilities. The deal process for LBOs leaks like a sieve, even before the required SEC filings are made.

  Needless to say, the market-moving information which pours in from all of these sources excites small waves of buying or selling, as the case may be, among insiders in the fast money trading complex. These wavelets periodically attract reinforcements, thereby imparting momentum and more replication of the original trades.

  At length, full-powered momentum trades become energized, and money piles on from the four corners of the hedge fund universe, along with that of momentum-chasing mutual fund managers, retail punters, and computerized trading algorithms. In this manner, new rips are continuously mounted and sudden wrecks are quickly abandoned.

  THE MOMOS AT WORK:

  THE CHASE AND CRASH AT CROCS AND GARMIN

  While many of the rips are so silly as to pass for financial humor, they do dramatize the extent to which the capital markets have been deformed. Left to its own devices, the free market would never deliver up the endless series of fad stocks and sectors which have flourished under the Fed’s prosperity management régime. During 2006–2007, for example, one of the more preposterous shooting stars was Crocs, a maker of brightly colored blow-molded plastic shoes that were a cross between ugly and impractical.

  Nevertheless, in response to an initial fad-driven sales boom, Crocs’ stock price soared from $14 to $70 per share in only twelve months. At its peak, the stock sported a PE multiple of 40X, implying that the nation’s closets would soon be jam-packed with polypropylene.

  As it happened, however, Crocs’ stock deflated back to $2 per share when the accounting illusion behind its spectacular growth became too evident to ignore. The culprit was its ballooning figures for accounts receivable and inventory, which rapidly became uglier than its shoes.

  These ballooning balance sheet ratios had been reported every quarter. But only belatedly did the momentum chasers recognize their obvious meaning; namely, that Crocs had continued to produce and to ship massive volumes of inventory long after its podiatric clunkers went cold with the kids.

  Since it couldn’t dispose of its towering two hundred days of inventory or collect cash from the trade “stuffed” with all this unwanted pr
oduct, it was only a matter of time before the jig was up. By the same token, there was never a time when Crocs was prosecuted for fraud, and for the good reason that there wasn’t any.

  In fact, the evidence that Crocs was a flash in the pan was contained in the company’s SEC reports all along, but was resolutely ignored by the stock market punters. The data they cared about could not be found in 10Ks and 10Qs anyway; it consisted exclusively of stock price momentum indicators such as twenty-, fifty- or hundred-day moving averages, and numerous like and similar charting benchmarks embedded in the stock market’s entrails.

  Needless to say, Crocs was no outlier. There were hundreds of crocks just like it. During the two years prior to its October 2007 peak, for example, Garmin had been even more of a rocket ship. Its stock price had risen from $20 to $120 per share, only to crash back down to $20 a few months later. While its innovative portable GPS device for autos was actually a viable product, Garmin’s peak EPS multiple of 40X was no more plausible than that for Crocs.

  Even as the momentum traders heralded its 100 percent sales growth in the year ending December 2007, it was plainly evident that the auto companies were scrambling to install navigation systems as original equipment and that demand for Garmin’s portable “aftermarket” product would dry up rapidly. In the event, its sales growth rate fell to 20 percent by June 2008 and turned negative by year end.

  The fact that Garmin’s sales today are actually 40 percent lower than their 2007 peak level was predictable at the time, since the new model cars carrying their own navigation systems were already in the well-advertised automotive pipeline. As the second Greenspan bubble approached its peak, therefore, it is evident that the stock market was not discounting future corporate sales, earnings, or much of anything else except the expectation of more juice from the Eccles Building.

  By the time of the 2008 bubble peak, the great financial deformation reduced the stock market to a momentum-driven gambling hall. Indeed, the senseless overvaluation that punters affixed to the likes of Crocs and Garmin was cut from the same cloth as the implausibly high valuations which had been assigned to the home builders, the mortgage brokers, Fannie and Freddie, and the Wall Street investment banks themselves.

  Yet as hundreds of other highflyers like the solar energy stocks, the teen retailers, and the casino stocks took their turn in this malignant pattern of chase and crash, apologists for the status quo always had the same answer. On the occasion of these crashes they advised onlookers to move along, insisting there was nothing to see except some minor breakage attendant to animal spirits that occasionally get too rambunctious.

  HEDGE FUNDS AND THE RULE OF RIPS AND WRECKS

  The Wall Street–hedge fund casino is all the more volatile because it deploys massive leverage in many forms. The tamest form of this leverage, funding obtained in the wholesale money and repo markets, is potent enough. As has been seen, most of the time the resulting carry trade produces handsome spreads and funds a steady bid leading to higher asset prices.

  But at junctures of extreme financial stress, the high level of carry trade funding, which builds up during the bubble expansion, results in violent market reversals. In these circumstances, wholesale funding evaporates and involuntary asset sales cascade into a bidless abyss. The devastating broad market collapse of 2000–2003 (45 percent) and 2008–2009 (55 percent) was dramatic proof.

  The most potent amplifier of volatility in the hedge fund arena, however, is the embedded leverage of options and OTC derivative concoctions. Exchange traded options require regulatory margin, of course, but in the case of momentum trades the margin factor actually turbocharges volatility.

  Options are an accelerator on the way up, since no extra margin deposit is required as the underlying asset price rises, while on the way down, they become a widow maker: any price drop requires the posting of additional margin on a dollar-for-dollar basis. Needless to say, when momentum trades start cratering, the margin clerks become purveyors of pole grease.

  Compared to exchange traded options, the OTC derivatives fashioned by Wall Street dealers are even more combustible. In these unregulated bilateral trades, margin requirements are not standard, regulated, or continuous, meaning that margin calls are often lumpy and precipitate; they tend to exacerbate losing positions as the dramatic, margin call–driven demise of Lehman, AIG, and MF Global demonstrated. Such OTC positions are also festooned with fillips like knock-out and knock-in triggers which produce drastic value changes when these defined trigger points are hit. In effect, these “weapons of financial mass destruction,” as Warren Buffett once called them, can simulate leverage ratios so extreme and opaque that they cannot even be meaningfully quantified.

  THE MYTH THAT SPECULATORS ARE LIQUIDITY PROVIDERS

  The Wall Street fast money casino is thus land-mined with potent agents of volatility. Yet these huge and financially metastasized secondary markets are, paradoxically, portrayed by apologists as agents of economic advance. Hedge funds and Wall Street trading desks are held to be doing God’s work; that is, providing trading liquidity in return for a tiny slice of the turnover.

  What looks like churn and hit-and-run speculation, they contend, is actually a sideshow. The real function of these rollicking secondary markets is enabling corporate issuers to sell new securities efficiently and permitting savings suppliers such as pension funds, insurance companies, and 401(k) investors to smoothly enter and exit investment positions.

  Like the case of Bernanke’s Great Moderation, however, the truth is more nearly the opposite. The Fed’s prosperity management régime has actually fostered a vast increase in capital market volatility, not a gain in liquidity. The proof is in the pudding. If these vast trading venues were meaningfully enhancing liquidity, then volatility would be abating over time, not reaching increasingly violent amplitudes and frequencies. In fact, the highly leveraged carry trades, the financial elixir of the Greenspan era, actually evaporate abruptly under stress and therefore amount to anti-liquidity.

  True market makers, by contrast, minimize leverage in order to maximize their market-making capacity during periods of stress. By thus keeping their powder dry, they can take advantage of that part of the cycle where the bid-ask spread is the widest and dealers can earn above-average returns on their working inventory.

  For these reasons, the liquidity function conducted by genuine dealers on the free market bears no resemblance to the leveraged, momentum-chasing prop traders. Beyond that, the free market seeks out efficient solutions to resource allocation, but having trillions of hedge fund capital absorbed in the “dealer” function does not meet that test by a long shot.

  It can be correctly assumed, therefore, that the $6 trillion of hedge funds domiciled in Greenwich partnerships and Wall Street banks do not toil in the service of the Financial Almighty. They exist not to bring liquidity to asset markets, but to extract rents from them.

  Needless to say, today’s hedge funds do not operate on the free market, and they are neither dealers nor investors. Their business of hit-and-run speculation generates no economic value added but nonetheless attracts trillions of capital because the state and its central banking branch make it profitable.

  Cheap cost of carry and the Greenspan-Bernanke Put are the foundation of this hothouse profitability. They mitigate what would otherwise be the substantial costs of funding portfolios at normalized interest rates and of reserving for asset price risk on the free market. Without these artificial economic boosts, the high-churn style of hedge fund speculation would be far less rewarding, if profitable at all.

  THE “KEYNESIAN” FOUNDATION OF HEDGE FUNDS

  What really makes hit-and-run speculation remunerative, however, is financial engineering in the corporate sector. It catalyzes momentum trades, a venue where the peculiar type of inside information which percolates through the Wall Street–hedge fund complex is concentrated. Indeed, financial engineering is what puts the “Keynesian beauty contest” principle of investment, as onc
e described by John Maynard Keynes, at the front and center of the hedge fund trade.

  In his famous 1936 treatise on macroeconomics, the learned professor prescribed how to compete in a theoretical newspaper contest to pick from among six pictures the girl the public would judge to be the prettiest. Keynes, who had been an inveterate speculator of some renown, advised not to pick the girl who appears to be the prettiest, or even the one that average opinion might select.

  Parse the matter still further, he urged: “We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

  Needless to say, there is much more snake oil of this tenor in the general theory of employment, interest, and money. But what Keynes wrote about the art of speculation in 1936 could not have been more apropos to the behavior of hedge funds in the deformed financial markets that his theories brought to full flower seventy-five years later.

  Mr. Market has seen fit to deliver to the hedge fund complex $6 trillion of capital, which is to say, a wholly insensible amount. This anomaly is explainable, however, by the fact that hedge funds operate in a financial setting ideally suited to the great thinker’s methodology.

  Thanks to the Fed, momentum trading is cheap and reasonably safe from unforeseen general market declines. Yet individual stocks are volatile enough to enable traders to profitably practice the “Keynesian” method; that is, to trade what they judge other traders will be buying based on whatever pictures of the corporate contestants come their way from legal sources, or perhaps not.