Mean Reversion

"Do you want to know why we make so much money? It’s because we’re smarter."

Greg Hawkins
Long Term Capital Management

"In the late 1980s, black limousines used to pull up each afternoon in front of Madame Onoe Nui’s house in Osaka, Japan," writes Michael Hewitt in his HCM Market letter. "Men wearing business suits and carrying briefcases would enter her house. They would only emerge hours later, in the middle of the night. While neighbors believed these gentlemen were visiting Madame Nui’s popular restaurant (or perhaps that the restaurant had begun serving more than just food), they were in fact coming to pay homage to a figure who was later revealed to be the single most important participant in Japan’s stock market bubble: Madame Nui’s pet ceramic toad. Toads are considered mysterious and powerful creatures in Japanese and other Eastern cultures. Senior executives from Industrial Bank of Japan (IBJ) would travel from as far as Tokyo to mingle with senior stockbrokers from Yamaichi Securities and other major trading houses at a weekly midnight vigil to honor the toad. Homage to the toad included first patting its head, then reciting prayers in front of a set of Buddhist statues in Madame Nui’s garden. The climax of the ceremony would come when Madame Nui seated herself in front of the toad, went into a trance, and delivered her stock market predictions, which were considered oracular and moved the Tokyo markets.

"Madame Nui parlayed her toad and a small set of loans into an enormous financial empire," Hewitt continues. "At its peak, Madame Nui’s borrowings reached $22 billion. But, alas, Madame Nui soon came to a now all-too-familiar end. She was arrested for financial fraud in 1991. It turned out that her borrowings were based on fraudulent deposit vouchers forged by friendly bankers. Madame Nui’s bankruptcy resulted in losses of more than $2 billion, the resignation of the chairman of IBJ, and the collapse of two banks. Madame Nui vacated her restaurant for cheaper quarters in prison, where she and several of her bank manager cronies spent several years atoning for their sins. I am…unable to provide the current whereabouts of the toad."

Ten years later, and half a world a way, toads were replaced by computers. And those at Long Term Capital Management of Greenwich, Connecticut, seemed to have a special gift…for a while…

"Bill Krasker, the partner who had constructed many of the firm’s models, was anxiously monitoring markets, clicking from one phosphorescent page to the next," begins Roger Lowenstein’s description of business at LTCM on August 21, 1998, in his book "When Genius Failed." "Krasker clicked from governments to mortgages to foreign debt, the entire atlas of credit…When he saw the quotation for U.S. swap spreads, he stared at his screen in disbelief…"

There are people who care as much about swap spreads as others do about the next Limpbizkit concert. In August, 1998, Bill Krasker, John Meriwether and two men who had just won the Nobel Prize in Economics, Myron Scholes and Robert Merton, were deeply concerned about swap spreads. Their computer models had told them that the spreads might move about a point or so on an active day. But on that Friday, the spreads were bouncing all over the place.

This was bad news for the hedge fund managers. They had as much as $1 trillion in exposure to various positions. Most of their positions were bets that prices in the future would regress to historic means. Prices that seemed out-of-whack with past patterns, reasoned the geniuses at LTCM, would sooner or later come back to more familiar levels.

The LTCM team had more at stake then just money. They had an edge. They were the smartest people on the planet and everyone knew it. The money they were making – as much as 40% per year since the fund began – just proved it. It was a new "computer age," said Business Week magazine. And the professors were its masters. Scholes and Merton were driving fancy new cars. "Merton had dyed his hair red, left his wife and moved into a snazzy pad in Boston," Lowenstein reports. The whole world – and the world’s money – seemed to lay at their feet.

Alert Daily Reckoning readers will recognize the professor’s insight. It is not so different from the one we rely upon. We have a fondness for absurdities. A stock that is absurdly cheap…or one that is absurdly expensive…represents a form of potential financial energy. Sooner or later, we guess, it will be less absurd.

Lying in a hammock at Rancho Santana, the concerns of swap traders seemed a world apart. But absurdity is always entertaining. The story of LTCM makes good vacation reading, even though there is no suspense. We knew from the start what would happen. Bond prices might regress to the mean…but so would the professors’ reputations and their investors’ fortunes.

Here at the Daily Reckoning, we like to warn readers, we have no crystal ball, of course. Nor even one of glass. And we freely admit that we do not know what the future will bring. But that is our secret edge – we give our limitations the respect they deserve. We appreciate our own ignorance, for example, and are constantly impressed by its range and depth.

We bet on regression to the mean too, of course. If a stock is very, very cheap…we may be inclined to buy it. Who knows; it may become even more cheap in the future. Occasionally, cheap companies even go completely belly up. But at least we might be invited in to pick up a piece of office furniture or a defunct desktop computer in the event of liquidation.

Besides, Daily Reckoning readers are encouraged to apply our investment guesses cautiously. Perhaps a stock is cheap. But don’t mortgage your house to buy it…

LTCM took the same insight, regression to the mean, and applied it as if they knew what they were doing. The professors presumed that spreads between, say long bonds and short ones…or between Italian bonds and German ones…were like throws of the dice. Will the spreads widen or narrow? You could look at the historical record, they believed, and compute the odds. If current prices seemed out of line with the odds, they took it as an absurdity and bet that prices would be less absurd in the future.

And maybe they would. But as Keynes once noted, "the market can stay irrational longer than you can stay solvent."

Solvency became a big problem at LTCM because they did just what Daily Reckoning readers are urged not to do – they borrowed heavily.

"It you aren’t in debt," writes Lowenstein, "you can’t go broke and can’t be made to sell, in which case ‘liquidity’ is irrelevant. But a leverage firm may be forced to sell, lest fast-accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often."

With its reputation and capital greatly leveraged, LTCM was forced to sell positions that, given enough time, might have regressed to the mean.

More to come…maybe…

Bill Bonner
March 01, 2002 — en route from Nicaragua to France

Your editor is currently en route from Nicaragua to France. Thus, we go straight to our man on Wall Street, Eric Fry…


Eric Fry, reporting from New York:

– Another day, another failed rally. That’s no way for a bull market to behave. The Dow dropped 21 points to 10,106, while the Nasdaq slid more than 1% to 1,731.

– Accounting concerns continue to dog the stock market…But more on that topic in a moment. First, a few words about that great American export: credit cards.

– The U.S. may not excel at exporting goods and services, but nobody beats us when it comes to exporting lifestyle. Chewing gum, Big Macs and "gansta rap" are but a few of our most successful exports.

– Add credit cards to the list. "South Korean wallets are bulging these days," Reuters reports, "not with cash, but with plastic. Lured by card-promoting tax breaks, lotteries and gifts, the swiping spenders of Seoul and other cities are helping fuel a consumer- driven economic recovery that sets South Korea apart from other Asian economies."

– Maybe the credit card boom is part of the reason why South Korea has been racking up a respectable 2% GDP growth while most other Asian nations are struggling to produce any growth at all.

– Should we tell the Koreans the bad news – the part about having to pay off credit card debts – or just let them have their fun? As we Americans know well, spending is the easy part; repayment isn’t. Even so, if you get into a pinch, there are two tried and true American solutions to any debt problem: borrow more money, or file for bankruptcy. Americans are setting records on both counts.

– "With the economy mired in recession," Reuters reports, "debt-burdened consumers and businesses filed for bankruptcy in record numbers last year, the Administrative Office of the U.S. Courts said Tuesday…Personal bankruptcy filings totaled 1.45 million in 2001, up 19 percent from 1.22 million in 2000."

– Says Sam Gerdano, executive director of the American Bankruptcy Institute, "There’s no question that people are now more comfortable with higher levels of household debt than ever before. It is a generational, cultural phenomenon. And what that means is that bankruptcy becomes a kind of safety net."

– A safety net for some perhaps, but a gill net for others. Just look at how many Wall Street analysts were snared by the Enron bankruptcy.

– "10 out of 15 analysts still rated [Enron] stock a ‘buy’ or ‘strong buy’ on Nov. 8," the New York Times reports, "the same day Enron acknowledged overstating profits by almost $600 million over the last five years."

– "Too many analysts failed to ask, ‘Why?’ Before they said, ‘Buy,’" Senator Joseph Lieberman said.

– "Why didn’t these analysts press for answers or see the lack of information as a warning sign?" wondered Sen. Susan M. Collins.

– That’s easy; Wall Street research analysts don’t actually research and they don’t actually analyze. They market. They compile the facts and half-truths required to support a "buy" rating.

– In many cases, this quasi-research harms no one because the stocks under review are, in fact, worth buying. But in the case of a bad stock that is labeled a "buy," the Wall Street community is complicit in the harm that results.

– Enron is a particularly egregious case. The big brokerage firms didn’t simply sell investors down the river by reiterating "Strong Buy" recommendations on Enron as the stock collapsed. Rather, by helping to create Enron’s offshore partnerships, and then keeping them a secret, Wall Street helped to construct the very vessel that whisked investors to their demise.

– Imagine a fiendish version of the Old Testament story about the infant Moses being placed in a wicker basket along the banks of the Nile, and later rescued by Pharaoh’s daughter.

– The Wall Street remake would feature brokerage and accounting firms loading unsuspecting investors onto a majestic yacht and then launching it out into the rapids upriver from Niagara Falls.

– Trust is a certain casualty of the Enron disaster.

– And we should not be surprised if distrustful investors assign a much lower valuation to stocks than trusting investors used to.


Bill will be back in the office on Monday. Until then, enjoy one last set of your loyal editor’s vacation musings, sent from Managua before he jumped on a plane to France…

Bon Weekend,

The Daily Reckoning Team

The Daily Reckoning