Against the herd

Bubbles develop and declines manifest in a certain manner. Knowing this pattern, you can book profits and curtail losses

Jojo Puthuparampil

History's first bubble is unrecorded. Perhaps it might have been triggered by Caveman A who traded a lump of brontosaurus flesh to Caveman B in exchange for hunting rights. In modern stock market terminology, a bubble refers to the run-up in share pieces until they reach so high a level that there is no one left who is foolish enough to buy. No one can predict when the bubble is going to burst or when the market is hitting its bottom. However, knowing the way bubbles develop and declines manifest you can book your profits and curtail losses. Allan Campbell’s book charts the pattern booms and panics follow.

Most bubbles tend to develop in a similar manner. Stocks start to rise in value for sound fundamental reasons. However, at some point people no longer buy stocks for their growth potential. They buy simply because stocks are going up. At that point, rational investing turns into 'irrational exuberance', and the bubble begins to inflate. Though we are foolish to buy stocks at this level despite knowing that they are overpriced, someone will be an even greater fool to buy them from us at an even higher price. To hear the bell at the top, turn your TV. "If pundits are talking about a new era for investors, it's time to sell," Campbell says.

Panic also follows a similar irrational logic. As stocks descent from their peaks, the dominant sentiment is to take advantage of the price dips and buy more stocks. This sentiment is especially prevalent if the bubble has been building for a long time, because the longer it has been since the last bear market, the less investors remember that stocks go down as well as up. As a result, there is often the bear-market rally. But when the rally stalls at prices below the previous high, some investors decide to use it as an opportunity to lock in whatever profits they still have. Thus, they sell, sending prices tumbling again. During this second tumble, panic often sets in as investors realise they have missed two opportunities to sell high. Now the concern is no longer about maximising gains, but about minimising losses. And selling is the only way to minimise losses. Every piece of news is interpreted negatively by investors who look for a reason to sell. As stocks go down, panic to sell begets more panic until everyone who wants to sell has sold.

At this point the market is at its bottom. Fortunately, panic, too, wouldn't last for ever. "When pundits start talking about an 'irrational depression' that will not easily be turned around, it's time to buy," Campbell counsels.

Contrarian signals work better in stock markets. That's why listening to conventional wisdom and doing just the opposite of what it suggests is a sound investment strategy. "You would ignore the voice of sentiment only if you are able to quantify whether the market is irrationally undervalued or exuberantly overvalued," Campbell reasons. And there are ample reasons why the market is not efficient but irrational.

The efficient market theory proclaims that the decisions of the well-informed buyers and sellers lead to fair prices. But if the theory is true, then stocks are always fairly priced and it makes as much sense to by them when they are trading at 50 times their earnings as when they are trading at five times. According to behavioural finance, humans possess ample traits that prevent rational stock market behaviour. The most decisive among these traits are: greed and fear (if humans are rational about money, casinos wouldn't exist), self confidence (this trait makes us believe stock market success is a result of skill, when often it is a result of luck), herd instinct (this mentality forces us to believe that the market, or herd, is right and we are wrong when the truth is the other way around), pattern recognition (we tend to see patterns when only randomness exists), myopia or lack of historical vision (we tend to consider recent events more seriously than earlier ones which actually bear more significance), and vanity (instead of admitting we are wrong, we keep on holding and stocks keep going down).

Studies have found that buying stocks when most strategists are bearish and selling them when most are bullish produced better results than buying when P/E ratios are low and selling when they are high.

The reason for this disconnect is simple: strategists tend to be bullish when economic and political conditions are good for stocks. But when conditions are good everyone is buying. By the time you read their recommendations, stocks already reflect the good news and are fully valued or overvalued. Conversely, the strategists are bearish when conditions are bad. But under those conditions, most folks have already sold; so stocks are cheap.

Conventional wisdom tells you not to act until you have all the information you need ('better safe than sorry'; 'look before you leap'). But with the stock market, you never have enough information. You never know what the economy will do or what political surprises are around the bend. But neither does anyone else, which is why stocks are always cheap during times of uncertainty.

When you begin to invest in stock markets, it is better not to listen to self-made pundits who flaunt terms like 'market timing', 'charting' and 'day trading'. These practices contain pitfalls that you might fail to spot. Market timing refers to the strategy of frequently increasing or decreasing your stock holdings in response to expected short-term stock market movements. This strategy doesn't seem to work because no one can predict market movements in the short term when trends appear random.

Technical analysis tells you the prices at which a stock attracted buyers or sellers in the past and indicates at what price it will attract them in future. But the future price of the stock will be determined by events that cannot be known in advance.

Day traders buy and sell stocks throughout the day to capture gains from small price movements. "Don't indulge in this exercise unless spending daytime in front of a computer screen watching your wealth fluctuate from second to second is your idea of fun", cautions Campbell. Beware!

Conquering Stock Market Hype

Author: Allan Campbell

Publisher: McGraw-Hill

Edition: 2004, paperback

Price: Rs725

The road to investing

The way of the successful investor is to do nothing—until you see money lying somewhere around the corner, and all that is left for you to do is go over and pick it up, says legendary investor Jim Rogers

Jojo Puthuparampil

"While I have never patronised a prostitute," writes legendary American investor Jim Rogers, "I know  that one can learn more about a country from speaking to the madam of a brothel or a black marketer than from meeting a foreign minister." Seeing and assessing markets across the globe from ground zero has been Roger's style. "The best way to profit from the global situation is to see the world mile by mile," he says. Adventure Capitalist is the mile-by-mile account of Roger's latest road trip across 116 countries, analysing regional markets and evaluating investment opportunities.

Behind the wheel of a sunburst-yellow custom-built convertible Mercedes, Rogers and his fiancé Paige Parker began their 'millennium adventure' on January 1, 1999, from Iceland. The journey—which ended three years later on January 5, 2002, in New York—took Rogers and Parker through 152,000 miles and half of the world's 30 civil wars, and resulted in the Guinness World Record for the longest continuous car journey. The couple traversed many countries where most rarely ventured such as Angola, Sudan, Congo, East Timor, and drove through deserts, jungles and epidemics. They marveled world's wonders like Grand Canyon, Victoria Falls and Taj Mahal, ran into deadly blizzards in Iceland, descended eight stories down ground level to visit an ancient subterranean city in suburban Istanbul, purchased diamonds from Namibia (which later turned out to be polished glass), camped with nomads and camels in western Sahara, witnessed 'butt dance' near the Senegal Mali border, moved past Bulgarian sex workers who raised their skirts to advertise their wares, drank salt-tea in Mongolia, gulped snake's gallbladder in China, and ate worms, termites and grasshoppers. Best of all, they saw the real world from the ground up – the only vantage point from which it can be truly understood – economically, politically and socially.

Rogers entered the investment business in 1968 with $600 in his pocket, and he left it in 1980, at the age of 37, with enough money to satisfy a lifelong yearning for adventure. He began globe-trotting with an around-the-world motorcycle trip 15 years ago, covering more than 100,000 miles across six continents (that journey became the subject of his first book, Investment Biker).

Rogers is a contrarian. His success in the market has been predicated on viewing the world from a different perspective. He dismisses the majority world view as bilge and counters much of what the glib Street savants say. His take on Iran, one of the so-called rogue countries, captures his approach. "Forget what Washington tells you; there is a lot of positive changes coming in Iran. Demographically, it is a very young country. And it is ripe for investment. I am very optimistic about its future." Rogers became a China enthusiast much before the world reckoned the communist country's capitalist credentials. “Twenty-first century belongs to China the way 20^th and 19^th centuries belonged to the US and Europe, respectively," he asserts.

According to Rogers, 'new economy' is not as hot as it made out to be. "Everyone talks about new economy. Well we have heard that before. The railroad and radio changed the world much more than information technology is said to be changing the world now. Radio Corporation of America (RCA) became one of the largest corporations in American history and made huge profits. But if you had bought shares in the RCA in the late 1920s, you would never have made any money because the shares never again got as high as they got during the mania. It wouldn't have been any different had you bought shares in the railroads in the 1840s. By the time the mania hits everyone is getting involved: banana salesmen, hairdressers and dentists. By the time the bubble has grown really big, the smart money is usually on the run," he says.

Rogers differentiates between trading and investing. "Traders are the short-term guys, and some of them are spectacular at it. I am hopeless at it—perhaps the world's worst trader. I see myself as an investor. I like to buy things and own them forever. And what success I have had in investing has come from buying stock that is very cheap. Even if you are wrong, when you are buying cheap you are not going to lose a lot of money. But buying something simply because it is cheap is not enough—it could stay cheap forever. You have to see a positive change coming, something that within the next two, three years everyone else will recognise as a positive change."

Risks never deterred Rogers in real life. But when it comes to investing he is surprisingly cautious. "I don't ever take risk with my money," asserts the adventurer who considers being the father of his daughter as his greatest escapade in life. "The way of the successful investor is to do nothing—not until you see money lying there, somewhere around the corner; and all that is left for you to do is go over and pick it up. You wait until you see something you think is a sure thing."

According to this adventure capitalist, the mistake that many people make in the stock market is buying something, watching it go up and thinking they are smart. "They take a big profit and immediately go looking for something else. That's the time when you should put the money in the bank and go to the beach for a while until you calm down. Because there are not many opportunities that are ever going to come along. But you do not need many if you do not make many mistakes."

Rogers' predictions are as startling as his perceptions: he insists it is time to dump shares and buy commodities (the commodity bull market has already begun), remains bullish on Angola and Bolivia (the transition of these countries from conflict to peace is positive), and foretells that the dollar, euro and yen will be doomed (he is yet to find a substitute for these currencies). He reserves the heaviest jab for desi pundits who position India along with China: India, he predicts, will soon break into several small countries.

India is not the only country that Rogers expects to disintegrate. "One of the more visible changes the world is undergoing right now is the end of the age of empire builders," he writes. "Over the past 300 years, thanks to technological advance, countries tended to grow bigger and bigger. That tendency is reversing. There are about 200 countries in the world today. Over the next three to five decades, there will be 300 or 400."

Born in 1942, Rogers had his first job at the age of five, picking up bottles at baseball games. Decades later, he co-founded the Quantum Fund, a global investment partnership, towards the end of 1960s. During the next 10 years, the portfolio gained more than 4,000 per cent, while the S&P rose less than 50 per cent.

Adventure Capitalist is the most adventurous journey one is likely to take within the pages of a book—the perfect read to armchair adventurers, global investors, car enthusiasts and anyone interested in seeing the world and understanding the markets as they really are.

Adventure Capitalist

Author: Jim Rogers

Publisher: Random House

Edition: 2003, hardcover

Price: Rs1,060

As hedge funds grow, so does risk

From fraud to exotic instruments, funds face varied risk management challenges

Jojo Puthuparampil

As hedge funds manage increasingly vast, complex and exotic portfolios, there is a growing concern about portfolio managers' risk and compliance officers' understanding of their risk exposures.

Over the past five years, the number of hedge funds has doubled, to more than 8,000, and total assets under management are approaching $2 trillion. This creates stiffer competition, which puts pressure on managers to take bigger risks or skate toward the edge of fraud or other malfeasance. According to Mark Sunshine, president of West Palm Beach, Fla.-based First Capital, which provides credit services for hedge funds, potential areas for fraud include misreporting assets, inflating returns, violating laws and regulations, ignoring disclose liabilities, and failing to follow the fund’s investment thesis and guidelines.

"Fund manager fraud is the number-one reason for serious loss—defined as greater than 50 percent—in a hedge fund," says Sunshine. "Because this is essentially an unregulated industry, there is little timely oversight of the managers."

There are also risks associated with self-dealing, which happens "when fund managers make investments with their personal money or the money of the fund management company," instead of the fund's money, explains Sunshine. "They then favor their personal investment over the investment  of the fund."

Managers can also hurt their funds by deliberately misstating the value of their portfolios or taking unacceptable risks. Anna Pinedo, partner at law firm Morrison & Foerster in New York, says that insider trading can also result in legal repercussions for hedge funds. "There have been a number of enforcement actions [by the Securities and Exchange Commission] against hedge funds and their principals for insider trading and market manipulation issues," she notes. "These actions are a good reminder to the hedge fund community that it is very important to have internal compliance procedures and for personnel within hedge funds to monitor internal adherence to the compliance procedures."

Exotic Investments

As the hedge fund landscape gets more crowded, funds look further afield for investment opportunities, pushing into areas such as credit derivatives and structured products. These highly customized, non-standard instruments can add risks that a manager might not even be aware of.

"Often, derivatives and structured products have a built-in leverage or gearing effect, which may make the effect of a change in an underlying or reference asset more severe than otherwise," says Pinedo. She stresses: "A thorough understanding and careful review of each product is required in order to be certain that the people at the hedge fund who are monitoring the portfolio understand the risk exposure under each derivative contract or structured product."

If hedge funds enter into back-to-back swaps or other derivatives contracts, there may be legal and business risks if the terms of the back-to-back agreements do not line up perfectly, she adds. "This is particularly true in the credit derivatives area where default and triggering events may not align," says Pinedo.

Lack of understanding is also an issue when it comes to correlating risks across asset classes and geographies, says Sunil Pai, chief information officer of Palm Beach Gardens, Fla.-based hedge fund ST Capital Partners. "The world has become much smaller in recent years, and there are a number of risks that have become or have the potential to become very correlated," he says. "Many newer hedge funds are run by inexperienced individuals—many coming out of big Wall Street firms—who have not lived through an event such as the hedge fund crisis in 1998 or the stock market crash in 1987. "These individuals may not be asking the what-if questions that are essential for adequate risk management," notes Pai.

Counterparty Risk

"Investment banks with large prime brokerage operations and commercial banks act as counterparties and creditors to hedge funds. They facilitate the implementation of many of the hedge fund managers' strategies and provide the capital that enables managers to leverage their exposures.  Concerns about counterparty risk management have become more pronounced with the increasing complexity of financial products," said Federal Reserve Board chairman Ben Bernanke at the Federal Reserve Bank of Atlanta's Financial Markets Conference in Sea Island, Ga. on May 15. "Complexity—especially when combined with illiquidity—amplifies the difficulty of measuring market and counterparty credit risks," said Bernanke. "The problems of valuation and of risk measurement faced by investors in tranches of bespoke collateralized debt obligations [CDOs] are a good example. Similar problems are faced by the core financial intermediaries that often act as counterparties to hedge funds in complex synthetic CDO transactions."

Given increasingly risky investments by hedge funds, banks may have the most to worry about, but hedge funds need to keep an eye on their counterparties as well, especially if the funds are straying far from their home territories.

"Funds must evaluate the creditworthiness of their counterparties," says Steve Howard, an attorney in the New York office of Thacher Proffitt & Wood. "If the counterparty goes bankrupt, the fund may not be able to recover its investment."

According to Sunshine of First Capital, some funds are producing high returns through excessive leverage. The higher the leverage, the greater the potential returns and the higher the risks. With ordinary borrowing, it is relatively straightforward to assess the degree of risk associated with an investment, but leverage can take many forms.

"It's much more than just debt," says Sunshine. "It includes derivative contracts, delayed settlements, swaps and options, and other synthetic instruments."

Morrison & Foerster's Pinedo notes that many complex financial instruments include embedded leverage as a feature. The embedded leverage not only increases risk in a hard-to-quantify way, but can also make the investment less liquid. As hedge funds come under increasing pressure to shorten lock-up periods, these instruments can create problems. "It may become more difficult to meet the short-term demands on the part of investors for redemptions," says Pinedo.

Valuation Difficulties

Hedge funds with investments in complex and illiquid securities may fail to accurately assess the value of their assets. The more complex the investment, the trickier the valuation process. For example, hedge funds need a more accurate means of valuing over-the-counter derivatives, Pinedo says.

There are inherent conflicts of interest in valuation, Pinedo points out, such as the strong economic incentive for hedge fund managers to overstate the value of a portfolio, since their fees are tied to returns. Valuation of positions for which market prices are not available also poses severe risks. It's important for a hedge fund to have standardized procedures and adequate oversight when it comes to valuation, she says.

According to Sunshine, lack of systems and infrastructure causes problems for many hedge funds. Technology costs money—which cuts into the bottom line. And so does management oversight. "Many fund management companies do not have adequate staff to manage their assets during an economic slowdown and are at risk of losing control of their investments if the economic tide starts to go out," Sunshine says.

Hedge funds must have appropriate systems to monitor and limit exposures and provide disaster recovery capabilities, says Pinedo. They must also have compliance policies to limit exposure and to segregate functions and activities among the front, back and middle offices.

"Operational risks are quite serious," she says. "Many hedge funds have grown very quickly and have not developed the systems and controls and procedures to keep up with their growth. Moreover, hedge funds generally are led by traders, who may not be accustomed to functioning in an environment where there are rigid internal controls and procedures."

Inadequate staffing creates other problems. "Fund performance in many cases is determined by the performance of a small group of people—in some cases one key individual," says Howard of Thacher Proffitt. "The fund could be harmed if key individuals leave or otherwise no longer manage the fund."

In this and other areas, size can be an advantage, says ST Capital's Pai. "Costs for regulatory compliance are going up while operational and debt funding costs are generally going down," he says. "Larger hedge funds have an edge in obtaining the best trading and fund-administration cost levels."

(This report was written for a New York-based news syndicate after speaking with US-based financial analysts)