Research Watch

Wall Street laid bare. Europe rebound ahead? Chanos on how to be a short-seller. On video: Zuckerberg, the musical.

PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.

Just a week after JPMorgan was left red-faced by a trading error that cost the firm $2 billion, Wall Street crusader Matt Taibbi has pounced on yet another investment bank mistake that is sure to prove costly. The journalist who famously labelled Goldman Sachs a “vampire squid” reveals that lawyers representing that bank and others accidentally released unredacted documents full of insights into Wall Street's blatant disregard of regulation, manipulation of experts, and the way client information leaks into the hands of hedge fund managers. Muppets beware. Meanwhile, Europe's woes have thrust wealth preservation back into the limelight, and Macquarie is paying close attention. Analysts at the Silver Doughnut have compiled a list of their favourite income stocks, whose yields are expected to withstand even a 2008-style market shock. And if you're considering selling out of speculative plays in search of something safer, John Hussman has a strategy designed to reduce risk and regret. Also this week, the bull case for buying the dip, and the bear case against it. Credit Suisse says Japan's balance sheet recession could be over, Jim Chanos explains how to be an effective short-seller and Paul Krugman gets zapped with a ray gun. On video, ahead of tonight's hyped Facebook float: 'Zuckerberg, the musical'.

Wall Street caught naked... “The lawsuit between Overstock and [Goldman Sachs and Merrill Lynch] concerned a phenomenon called naked short-selling... [which] is a) highly technical, and b) very controversial on Wall Street, with many pundits in the financial press for years treating the phenomenon as the stuff of myths and conspiracy theories. Now, however, through the magic of [a mistakenly unredacted court] document, the public will be able to see for itself what the banks’ attitudes are not just toward the 'mythical' practice of naked short selling, but toward regulations and laws in general. 'F--- the compliance area – procedures, schmecedures,' chirps Peter Melz, former president of Merrill Lynch Professional Clearing Corp, when a subordinate worries about the company failing to comply with the rules governing short sales. We also find out here how Wall Street professionals manipulated public opinion by buying off and/or intimidating experts in their respective fields. In one email made public in this document, a lobbyist for SIFMA, the Securities Industry and Financial Markets Association, tells a Goldman executive how to engage an expert who otherwise would go work for 'our more powerful enemies' '¦ 'He should be someone we can work with, especially if he sees that cooperation results in resources, both data and funding,' the lobbyist writes, 'while resistance results in isolation.' '¦ The plaintiff’s motion [also] refers to ... 'an email from [Goldman executive] John Masterson that sends nonpublic data concerning customer short positions in Overstock and four other hard-to-borrow stocks to Maverick Capital, a large hedge fund that sells stocks short.' Was Goldman really disclosing 'nonpublic data concerning customer short positions' to its big hedge fund clients? That would be something its smaller, 'Muppet' customers would probably want to hear about.” (Matt Taibbi via Rolling Stone, May 15)

Income you can depend on...

“'Vanilla' yield strategies significantly underperformed in the equity market sell off in 2008. High leverage had been used by many firms to 'manufacture' dividend streams that relied on low cost debt and unrealistic high growth expectations. Hence for many high yield stocks the change in growth and debt market dynamics saw their underlying dividends become unsustainable, and 'high yield' quickly proved illusionary. '¦ In order to avoid the traps of a vanilla yield strategy we apply filters aimed to avoid 'value traps'. ... 1) Payout ratio: Remove stocks with payout ratio >90%; 2) EPS growth: Avoid stocks that had negative EPS growth in 2 or more of the last 4 years; and 3) Earnings stability: Remove stocks with poor EPS stability from FY-2 to FY1. Applying this enhanced filtering approach provides the [above] list of stocks as meeting our sustainable income approach.” (Maquarie Equity Research via Scribd, May 14)

A tasty Greek dip...

“Jonathan Wilmot, chief global strategist at Credit Suisse, reckons that Europe is set to lead a rebound in global growth this year. He and his team are saying BUY Spanish and Italian bonds, and probably equities as well. '¦ The core bullish argument is broadly as follows: 1) The revival in risk since last autumn is so far very much in line with the recoveries from the “Deep Panics” of 1982, 2002 and 2008/9 – and those panics were followed by rallies of 50 per cent over more in global equities within 18 months. 2) ... the eurozone is not going to fall apart; instead some sort of pro-growth compromise will be cobbled together. There’s already consensus on the fact that austerity alone cannot work. 3) The confidence shock at the end of last year hit Europe the hardest. But while production slumped, aggregate demand didn’t. Hence any uptick in demand now will set up the need for significantly higher European production.” (FT Alphaville, May 11)

Or not... “Professional investors and especially hedge funds spend a great deal of time seeking out 'asymmetric' trades. These are deeply unfashionable trades that are very cheap to lay but contain very large potential upside. '¦ Those suggesting you 'buy the dip' on Greece are recommending you do precisely the opposite, making an asymmetric bet with limited upside and large downside potential. Consider, if Greece and Europe do manage some kind of happy rapprochement, then yes, you’ll get some upside. Perhaps 5 or 10% before the reality that global growth will still be subdued sets in. But if Greece exits the euro, you’ve got an almost limitless and unfathomable downside to look forward to as Lehman Brothers II freezes global credit, trashes global equities and potentially ends the era of free global capital markets as governments worldwide nationalise and guarantee every bank in [sight]. Unless you are going to 'buy the dip' using some kind of asymmetric instrument – and good luck with that given the consensus is still firmly on the side of ongoing growth – then you should stay right away from betting on happy outcomes in Greek politics.” (MacroBusiness, May 14)

The 40% rule'¦ “There are ... many investors - particularly those close to retirement - who have seen their financial security devastated by retaining investment positions that they were actually very unprepared to carry through a major decline, and then selling at panic lows. I would strongly encourage those investors to review their exposure to risk, and their tolerance for loss, and to reduce any 'speculative' positions that they don't actually intend to retain through the completion of the present market cycle. ... If you're holding a speculative position that you want to reduce, recognise that unless you sell at the exact top - which is unlikely - you're going to have some level of regret. If you sell part of the position and the price advances, you'll regret having sold any. If you sell part of the position and the price declines, you'll regret not having sold it all. Once you accept that there will be some regret in any event, the key is to choose an acceptable level. The '40% rule' is sometimes helpful - immediately execute 40% of the desired transaction, which gets you moving and helps you to be more objective, since you've done something but still have the majority of your position. Then you do it again with part of the remaining position, being as opportunistic as possible. Usually, two or three pieces is sufficient. The transaction costs are somewhat higher, but this sort of approach can reduce the risk of being paralysed in an inappropriate speculative position.” (John Hussman of Hussman Funds, May 14)

HFT is coming to Asia... “Citic Securities, China’s largest broker, has agreed to buy algorithmic trading technology from Progress Software, a Nasdaq-listed company, in the latest sign that rapid automated trading is spreading from western markets to Asia. A race has been under way in the US and Europe among banks and brokers using algorithms to attract business from institutional investors. Such algorithms are either built internally or bought from technology companies. That trend is emerging in Asia, with China the latest market to adopt the practice as domestic brokers seek to offer Chinese asset managers tools to trade on the Shanghai and Shenzhen exchanges. Some Chinese brokers already use basic algorithms but the deal between Citic and Progress is a sign that the phenomenon is being embraced by the biggest operators with deep enough pockets to invest in the kind of sophisticated technology typically available in London or New York.” (Financial Times, May 14)

The end of Japanese de-leveraging?...

“Unlike the US, UK or Eurozone, Japan’s corporate sector over the last 20 years faced a daunting prospect of having to de-leverage against the backdrop of deflation and flat nominal GDP. In our view, the Japanese corporates have performed a near “miracle” of reducing US$6 tn of debt without help from growing economy and despite the reluctance of BoJ to embrace a more aggressive monetary policy. It seems there is growing evidence that after 20 years, the Japanese corporate sector is finally “healing”. We focus on three signs: (1) the corporate sector is no longer reducing debts or increasing cash; (2) private investment is no longer declining; and (3) ROE and ROIC are gradually recovering (though from depressed levels). At the same time, Japan’s labour productivity growth rates continue to offset the poor demographics, while competitiveness, innovation and complexity indices remain strong. It seems likely that the corporate sector could surprise on the upside.” (Credit Suisse, May 16)

The Greek apology horse... “The nation of Greece said sorry to the European Union with a present of an enormous wooden horse. Left outside the European Central Bank in the dead of night, the horse has now been moved into the ECB’s central lobby where it is proudly on display. A gift tag attached to the horse, which is surprisingly light for its size and has small holes along the length of its body, suggested that it should be placed in the bank’s vaults overnight to avoid it being targeted by thieves. '¦ Oddly, Greek representatives in Brussels have hinted that they may soon be in a position to settle their debts and have puzzled the French and German banks that hold their loans by asking if there is any discount for cash.” (The Daily Mash, May 15)

How to be a short-seller... “I've learned there's a big difference between a long-focused value investor and a good short-seller. That difference is psychological and I think it falls into the realm of behavioral finance ... if you're a short-seller, that's a cacophony of negative reinforcement. You're basically told that you're wrong in every way imaginable every day. It takes a certain type of individual to drown that noise and negative reinforcement out and to remind oneself that their work is accurate and what they're hearing is not. '¦ Start first with the SEC filings, then go to press releases, then go to earnings calls and other research. Work your way out. Most people work their way in.” (Jim Chanos via Market Folly, May 10)

Video of the week: Zuckerberg, the musical... A trip down memory lane for the life and times of Facebook founder, Mark Zuckerberg, from foundation to float.

(YouTube, May 15)

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