Business Blog: Hoover’s Business Insight Zone

That’s the verdict of Eric Janszen’s provocative cover story in the current Harper’s magazine:

The next bubble:
Priming the markets for tomorrow’s big crash

Online access is limited to Harper’s subscribers, but here are two choice tidbits:

Our economy is in serious trouble. Both the production-consumption sector and the FIRE [finance, insurance, real estate] sector know that a debt-deflation Armageddon is nigh Read more

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If the economy heads south, how do think it will it affect your organization?  How will it affect the way you manage your business affairs?

It seems to me that the best businesses are managed to thrive in good times and bad — but that’s much easier to say than to do.  If any of my readers can offer their own specific insights into the process, I’ll be grateful to hear them.

(Thanks to reader Dave Livingston for suggesting this topic.)

A quick observation in line with my earlier comments on the nature of the IPO market: It’s worth remembering that there are (at least) two levels of a “market” for merger & acquisition activity:

1. The overall market for M&A. At times this runs sky-high, as it did for tech companies during the boom that ended in 2000, and as it did over the past couple of years for private equity firms doing buyouts. It’s obvious, yet still worth noting, that this broader market is highly sensitive to macroeconomic conditions; witness the current drying-up of liquidity — or just deal-making aggression — among the financial houses.
2. The specific market for a particular asset. Ingersoll-Rand is ponying up quite a chunk of money ($10 billion) for Trane because it believes that adding Trane’s product lines to its own with (a) make it more dominant in the worldwide HVAC industry; (b) insulate it further from the cyclicality of its other businesses; and (c) allow it to operate the Ingersoll-plus-Trane HVAC businesses at a cost savings. The point isn’t how the overall M&A market looks, but how appealing Trane-in-particular is to Ingersoll-Rand-in-particular.

Maybe this is all obvious stuff, but I find that even the obvious bears repeating, especially in light of the business media’s tendency to over-identify trends in the marketplace. Yes, of course there are macro trends, but the presence of them doesn’t necessarily affect the likelihood of a particular deal.

From where I sit, the signs are mounting that the United States has entered a recession — or else is entering a recession, or else will very soon.  Latest anecdotal information:

Americans late payers on most loans since 2001

NEW YORK, Jan 3 (Reuters) - Americans are falling further behind on consumer loans, with late payments rising to the highest level since the nation’s last recession in 2001, data released Thursday show.

True, it is just an anecdote, not a total picture of the economy, but it seems to be part of a drumbeat.

In any event, if it looks like a duck, and walks like a duck, and quacks like a duck . . . for practical purposes, it makes sense to think of it as a duck.  Maybe it’s selection bias on my part, but I see plenty of cues in the business news that indicate that lots of business decision-makers are acting like we’re in a recession already.

It will be interesting to see if/when the official word comes down verifying this hunch.

To me, that’s a key philosophical question raised by this post from the environmentalist blog Gristmill:

Throw the book at him

Sickening. Kevin John Moran of Camano Island, Wash., was just convicted of illegally cutting down 27 old-growth cedars on public land. They were between 400 and 700 years old. And they were dry-side trees, even rarer than the Northwest’s west-slope titans. . . .

The blogger, Eric de Place, notes that the maximum penalty Moran faces is 10 years in prison and a fine of $250,000. The charge is “theft of Government property,” there being no specialized penalty — so far as I know — for egregious damage to an ecosystem or the country’s natural heritage.

Now, there are plenty of folks who will read “10 years in prison and a fine of $250,000″ and think that it’s more than enough for cutting down some trees. But at some point, doesn’t a thing stop being a thing that can be valued strictly in economic terms? Outraged or no, de Place seems to be making the point that there ought to be some charge worse than theft — maybe something like “wanton destruction” — to cover offenses like this one.

Economics would say that the oldness of the trees, their magnificience, their role in their ecosystem, or what have you are “externalities” from a financial perspective. The point is that Moran took public property that didn’t belong to him, and that property was in the form of trees. Period.

Yet if the threat of global warming is as bad as many scientists fear, and if deforestation continues around the world as it has done lately, I expect that at some point penalties for wrongfully cutting down trees — especially big and old ones — will run much stiffer.

This Whitney Tilson piece in the Financial Times touches on the work of Jason Zweig, whom we discussed a few days ago:

. . . Taking a proverbial deep breath before responding to short-term market moves goes a long way to avoiding panic-induced mistakes. This gives our “reflective” brain time to kick in and enable a more objective decision, says Zweig. Also important are regular disciplines or checklists to follow in making any buy or sell decision. Many investors institute formal reviews of any holding whose value falls a given percentage, asking what – other than the share price – has fundamentally changed in the investment thesis. This doesn’t ensure the right decision is made, but increases the likelihood that any decision is made for the right reasons.

Good advice. Sounds a lot like what Warren Buffett does at Berkshire Hathaway.

The more I read about what’s going on in the financial markets today and what has gone on to get us here — over-reliance on subprime debt etc. — the more I’m convinced that in practice the financial markets operate much less rationally than some would have us believe.

“Quant” fund managers, using fancy mathematics derived by Nobel-crowned economists, have made big waves in recent years. Heck, a very successful quant-minded mogul just picked up his second World Series ring.*

Nassim Nicholas Taleb, author of the scintillating book, The Black Swan: The Impact of the Highly Improbable, lays into the quants and their modern portfolio theory (MPT) in this blistering Financial Times column:

The pseudo-science hurting markets

…MPT produces measures such as “sigmas”, “betas”, “Sharpe ratios”, “correlation”, “value at risk”, “optimal portfolios” and “capital asset pricing model” that are incompatible with the possibility of those consequential rare events I call “black swans” (owing to their rarity, as most swans are white). So my problem is that the prize is not just an insult to science; it has been putting the financial system at risk of blow-ups.

I was a trader and risk manager for almost 20 years (before experiencing battle fatigue). There is no way my and my colleagues’ accumulated knowledge of market risks can be passed on to the next generation. Business schools block the transmission of our practical know-how and empirical tricks and the knowledge dies with us. We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology (without the aesthetics), yet the lessons are ignored in what is taught to 150,000 business school students worldwide.

…The knowledge and risk awareness we are accumulating from the current subprime crisis and its aftermath will most certainly not make it to business schools. The previous dozen crises and experiences did not do so. It will be dying with us, unless we discredit that absurd Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel commonly called the “Nobel Prize”.

Tom Peters pointed to this piece and used it to reiterate his disgust with quants and their methods. Mind you that Peters was trained in engineering at Cornell and has a Stanford Ph.D. in business, so he’s hardly anti-math. He just agrees with Taleb that an overemphasis on quantitative methods stinks.

I was around Bill Sharpe, the Nobel-holding, more or less father of contemporary portfolio theory, engine of our current woes, when he did the work that won the prize—I was mostly ignorant of what was up, but appalled by the apparent arrogance of Sharpe and his devotees. It was clear—to them—that risk would be tamed, once and for all.

Apparently risks are just a little more resistant to quant methods that has been thought. And apparently I should start qualifying my statements when I talk about “Nobel-crowned” economists.

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* I hope John Henry’s Wikipedia biography is accurate, but geez, doesn’t it read like it’s made up? Testicular cancer at 15? “majoring in philosophy but failed to obtain his degree due in part to traveling with rock and roll bands called Elysian Fields and Hillary.” Seriously? Wow — and here I thought he was an Ivy League-style stiff.

My go-to expert on oil prices is Geoff Styles, who has previously discussed the complexity in comparing oil prices on an apples-to-apples basis over the decades. (Hint: it’s not as simple as using the Consumer Price Index to account for inflation.) This post from last Friday — just before oil futures climbed to $93 — is apt reading.

Breaking The Record

…Production in the OECD countries is barely replacing the natural decline of mature reservoirs. The non-OECD output that has enabled the expansion of demand in the last several years has come mainly from projects that were planned under more attractive fiscal terms, in host countries that have since cooled towards international oil investment, at least from the western oil companies. Producing countries may be entitled to a fair share of the rent on their own resources, but they are also quite capable of killing the golden goose. Meanwhile, spare OPEC production capacity that might have been adequate a decade ago is now too small to dampen the volatility of an 85-86 million barrel per day market….

At some point, either supply or demand will give way, and prices will fall — at least somewhat.

Right? Right? . . . Anyone?

The fact that we don’t have a great answer for that is a key marker that we’re living in interesting times.

Since I’m not much of an economist, this is more a question for discussion than an expression of any clear verdict on my part. For now I’ll say that some very smart folks think we are headed for a recession; that list of folks includes economist Nouriel Roubini, zillionaire Warren Buffett, and the top executives of Caterpillar. As much as two-thirds of the general U.S. population agrees with them, but opinions vary.

U.S. companies disagree on prospects for a recession

…Almost two-thirds of Americans said a recession was likely in the next year, and a majority said the economy was already faltering, according to a Bloomberg/Los Angeles Times poll taken from Oct. 19 to 22. The survey showed the gloomiest view of the economy since February 2003.

A survey of chief executives released this month by the Business Council predicted that U.S. growth would slump to 2 percent or less next year but that the economy would avoid a recession, defined as two successive quarters of declining gross domestic product….

This puts me in mind of The Epicurean Dealmaker’s witty post from this weekend, in which TED discusses just how poorly mathematicians sometimes do when they try to predict the movement of markets.

Down the Rabbit Hole

…Write this down: Black-Scholes [a prevailing theory of option pricing] works not because it describes some external ontological fact about how pricing relationships between securities and their derivatives have to work; it works because everyone agrees, more or less, that that’s how prices should work. It is a convention, not a physical or financial law. This is the central epistemological trap that quants fall into when they conflate the tools, techniques, and ontological assumptions of physics, which attempts to describe that which is (more or less independent of us humans), with those of mathematical finance, which attempts to descibe how human beings trade and value financial instruments and their derivatives….

Myself, I tend toward caution, so if I were running a company, I would long ago have put back a supply of dry powder to counter the effects of the mortgage crisis and the shriveling of the credit markets. My own view is that the marketplace — not just the financial markets, but the broader sphere of business — has more corrections to make before it stabilizes again. Some of these corrections will be large and painful. Whether that amounts to a recession, I don’t know.

What do you think?

Confession time: after a summer of relentless headlines about the mortgage meltdown, credit crunch, and assorted alliterative anti-affluence ailments, my eyes have started to glaze over when I read stories about the latest on CDOs, SIVs, et al. So I glanced at a few things about the supposedly big deal announced on Monday, through which Citigroup, JPMorgan Chase, and Bank of America will help to create a Master Liquidity Enhancement Conduit (MLE-C).

If you’re confused by that title, you’re not alone, but you can get clarification from this Floyd Norris article:

3 Major Banks Offer Plan to Calm Debts in Housing*

The biggest banks in the United States, with active encouragement from the Treasury Department, unveiled a plan yesterday to keep the housing-related debt crisis from worsening.

The plan calls for the banks to create a new financing vehicle to try to restore confidence and reduce the risk of a market meltdown by propping up an important part of the debt markets. But the banks hope to take minimal risk and avoid actually investing any of their own money.

If Norris isn’t the dean of financial journalist in the US, I’m not sure who is, and his treatment here is sound. But the most interesting analysis I’ve come across is this one from Andrew Leonard in Salon, who thinks the MLE-C plan implicitly enables the continuation of what he calls “Enron economics redux.”

First he lays out Wall Street’s reaction to the announcement of the plan:

Way to spoil the party! The Dow Jones industrial average immediately dropped by 108 points on Monday and another 71 on Tuesday. Why? Because the announcement of a rescue plan is tantamount to shouting, in capital letters: WALL STREET, WE STILL HAVE A PROBLEM.

When combined with Treasury Secretary Hank Paulson’s somber speech Tuesday morning warning that the housing crisis is set to drag on indeterminately, one can only conclude that the stresses that have flowed from real estate into the financial markets are going to ramp up. The purpose of the super conduit may not be to clean up the mess that already exists, but prevent matters from getting considerably worse.

Leonard then digs into the underlying issues of “conduits,” which are financial vehicles designed to make money by arbitraging long-term and short-term debt yields. (Read his description; it’s better than mine.) And he points out the ways in which conduits are supposed to be opaque — designed, as they are to live outside the typical categories of investments expressed on a bank’s balance sheet.

He also raises larger questions about the efficiacy of the Treasury/megabank plan:

Will it work? Nobody knows, and analysts are all over the map on the question of whether to call the plan a bail-out, a shell game, or just a highly ironic attempt to solve a problem by engaging in the exact same behavior that caused it. The only thing we know for sure is that the Master Liquidity Enhancement Vehicle will be featured in the center ring of the Wall Street circus for a while to come.

That circus is increasingly complex. It stretches far beyond Wall Street — throughout the globalized financial world, in fact. It involves many convoluted relationships between public and private entities, between individual consumers and massive institutions, and between the industries and economies of various countries. (German and Japanese banks have suffered from exposure to the US mortgage lending market, to pick just one handy example.)

In this environment, where so much uncertainty has reigned as the unexpected impacts of “exotic” financial instruments have begun to be felt, Leonard’s call for greater transparency is apt. Maybe the MLE-C plan has merit, but in any event it’s hard to get down to the brass tacks of fixing the mess in the financial markets if we can’t figure out where those brass tacks are.

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* Probably I’ve mentioned my increasing frustration with the Times’ headline writers. This one offers a case in point: the first thing mentioned in the headline is three banks . . . but the names of the banks don’t show up until the seventh paragraph of the story. I’m not even going to entertain counter-arguments on this point: the mismatch between the headline and the story is simply wrong-headed. Memo to Times headline writers: Either cast the headline to say something like “Treasury-Backed Plan to Calm Housing Debts,” or else name the banks at the top of the story.