Of Smoke and Fire

What, exactly, is insider trading? Do you know? I know what we all think it is, which is:

  

      a.      Trading on information of an unannounced impending takeover; or 

      b.      Trading on non-public knowledge of an earnings announcement

Ivan Boesky. Bud Fox and Gordon Gekko, right?

The problem is, the government doesn’t seem to have the same clear-cut view of this that we all do. It could be that they are making it up as they go along. The key seems to be what constitutes “non-public knowledge,” and how it is one comes to possess it.

But before we get into that, let’s look at who they are targeting. Can we draw any conclusions?

I will say up front that I have no idea whether any of the firms that were raided by the FBI have done anything wrong, either by the standards above or the evolving standards of the government. Indeed, at least two of them, Level Global and Diamondback, are now saying they are not the targets of any government investigation, something the U.S. Attorney's Office has confirmed. 

The odd thing here is that the FBI can't just raid a firm because they feel like it. A judge has to agree that there's probable cause that a crime has been committed. I have spoken to someone familiar with the ways of U.S. Attorneys, and the explanations for this can be any one of the following:

1. Level and Diamondback did nothing wrong but there could be evidence on premises of wrongdoing by others (this seems a stretch - there's evidence, but these firms weren't involved?)
2. The firms are not being targeted but the Feds are narrowly looking at one or two rogue employees within those firms. Diamondback has placed a portfolio manager on leave, which would seem to underscore this theory.
3. The firms are not "targets" of an investigation but are "subjects" of an investigation. That means that the Feds believe the firms have committed crimes, but they need more evidence to prosecute. An indictment is not imminent, but could come later. If this were the case, Level and Diamondback are engaging in some language parsing. However, the U.S. Attorney coming out and confirming that they are not "targets" suggests that they are probably not subjects either. The Feds were under no obligation to say this, and probably wouldn't if an indictment were in the offing.

Based on what we know, I'd say "2" is the likely explanation.

What all three firms have in common, though, is that they are all were spawned by Steven Cohen’s SAC Capital Advisors, a tremendously successful and aggressive shop that specializes in high turnover trading strategies. It doesn't take genius to figure out that SAC is the primary target here. The smoke is everywhere.

But is there fire? 

The most curious thing, to me, about SAC is its track record: reputed to be about 30% average annual returns since 1998. I know what you’re thinking, 30% is outstanding but not impossible. Buffett’s is 21.5%. But here’s what you don’t know: unlike Buffett, SAC reputedly charges a whopping  50% incentive fee, which would mean they’ve averaged in the neighborhood of 60% gross returns. This is the part that’s a little hard to understand.

To further explore the comparison, Buffett makes his money by making significant long term bets on undervalued companies. He sees trends before most and has the stomach to make big bets when others are gun shy. It’s easy to understand that once in a while someone might come along who is just very good at this.

Or, it’s equally as easy to understand how once in a while someone is just very lucky. Buffett doesn’t make a lot of investments, after all. Maybe he’s just been on a multi-decade streak of sevens. While it’s improbable that any one person can do this, it’s actually highly probable that a random investor out of a large pool will.

If I had to say, Buffett's career has been the result of both skill and good fortune, not unlike most successful careers.

SAC reputedly trades on information flow and quantitative modeling. I know something about the latter, since it’s what I used to do. I got out of that business because I no longer saw an edge. Everyone now has access to both computational power and data, and everyone knows the basic approaches to use.  It’s possible to occasionally find an edge, but it disappears quickly. This didn’t used to be the case.

It's hard to see where they get enough of an edge with information flow, either. Advantages here tend to be fleeting as well, and while a small fund might be able to meaningfully exploit meaningfully an edge, SAC manages a beastly $12 billion. Difficult to see how they can move that elephant around quickly enough. Also, $12 billion is a non-levered number. In reality, it's probably more like $25 or $30 billion.

How about luck? If Buffett’s lucky, isn’t it equally likely that Cohen could be lucky as well?

No, it’s actually far less likely (although not impossible). Two reasons for this. First, Cohen’s 60% gross returns blow Buffett away. Instead of being a five sigma event, as some have suggested of Buffett, Cohen represents a far crazier improbability.

Second, Cohen is placing thousands upon thousands more bets every year than Buffett. This matters because it increases the odds that his lucky streak will end. To understand this, it’s easiest to think in terms of flipping coins. How easy is it to flip heads once? Pretty easy. 50/50. How easy is it ten times in a row? One in 1,024.

Buffett doesn’t toss the coin too often. He makes large, infrequent bets. Cohen, on the other hand, makes lots and lots of smaller flips, making it far harder to beat the odds. Further, it wasn’t just Cohen beating the odds; his spawn were doing it as well, albeit for a shorter period of time.

So, while I don’t know of the specifics, let’s just say it looks circumstantially…interesting. Honestly, I don't know how you make 60% even with inside information. A whole lot of things have to be working for you to get to 60%. There are lots of smart people out there, and they don’t come close.

For the record, I doubt very highly they ever trade on what you and I think of as inside information. It doesn’t make sense on a number of levels. 

The real question is the use of so-called “expert networks” and what sort of information is being obtained. The Feds are suggesting there that funds have pushed too far into this legally gray area.

On the other hand

I believe the government may be doing the same from the other direction. They want bad guys, and they want them now. That insider trading laws are poorly defined is highly convenient.

So, what is insider trading, exactly?

Case Study #1

You are sunbathing and you over hear a CEO say they have engaged Morgan Stanley to seek buyers of a subsidiary. You buy shares of the subsidiary and make a tidy profit. It just so happens, this is exactly what happened to Barry Switzer, former Super Bowl coach. Guilty? Yes, according to the government. No, according to a judge in that case.

Case Study #2

You are a rail yard worker and you see an unusual number of suits being given tours. You buy your company’s stock figuring someone’s looking to take it over. It turns out you're right. Guilty? The SEC thinks so. This case is still pending.

What if you have a friend who is a cashier at Staples and you ask them how back-to-school sales are going? Is it inside information? Unclear. The government may think so.

What if you sit in the Staples parking lot and count customers, and then make assumptions about how much people are spending? Isn’t that just good research? Hmm, maybe not. After all, not everyone has that information. You have an unfair advantage, even if you created it out of your own hard work and diligence.

The point is, when laws are poorly defined, overzealous prosecutors can use them to criminalize almost any kind of behavior.

And let’s face it, this administration needs villains. It’s Orwell 101, a state of perpetual war to justify every increasing incursions into domestic liberty. They have methodically rifled through other industries - oil, insurance, health, etc. – but Wall Street plays best, according to the polls. Mark my words, they will try to put faces on this, to make it personal. Nothing would make them happier than bagging Cohen.  He is conveniently non-photogenic.

And there’s this:

 

The Cohen Spread

Yes, those are private golf holes in the back and a skating rink to the left. Hard to see the ice cream parlor from this altitude (it's there).

And:

 This Is Art

Cohen paid a reported $12 million for a shark floating in formaldehyde. (Supposedly, it’s starting to decompose, but hey, he probably got a few good years out of it.)

It’s all fine, as far as I’m concerned. A little garish (okay, a lot), but people are entitled to spend their money how they please. It doesn’t mean I have to have them over for dinner. Problem is, that’s not how Obama sees it. He doesn’t understand how it’s possible to accumulate wealth like this legitimately, and bringing folks like Cohen down to size, through whatever means, is just another way to redistribute wealth.

This is why it doesn’t bother anyone in government that when they raid a financial firm’s office –particularly a hedge fund - they no longer even have to prove their case. They know full well they may have already destroyed the business. Investors are just too freaked out these days by reputational risk to hang around. All parties may have the comfort of being completely innocent, but it may be from the ruins of what they spent years building.

Lastly,  there is Cohen's apparent political transformation. He gives a lot of money to politicians, and in 2006 it went exclusively to Democrats. In 2008, he spread things around roughly 50/50. For instance, he gave money to both the Democrat and Republican Campaign Committees (hate that!). He gave to Reid and Baucus but also Mitch McConnell and Eric Cantor. Interestingly, not a cent to Obama.

Like a lot of folks in the financial community, though, Cohen has been given pause, presumably by Democrat spending and regulatory excess. In this year's election cycle, he gave every last cent to Republicans. Is there a little retribution in the works? Make an example of Stevie so everyone else learns their place? With our current administration, there are too many examples of thugishness to rule this out as a possibility.

So, there you have my take on this from two different perspectives. If you had to pin me down, I’d guess that SAC and others on the government hit list didn’t commit acts of insider trading but that they were very aggressive about what they viewed as legitimate information gathering. But I also think that the government is being equally aggressive, maybe unfairly so, in the other direction. The question is where did the investment firms draw the line, and where is government now deciding to draw it.

In the end, perhaps some good will come out of this in the form of better understood law.  One hopes it is not at the cost of the reputations and careers of the innocent.

Election Post Mortem

It's old news at this point, but it wouldn't be right not to grade myself on the election results. As you recall, I built a model for predicting the house results. I assigned each race a probability and added them all up. The number I arrived at was a 71 seat pick-up for the Republicans. The actual number will be either be 63 or 64 seats, depending on the outcome of New York 1 (the Hamptons).

I will give myself a B+ most prognosticators were in the low 50s, so I was correct in assuming the tide would be bigger than most thought, but I overshot the mark. I believe Democrats waged an effective last minute get-out-the-vote effort that prevented an even bigger blow out.

In my view, Democrats should be happy, or at least relieved. There really weren't any big surprises that went against them. No Barney Franks or Steny Hoyers. No Dennis Kuciniches (sigh). And they held on to a lot of close ones. They won 23 seats with less than 52% of the vote and another 22 with less than 55%.

And now the real fun starts: handicapping the Republican field for the White House. But that can wait a couple months.

The Real Reason To Ban Earmarks

Yesterday, Mitch McConnell said that banning earmarks won't save any money. By that, we are to assume "real" money, because earmarks only add up to $20-30 billion a year - remarkably, not much in the scheme of things.

McConnell is completely missing the point, and he was properly rebuked by Jim DeMint today. DeMint pointed out that earmarks - pork - are used to push bad legislation over the finish line. Obamacare would not have passed without the Cornhusker Kickback and the Louisiana Purchase. The odious Dodd Frank bill would not have passed without goodies carved out for Scott Brown.

Get rid of earmarks, and we make it that much harder for bad law to be born.

Update Soon

Note: I will submit a final analysis of my ability as a prognosticator as soon as final numbers are in. There are still a number of races that haven't been decided.

Final Call - 71 Seats

Here are the Naked Dollar's final predictions:

+71 seats for the Republicans in the House
+9 seats for the Republicans in the Senate
+13 governor seats for the Republicans

As predicted a couple of weeks ago, control of the Senate will likely come down to West Virginia and Washington. Republicans need to carry both.

National Pulse Index - November 1st

The picture is clear now - Republicans have all the momentum heading into tomorrow. I will make final predictions tomorrow. Right now it looks like Repubs pick up 71 house seats, 9 senate seats, and 10 governorships. An epic meltdown for Obama, Pelosi, and over reaching liberalism  is in the offing.

Year End Tax Suicides

A while ago I suggested that people might actually commit suicide towards the end of this year to avoid the enormous hike in the estate tax at the end of this year:

See: Death and Taxes

It seems that more people are picking up on this: http://www.newser.com/article/d9j5lab81/wyoming-congresswoman-says-some-constituents-planning-to-die-before-dec-31-estate-tax-rise.html

National Pulse Index - Halloween Edition

Until the last three or four days, the month of October was basically a wash between the parties. Now the late break towards the GOP is clear. Over the last three days, the Republicans have enjoyed an average of 25 net points of polling upticks nationally per day, the biggest three-day reading yet. Over the last six days, the have a total net of 118. That's a big number. This is happening despite Dems solidifying their races in places like California and New York. Given their isolation, there might be some softness in those states' numbers, though.

House model still at +71 seats for the Republicans.

National Pulse Index - October 30th

Republicans continue to have the late momentum. Interestingly, all the back and forth for the month of October has been roughly even, with the Republicans netting a positive 17 points of polling upticks vs. Dems. Not much, in the scheme of things.

For an explanation, go here: National Pulse Index Explanation

House model steady at +71 for Repubs.

Elections and the Gravity of the Cocktail Party Middle

Elections tend to swing on the whims of independents, that is, voters not affiliated with any party. The overall percentage of independents has grown dramatically over the last couple of decades, so politicians ignore them at their peril.

But who are these folks? It seems to matter, because the media gives us breathless reports on them almost hourly. The message I get is that they are the thoughtful voters, the ones who carefully weigh every candidate on the issues, and then come down from the mount close to election time, brows furrowed with the weight of all that cogitation, to deliver their verdict.

What a load of hooey. 

Before I get into exactly why, I will say that there are smart independents out there. Many of them have grown weary of one party or the other and have thrown in the towel, and I am somewhat sympathetic of this decision. But on the whole, I don’t think they are the enlightened bunch they are made out to be. I am on to them.

Here’s why. Have you ever noticed that when two people sit opposite each other, they tend to copy each other's postures? One leans back, the other leans back. One crosses their legs, so does the other, without conscious thought. This is a well documented phenomenon known among psychologists as postural mirroring.

The same precise effect happens with preference sets. People tend to gauge the viewpoints and behavior of others around them and modify their own positions accordingly. Over time, certain viewpoints or behaviors will become acceptable that weren't previously. Blogger Glenn Reynolds once pointed out, by way of example, the sudden appearance of American flags across our landscape (particularly on cars) post-9/11. Were people suddenly more patriotic? Probably not, but opinions and behavior are highly contagious. Once a few opinion leaders started waving the flag, others took this as an "all clear" signal that they could overtly display their patriotism, and they did. This is sometimes called a "preference cascade."

A year later, the flags were gone as the process reversed itself. Investment bubbles  and fashion trends come and go in much the same way.

Nowhere is this phenomenon more acute than in the realm of politics and political issues. The explanation is rooted in the fact that most people don't pay much attention, but they don't want other people to catch on to this fact. No one wants to appear uninformed.

This is where the cocktail party theory comes in. I know this doesn't describe anyone reading this, but let's pretend for a moment that you are that uninformed person, and you find yourself at a party. Suddenly, much to your horror, the conversation turns to politics. You very much don't want to look like an idiot. What to do?

The answer, assuming you are forced into the conversation, is to take a position as close as possible to those around you - the cocktail party center. No one will challenge you if you're agreeing with them. Disagree about anything and you might be forced to back up your opinion with facts or logical argument. That would be risky.

This ends up being self-reinforcing: the more you observe and mimic others, particularly from your own social milieu, the more you end up truly embracing their opinions, and the more you, in turn, tend to then influence others.

In my own hometown, this phenomenon was rampant in the last election cycle. Probably around 2005, it became unfashionable to voice support for George Bush. Not our kind, dear. Can’t even pronounce “nuclear.”  I watched as the independents and more than a few Republicans quickly modified their views to reflect those of progressive opinion leaders, who were pumping up the volume at the same time that conservatives turned mute.

When Obama came along, the table was set. Supporting him was "enlightened" and "sophisticated." Nod your head and watch your social stock rise.

Now, the process has completely reversed. Progressives are dispirited and conservatives are making the most noise. The prevailing view is that Obama has been a disappointment. "I voted for him, but he hasn't lived up to my expectations," is now the precise cocktail party center. The preference cascade has flipped over, maybe in record time.

I don't begrudge the uninformed. Well, maybe a little. And maybe occasionally a lot. People want to live their lives and not spend hours figuring out the pros and cons of every issue and candidate. That's their prerogative. But hey, let's not pretend they're Stephen Hawking.