Sunday, October 31, 2010

Tuesday, October 26, 2010

Should investors react strongly and positively to Citi's earnings news?

Since one of my friends liked this entry, I will expand it a bit more here.

From WSJ today:

"The bank's third-quarter profit was $2.2 billion, up from $101 million a year earlier, with per-share profit of seven cents coming in just above analysts' estimates. The amount the bank set aside for credit losses fell. Revenue rose 2% from a year earlier, to $21 billion, but fell 6% from the second quarter."

The markets react strongly and positively to the positive earnings news from Citi.  It actually brought up the whole financial sector, and the whole markets.  However, if investors know something about earnings management, the earnings pattern of Citi smells like classical  accrual earnings management.

Generally, firms that announce earnings slightly beating zero threshold (e.g., 1 cent per share) or analyst estimates (e.g., if analyst consensus is 6 cents and the announced earnings is 7 cents) are found to be most likely to have managed/fudged earnings.  See Burgstahler, D., Dichev, I., 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99-126 for further evidence.  The academic literature even find that firms may manage earnings just enough so that it is e.g., 0.5 cents about zero or analyst consensus.  When the number is rounded up, it becomes 1 cent more than zero or analyst consensus.  I am not sure if Citi is using this later roundup tools.

How could firms management earnings?  Generally, they could use either accrual or real earnings management (AEM and REM). In AEM, firms exploit the flexibility under GAAP to classify items differently.  For example, the following paper show the the main forms of accrual earnings management are as follows:

    * Unsuitable revenue recognition
    * Inappropriate accruals and estimates of liabilities
    * Excessive provisions and generous reserve accounting
    * Intentional minor breaches of financial reporting requirements that aggregate to a material breach.

See Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365-383.

So the way that Citi has met and slightly beat earnings expectation is through the third forms above. Although I am not able to check extensively, this pattern makes me suspicious that as one of the masters of the Universe, Citi must know how to do it right so that the trace of earnings management may be less obvious.

Companies also do real earnings management, which include abnormal production to affect costs of goods sold expenses, along with timing sales recognition, R&D and advertising spending, and asset sales.  For example, company could cut the current period R&D expenses to meet earnings expectations.  They could also slash price and bring forward sales into the current period to management earnings.  They could try to realize gains on asset sales to boost up earnings.  Different from AEM, REM 1) involves changes in the timing or structuring of operations, investments, and/or financing transactions; 2) have cash flow consequences; 3) do not necessarily reverse automatically; and 4) are more difficult to detect because it is easily disguised as normal operating decisions.  In a survey of CFOs, the following paper finds that managers prefer to use REM.

See Graham, J., C. Harvey, and S. Rajgopal, 2005, The economic implications of corporate financial reporting, Journal of Accounting and Economics 40, 3-73.

A well known paper by Sloan shows that accrual earnings management can predict future returns.  Firms with more AEM to boost up earnings would subsequently outperform in stock prices.  The main explanation is that investors do not fully understand the impact of accruals and blindly react to the announced earnings numbers (which is partly fudged).  So if that is the case, Citi shareholders are likely to experience some relatively lower returns in comparison to stocks with similar risk/characteristics.  This accrual characteristic has been used by buy-side money managers extensively in the last ten years.

See Sloan, R., 1996, Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315.

Similarly to Sloan 1996, I have a recent working paper in which I find that firms practicing more REM to increase earnings would suffer lower future stock returns.  See my paper "Real earnings management and subsequent stock returns: at  The paper has been presented at the annual meeting of Chicago Quantitative Alliance, a national organization of mostly buy-side researchers and portfolio managers this September.  It has made every top ten downloaded list that fits its category.  Part of the paper is likely to be in most every buy-side managers' toolkit in the future. 

Sunday, October 17, 2010

401k track record from 4/2001-9/2010: 109%

I finally get the 401k statement for some other reason.  I requested that they provide year by year return number so that I can show that there is probably no year with negative returns.  However, it does not have a break down for each year (maybe I will ask them again, which will take a while).  But it does have a total return over the whole period.  The total return from 4/16/2001 to 10/1/2010 is 109% (so over about 10 (9.5) years).  And it is restricted to only a short list of mutual funds (generally the choice is less than 10).  So it is a very constrained investment opportunity set and I do not have full time to trade this that frequently (and it has restrictions against frequent trading).

The annualized return, if you put into excel, is about 8.1% per year.  I hope this does not disappoint my readers given the simultaneous markets' performance.  If 8% annualized a year in the last decade sounds boring, how about no or almost no negative returns in any of the last 10 years ;=).  So the Sharpe ratio, or the ratio of return to volatility, is likely to be quite higher, because of the relatively little volatility in performance.  I also get every trade executed in and out of the mutual funds from this statement.  If you or you know any one who have a chunk of money and would be interested in this kind of performance (or better), I would happy to provide the service.  I have my own company to take care of the administrative stuff.  The investments will be in highly liquid securities (or pure mutual funds, like my 401k), and will have relatively low risk exposure and low correlation with market performance through my 'impressive' asset allocation.

The reason for little volatility or negative performance in my performance is because I had everything in cash in 2002 and 2008, the two big market down year.  There is no long-term T-bond fund in the 401k account so there is no way to capture the upside in those down years.  But zero return is still way... better than 30-50% downside, right?

Another thought, I wonder how many are educated enough to recognize, this kind of long-term performance would be quite attractive in any environment (either at the start of 2000, when bull markets are raging, or at the depth of the bear markets in 2008).  These are equity like returns with bond like risks.  That is close to heavenly investing.  I hope I can repeat this performance for the years to come.  The paranoid survives. 

Thursday, October 14, 2010

Confirmation about my predictions on US and Chinese trade balance

As I mentioned earlier, this will be the case for the quarters to come

until we have some serious threat of trade war or maybe actual trade war.  This is the single most important threat to the smooth rise of the emerging markets.  This is confirmed again with the latest data

"The U.S. trade deficit with China grew to $28.04 billion from $25.92 billion in July. Imports from China grew 6.1% to a record $35.29 billion. Meanwhile, exports fell $92 million to $7.25 billion."

Monday, October 11, 2010

If you want to see what it means by pyramid builders, look at this

"Four of Bank of America's top 10 shareholders have sold 10% or more of their holdings since March, and the bank's shares are down 34% since reaching a 52-week high of $19.86 in mid-April."

I did not check those holders specifically. Since a few top hedge funds earned an enormous profit from loading a huge amount of shares of BOA and other banks, it is likely that some of them are among those four.

Monday, October 4, 2010

Are Americans really sour on “Free Trade”

WSJ/NBC poll shows that about35% of Americans are for and against free trade around 2000.  Now above 50% of people are against free trade, whereas less than 20% of people are for free trade.

In comparison, in the policy circle, the majority of pundits are still for free trade.  What's the problem here?

The problem is about the definition of free trade.   Trade is not free unless your trading partners do not manipulate exchange rate, repress compensation, run ultra low or negative interest rate, subsidize exporters with substantial sums.  I am not hinting at just China, but all the whole East Asian region and Germany.  If the current trade system is "free trade" system, Americans are rightly rejecting this fake system.  Without righting the wrongs in this system to make trade really free, this current trade system is bound to collapse in less than 10 years, and likely shorter period of time. 

When that happens, the bulls on emerging market stocks and debt should be ready for some real rock and rolls.  That is the weakest link of the whole recovery thesis and emerging market emergence thesis.  If there is some way to bet on this collapse, I would be most interested in it. 

Sheer determination is neither sufficient nor necessary to make a great nation

(This is a post that I wrote about a month ago but did not have to post.  I have added a news article that confirms my predictions.)

Many great nations of the world today and in the past (not necessarily big nations) seem to share a common characteristic: sheer determinations (for example, the determination to succeed against all odds and the determination to endure in the face of great sacrifice).  Many aspiring nations thus try to instill this seemingly intuitive concept in their population.  However, I want to argue that sheer determinations in fact are neither sufficient nor necessary for a great nation.  On contrary, when combined with wrong policies, they could lead to a tragic end.  For example, the great experiment of communism failed not due to a lack of sheer determinations.  It was executed and implemented with sheer determination paralleled only by religious zeal.  However, this utopia was unable to produce workable policies, which lead to not only its own failure, but also extreme human catastrophes and sufferings. 

Today I fear that nations such as Ireland or Spain are making the same mistake.  Their mistakes are so similar that understanding the correct solutions to their problems would have profound implications to large, and particularly small nations in the Western world. 

Take Ireland as the example.  With the determination to succeed, the Celtic tiger achieved tremendous growth in the last couple of decades.  However, this growth also induces a huge property bubble.  With the bubble collapsing through the Great Financial Crisis in 2008, Ireland made two mistakes that are being repeated by almost every developed nation, large or small, in the world. 

First, Ireland bailed out the stakeholders in Irish banks and put all the liabilities on the public balance sheet.  Since Irish bank's liabilities are very large in comparison to Irish government balance sheet, this approach puts tremendous burden on the Irish people.  This burden is the root cause of the extreme austerity practiced by Irish government today.  At the same time, since this approach does not completely unclog the financial system, the wobbly Irish financial institutions are still reluctant to provide sufficient funding to the Irish economy.  This movie is being played in most Western nations today. 

Second, as if Irish people have not suffered enough in the last few centuries, the Irish people not only needs to repay the debt that went sour but also suffer severe cuts in their welfare.  The Irish government, and many wrong-headed policy advisors, have so far cast a cursing spell on the Irish people by successfully arguing that the sheer determination to endure in the face of great suffering is sufficient and necessary to solve the problems and that growth can result from severe cuts of government budget in the face of a quasi depression.

Both approaches are completely mistakes.  In the first situation, the correct approach should have been wiping out the shareholders, forcing bondholders to take a big haircut and to convert their remaining stakes into equities, and inject government funds as debt (and equities if necessary) in the failed financial institutions.  The reformed financial institutions could easily raise further equity and debt financing on the public markets given their clean balance sheets.  These institutions would also be willing to lend for the same reason.  I have suggested this approach since the fall of 2008. 

After Ireland committed missteps in the first situation, the correct approach for a small nation like Ireland would be to replace Euro with Irish pounds and devalue its currency substantially in the process.  Ireland suffers from a loss of competitiveness problem from the collapsing property bubble.  Its problem could be solved through either internal deflation or currency devaluation.  Since it shares Euro, currency devaluation is currently not available.  Internal deflation is much more painful and does not guarantee success.  In the recent years, as Ireland cuts benefits and services, the magnitude of GDP shrinks, due to the cuts directly and the increased saving by the population as a response to the cuts.  The double-digit fall in GDP actually leads to an increase in total debt to GDP ratio (due to the sharp fall in GDP) and the credit spread between Irish government bonds and German Bunds (the benchmark risk free securities in Europe).  See this new article here:

The sheer determination to endure in the face of great suffering is not sufficient to solve the problem of a small nation like Ireland.  In fact, it is not sufficient for big nations like the U.S. for the same reason. 

Since Ireland is a small nation (its GDP is less than 5% of the European GDP), the sheer determination to endure in the face of great suffering is not even necessary to solve Ireland's problem.  Instead, if Ireland replaces Euro with Irish pound, and devalues its currency substantially in this process, the export-driven growth would be able to pull Ireland out of the current slump, just as in any similar crisis in the past, especially for emerging markets.  The smaller Western nations in deep slumps should understand that the sheer determination to endure in the face of great suffering is neither necessary nor sufficient to solve their current problem.  Adopting the current approach would help solve their problem sooner.  (Unfortunately, the second solution will not apply to large nations). 

Pyramid Builders

It is a little surreal that stocks were poised for substantial further gains after September.  All the risk factors are there, and the warning signs getting louder.  However, thanks to people like John Paulson, who are "na├»ve optimist" as phrased by Wall Street Journal (not me, see Paulson and the bulls bounce back at, and David Tepper, who is opportunistic in taking Bernanke put (, the market got back to life in September.

What these hedge fund managers, and many other institutional managers, are doing is simply building pyramids.  The liquidity is very low (, with most investors sitting on the sidelines.  So the strategy of Paulson & Co. is to push stock prices up to get a good return number for their own fund.  More importantly, by pushing up tock prices, they create the fear in the weaker mind of some investors about missing any potential rally.  If they could push hard enough, they may be able to build a pyramid scheme, and then get out before every one else, making some handsome sum for themselves.

If we do not have enough weaker minds, then these pyramid builders may have trouble holding the bag on the top of the pyramids by themselves. I sincerely hope they do not succeed in luring the weaker minds, because that is likely to make those weaker minds suffer another serious blow in their personal wealth when these weaker minds find themselves holding the bag at the top of the pyramids. 

How stretched is the market? We could look at every major economic number and they are still trending down. I would post the US PMI data along with stock data here, and the European number is the same.  PMI usually have strong predictive power for stock returns during the recessions.  This relation may break up during recovery, because stock prices would bounce back much more quickly.  However, what we see is that the US PMI is trending downward again after a good recovery later last year and early this year.  The stock price and PMI have the largest diversion (stock prices sharply up and PMI down at intermediate level) since a long time.  This only smells trouble for stock prices for months ahead, especially the likely trend for PMI is further down.

What's different from the last Bernanke put early last year and the current situation is the one-legged nature of stimulus.  Last year, the monetary stimulus, aka the last Bernanke put, jumped start the rally.  The rally probably would have fizzled out quickly without the substantial fiscal stimulus.  The fiscal stimulus also helps sustain and amplify the inventory restocking cycle.  That is probably the main reason that we could have such a long rally up to today.

However, this time around, we have no fiscal stimulus to sustain the rally.  The current fiscal stimulus can only provide drags on the economic growth (I talked about this in earlier posts).  There will be some small fiscal package here and there, but there will be no 800 billion package any more.  Although some would still have some delusion about Republican sweep in the House, and potentially Senate, the only consequence of that outcome will be a divided Congress that does not function at all.  With Republican's eye set for White House in 2012, do not expect any stimulus, unless the economy has already fallen into abyss again, similar to late 2008.  They would not appreciate any real recovery, which can only benefit Obama, and derail the Republican political goal in 2012.