Then and Now
The investment management industry is not standing still. Investment capabilities and skills have grown tremendously since the introduction of the IBM PC in 1981 that brought processing capacity to the desktop over 30 years ago. The explosion of available information and in the ability to process vast quantities of data has transformed the investment business since then, particularly in the evaluation of risk and in the use of derivative securities to both presumably manage risk and to leverage it.
One problem with all of this, however, is the concurrent growth in the difficulty in identifying the signal in the midst of an extraordinary amount of noise — the noise of hollow information. The investment industry has focused attention and resources on gaining access to vast amounts of data faster, before competitors, and on evaluating it faster. At times, this may be (or may have been) a winner's game, but just as often today, reacting to information flows is a loser's game. The world has failed to differentiate between gaining an inferential edge and gaining an informational advantage. The former is a source of sustained competitive advantage whereas the latter creates only a transitory advantage.
Risk Management
Wall Street and Main Street have taken two different paths during the post WWII period. Main Street appears to have become less volatile (the financial crisis of 2008 notwithstanding) and Wall Street more so. Adverse exogenous events don't seem to have the same power to derail the economy the way they used to and the performance of various sectors of the economy have become increasingly uncorrelated, in part due to the increasing globalization of tradable-goods industries. The opposite has been true on Wall Street, however, and individual stock volatility has far outstripped the change in underlying fundamentals. The interaction of expectations, particularly correlated beliefs, is in great part responsible for the rather massive rise in endogenous sources of volatility of individual stocks and bonds.
Why has this happened?
  • Interest rate volatility took a permanent upward shift following the elimination of Reg Q in 1981. Reg Q controlled the interest rate financial institutions could pay on savings deposits, enabling the Fed to raise rates above the limits, which resulted in disintermediation and a decline in housing and consumer lending. The cooling of the economy kept the upside change in interest rates in check. Following the elimination of Reg Q, the Fed lost its ability to dis-intermediate financial institutions, and as a result it took both larger changes in interest rates on the upside to cause economic activity to slow and a greater decline in rates to stimulate activity. This volatility in rates adds to stock volatility as discount rates gyrate up and down to greater extremes.
  • Specialists and broker/dealers no longer serve in the function of being a provider of liquidity as a last resort to create stable pricing markets. Despite high trading volumes, the liquidity provided by brokers willing to use firm capital to position stocks is virtually gone. Greater volatility is a result.
  • The electronic delivery of information now hits the desktops of investors simultaneously, and as traders simultaneously attempt to react with transactions, massive price changes (up and down) occur as investors try to get through the execution door simultaneously.
  • Twenty years ago, Wall Street analysts received less earnings guidance from management. The narrowing of consensus expectations around management guidance increases the opportunity for both positive and negative surprises, and the resulting volatility of stock prices.
As a result, both markets and individual stocks repeatedly overshoot the real changes in underlying fundamentals, creating valuation extremes of which we attempt to take advantage



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Last updated: June 03, 2015

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