Wednesday, December 31, 2008

A Year Never to Forget

The thing about moving forward is that you're always coming from somewhere. Sometimes, it’s a position of strength, other times it’s not.

But, in any case, we couldn’t be where we are without having come from some place before. And to write that off would be akin to ignoring the face in the mirror.

In the case of the stock market, just having finished its worst year in about three generations, we're moving off of an extraordinarily depressed level.

The chart below shows this in quintiles for the past fifty-five years. By pure coincidence, this period begins and ends with the best and worst performances. Over this time, the market compounded at an annual rate of 6.8%. For every down-year, there were nearly three years of gains.

As to 2009, we should at least take comfort in two points:
  • Statistically, a repeat performance of 2008 would be extremely remote.
  • Of the the ten other years in the same quintile, seven up-years followed for an average gain of 19.4%.
Our greatest hope for the new year is a restoration of market confidence. Without it, there's no efficiency in price discovery, no pricing mechanism allowing funds to flow smoothly across the economy, and no incentive for innovation and entrepreneurship.

However, let's not forget 2008 for its lessons – and their historical importance. Now, we have that unique opportunity that only comes with such a downturn to completely clean house and remove some pretty big impediments.

If we can accomplish this, then good progress will come.

To you and yours, Happy New Year!

Tuesday, December 30, 2008

Adjustment in Crisis

One thing's for sure: We live in an age of suddenness.

No matter how much information we employ, we're constantly surprising ourselves. Take the stock market. Since the 1950s, volatility has averaged 9.8%. It’s now hovering at nearly four times that level. In fact, since 1998, it's averaged close to 14%.

What gives? Despite all our computing power, why can’t we get a better handle on things?

Well, we suspect the answer has a lot to do with the “handle” still having a grip on us.

Over most of the last generation, two game-changers stand out: information technology and global socioeconomic change.

In a relatively short period of time, we transformed the way we communicate with each other. We also upended a multi-decade geopolitical balance. The result: an eagerly competitive and interlinked global economy like no other before.

Viewing the downturn against this makes it seem, well, less ominous.

First, though, we need to accept two truths.
  • Global conditions extended the reach and depth of capital markets.
  • Information technology redistributed the balance of power on Wall Street.
Second, we need to accept these as evolutionary. The world, friends, is changing, and there's no going back!

Ultimately, it's all good, because, at the end of the day, it’s about increased competition for capital – a dynamic that promotes innovation and wealth creation.

The big risk? That would be in folks not seeing the "crisis" as an adjustment (painful as it is)
. And by misjudging the big picture, they could implement policy that hampers or, worse, reverses, this natural and necessary change.

Sunday, December 28, 2008

What's IT Worth?

Health Care + Information Technology = (?)

A. Efficiency & Value
B. Optimized Care
C. Both
D. Total Frustration

If we were to poll different age groups of practitioners, we suspect most folks 45 and younger would answer A, B or C. More seasoned professionals would pick D.

Macroeconomics teaches us that technology advances economic growth, but health care does not follow traditional economic rules: consumers do not pay, payers do not consume and committees (rather than a marketplace of individuals) determine pricing. If anything, say the doubters, Health IT does little more than highlight the system's inefficiencies.

There's also the matter of standards: Until IT systems can actually communicate with each other, very little can actually be accomplished.

A recent Google news search on electronic medical records, for example, reveals a conflicted picture of hope and hopelessness: "More Hospitals Using EMRs", "Fraudulent Use", "More Trouble Than Worth"

"The only truly promising way to save money is to change the way health care is organized and delivered," notes a recent Op-Ed piece in the New York Times. "85 percent of doctors work in small, fee-for-service practices... They are unable and unwilling to be held accountable for the quality and cost of the care they deliver." The author addresses a basic, unfortunate fact about health care: it's the culture that's broken.

The system might just be too entrenched to sort itself out; that is, unless it can be reformed as a more familiar economic framework.

At the very least, we should embrace surging enthusiasm for IT's potential. Let's just make sure it's channeled appropriately.

Saturday, December 27, 2008

Framing the Stimulus

This weekend, Larry Summers states the case for the Obama stimulus package. Lawrence Lindsey proposes criteria to assess the package.

Despite representing opposing aisles, both economists agree some form of stimulus is needed. The Obama plan is expected to encompass massive infrastructure spending, from roads to Broadband Internet.

Mr. Summers writes of a $1 trillion shortfall in GDP and the opportunity for high social returns spanning "energy, education, infrastructure and health care". He argues: "In this crisis, doing too little poses a greater threat than doing too much."

Mr. Lindsey, meanwhile, offers three evaluation criteria: "First, does the program target the weakness in the economy that caused the recession, or is it largely peripheral? Second, are the funds going to be spent in a timely fashion? Third, does the program fundamentally strengthen the economy going forward into the expansion phase?"

This crisis, he notes, centers on an "extreme household balance sheet problem". "Shovel-ready" spending occurs best in the private sector. And, the best stimulus would be a permanent reduction in employment taxes. He advocates a greenhouse emission tax to cover any lost revenue.

Mr. Summers, in his comments, carefully defines the president-elect's plan as both an "investment" and a private-sector solution; its "key pillar": the creation of three million new jobs within two years.

Regardless, its passage depends on two points:
  1. whether folks view government as an ally or an adversary, and
  2. the extent of economic adjustment already taking place.
Unlike TARP's formation, the Obama plan faces a debate of weeks instead of days.

Sunday, December 21, 2008

What's in Demand

Over the next several weeks and months we'll be hearing a lot more about aggregate demand – the economic measure of how much we're collectively willing to spend on goods and services. Accordingly, the richer we all feel (paycheck and net worth expectations), the more we consume.

Right now, since most of us don't feel that rich, we're consuming a lot less than only a few months ago.

Aggregate supply, or the amount we produce, balances against this. Financing costs, operating costs, taxes and technology affect its shape and steepness (economists represent this graphically as an upward sloping curve).

Almost overnight (September 2008), financing and operating costs reversed direction and anxiety shifted from inflation to deflation. The trigger: a sudden drop in demand (alternatively, a sudden rise in savings).

How policymakers view demand affects legislative choices. Many ascribing to Keynesian economics – such as the incoming administration – see it as a fixed picture defined by employment levels. Their response to expectations of rising unemployment is massive infrastructure spending. Government spending, they argue, complements consumer demand and expands GDP (a multiplier effect).

Others see demand more as a pricing mechanism. Rather than something tightly correlated to employment, it's a self-adjusting, constant-motion process. (Employment, after all, is itself constantly adjusting.) The best remedy in their view is for government to step as far back as possible. They advocate massive tax cuts to advance price discovery.

At the very least, let's hope legislative action reflects the economy’s complexity, and targets a basic goal of increased transparency in consumer decision-making.

Sunday, December 14, 2008

A Simpler Equation

The election might have ended all hopes for supply-siders, except now the electorate doesn't appear quite so warm to a full-on Keynesian approach. The most recent testament: souring opinion on a Detroit bailout.

While economists feverishly debate the appropriate model to fix the economy, political reality holds that Washington will legislate some sort of hybrid approach. Even President Reagan was not a purist: he reduced taxes, but also increased spending.

Whatever legislation emerges we certainly hope does some good, even if it fails to resolve the economic debate. In fact, it's likely to shape new schools of thought based on its success.

Meanwhile, folks are adjusting lifestyles to more basic needs. This process apparently also includes a reassessment of core convictions, which began some months ago and continues today.

And the worse conditions get, the more basic these convictions become. Luxuries aren’t just tangible objects, they can be belief systems too. The idea of something can be quite different than what its reality actually means to someone.

For most, this comes down to preserving some sort of equilibrium – keeping kids in a desired school, staying within a desired community, or simply keeping up appearances; for some, it's a question of survival – there’s a lot less net worth to cover lost income.

Just as political intentions may not match the economic model, the electorate’s views may not support political intentions.

Though constantly in motion, this equation is becoming much less complex than only a few weeks ago.

Saturday, December 13, 2008

Game of Tag

Today's social Internet converts dynamic interaction into highly productive tools. Users view and assess information in ways they never have before.

One vivid example of this is the tag cloud. Using statistical algorithms based on popularity or conviction (not necessarily the same thing), a tag cloud displays a site's word content. An index, on the other hand, sorts information sequentially and one dimensionally.

Here's what Talking Transitions' tag cloud looks like (this, by the way, only covers what's visible on this page, so no previous commentary); size indicates frequency:

Imagine we could create a cloud for all commentary on the economy (possible – we think – but beyond our scope). Which words and phrases might appear in the larger sizes?

We'd guess: risk, bailout, deleverage, volatility, depression, blame, savings, foreclosure, socialism, capitalism, Keynes, corruption, taxes, real assets, hard assets, transition… Others might pick different or similar lists; the final output could itself be different or similar.

(We’re assuming what the cloud might look like. A tag cloud, on the other hand, makes no assumptions.)

While we may each assess events differently, Internet functionality now allows us to aggregate and view the underlying information in fast-evolving and widely accessible ways.

No one quite knows what economic effect this has, other than we're all a whole lot more aware of how powerful information is. We also know we're well-positioned to advantage of this.

The consequence: a very different market dynamic than the early 1980s or 1930s.

Some might say it’s what first upset economic balance, and what could eventually restore it.

Sunday, November 30, 2008

Efficient Electricity

If oil is the economy's lifeblood, then electricity is its life-force.

From 1949 to 1980, US electricity consumption grew at 7% CAGR – nearly twice real GDP. After 1980, this dropped to 2%, or two-thirds of GDP.

The chart below illustrates two dynamics (both as five-year moving averages to approximate the average economic cycle):

  • relative growth of GDP to consumption, and
  • GDP-per-KWh (adjusted for total households).

(For consumption, we use total sales to residential, commercial, industrial and transportation sectors.)

Significant decade-by-decade patterns underlie the long-term trend:

In the 1980s, the PC emerged as a potent energy-burning productivity tool, and economic growth began surpassing consumption growth. In the 2000s, the Internet produced the same effect, and this differential accelerated.

Low inflation and consumer electronics penetration contributed to higher GDP-per-KWh in the 50s and 60s; GDP per household, though, was also low.

Key factors separate the 2000s from the 1990s, resulting in higher GDP-per-KWh: IT productivity, financial leverage (a not-unrelated factor) and new revenue opportunities in emerging markets (also not unrelated).

The 1990s, in contrast, witnessed an enormous peace dividend. This opened military industrial capacity to private consumption; the information revolution did not arrive until late in the decade.

Once again, political upheaval is underway: a throwback to Keynesian economics. Unlike prior periods, vast commercial networks interconnect the global landscape, while the Internet continues to shrink the world.

More than ever, electricity efficiency reflects global competition for capital.

So what now? Does government intervention stifle this efficiency? Would the Internet economy allow this to happen?

Tuesday, November 18, 2008

Mutually Assured Destruction

We're all stressed about the economy and our finances.

For an increasing number of us, though, it's a question of survival. How do I get from today to year end when my income is down 50% and threatening to go to zero, and my already-stripped-down expenses haven't budged?

This is the type of uncertainty that forces us to reduce our outlooks from years to weeks – and, indeed, days.

What do I absolutely need, what can I jettison?
Problem is, asset markets are rapidly deflating. You name it: stocks, bonds, property, commodities; we’re collectively mired in one heckuva across-the-board event.

The paper values of everything we possess are sinking fast; even more so if we actually unload them, because, in this market, one seller begets two more, and so on.

The vicious circle would have no end, if not for a critical market dynamic.

As more and more of us shorten our timeframes, such that the sacrifices of a few become the sacrifices of many, we become less able to use time to arbitrage against each other.

Not only do the dollars I owe become somebody else's revenue risk, they also amount to a proportionate sense of pain. And the less able folks are to withstand this, the more likely (and faster) they will renegotiate transaction terms.

Eventually, against the threat of nuclear oblivion, we find a point of stability, because it's in no one's best interest for mutually assured destruction to actually take place.

What that point is, or when it occurs? Nobody knows – least of all the Beltway's denizens.

Sunday, November 16, 2008

Primary Care: Profession in Peril

In medicine it pays to specialize. According to one recent study, specialists earn more than two-times the pay of primary care physicians ("PCPs").

Listed below are a few of the more sobering truths about the primary care profession:

  • From 1995 to 2003, inflation-adjusted income declined 10%.
  • PCPs feature the lowest average salary among provider-types.
  • Primary care ranks at the bottom of residency positions filled.
  • Only 2% of graduating medical students choose to become a PCP.
  • Since the early 90s, 20% have left their profession; 62% say they'll leave if Medicare doesn't increase payout.
  • 44% of family-medicine residents attended U.S. medical graduate schools versus 72% in 1997.
  • By 2025, experts expect demographics to increase demand by 25%; supply, meanwhile, will only increase between 2% and 7%.
  • Currently, 20% of Americans don't have access to primary care.

Many believe these speak to the heart of our health care problem: big dollars wasted on poor outcomes. We may enjoy the world's best radiologists and orthopedic surgeons, but the system is either too quick to refer us, or simply doesn't address the full episode of care.

And it’s not a question of market forces reshaping the profession. With Medicare the default price-setter – and implementing a payment structure strongly favoring specialists – they simply don’t apply. The chart below shows this as the percentage of primary care positions filled against Medicare expenditures as a percentage of GDP.

But what if the market economy did apply? Probably the only person more grateful than the PCP would be the consumer himself.

Tuesday, November 11, 2008

Collective Wisdom

James Surowiecki's 2004 bestseller "The Wisdom of Crowds" popularized scientific evidence supporting how large numbers of people can collaborate as independent thinkers and more accurately solve complex problems than any one individual.

“The wisdom of crowds has a far more beneficial impact on our everyday lives than we recognize, and its implications for the future are immense,” he writes.

As expressed through Facebook or World of Warcraft, no demographic would seem to grasp this better than young adults: specifically, 18 to 29 year-olds.

In the presidential election, this segment voted for Barack Obama by a 2:1 margin. Observers point out an even split would have given John McCain the win.

Indeed, its collective wisdom made for an historic outcome, but has it also contradicted its networked nature's core principles? The answer depends on how much it's anticipated the policies of a larger and even more interventionist government.

Surowiecki acknowledges that because groups are typically unwise about their own wisdom, they require a leader to draw this out. He also states that the potential for bottom-up decision-making is becoming more plausible.

Since early September, the current administration and Congress have dramatically undercut market forces, favoring instead taxpayer bailouts and backstops. Although full consequences will not materialize until months and years ahead, the "leader" in this case has clearly imposed itself over the wisdom of market-based price discovery.

The government-knows-best approach could well extend. Ultimately, it will find itself pushing against the countervailing force of collective wisdom and its expansive parameters.

Sunday, October 26, 2008

From Big Government to Big Inflation

Political leaders are nationalizing an increasing share of our capital allocation process.

This, combined with the likelihood of a near-term decline in personal consumption, should increase government’s share of the economy dramatically in the months ahead.

How much might this actually shore up economic security? How would this affect monetary policy?

In the chart below, we consider both questions in side-by-side measures: government consumption as a percentage of GDP (blue line), and GDP volatility (green line).

(We calculate volatility as the five-year standard deviation of the annual percentage change in quarterly GDP: five years to approximate an economic cycle.)

Since 1953, both measures have trended downwards. Though spiking during recessions, volatility has moderated markedly since 1985. Government spending, meanwhile, took two big steps down: first, between 1970 and 1972 on surging household net worth; and, second, in the early 90s on the massive peace dividend stemming from the end of the Cold War.

Although volatility and government spending show clear association, monetary factors also weigh heavily into this, as during the late 70s and early 80s when inflation skyrocketed (and volatility jumped), or later when it abated.

We should therefore closely watch the risky effects of an enlarged government presence on the Fed.

While Bernanke’s űber-aggressive attempts to stave off deflation would seem justified, a sudden reversal in credit markets could dangerously accelerate money velocity.

And with inefficient banks – and inappropriate business models – still gumming the system, the inflationary effect could be devastating.

Thursday, October 23, 2008

Creative Destruction

Joseph Schumpeter (1883-1950) is widely celebrated for his work on innovation, in particular his invocation of "creative destruction" as capitalism’s key dynamic.

Thomas McCraw's 2007 best-selling biography further popularized Schumpeter’s theory, which now seems almost commonplace in the financial press.

Less well known is his prediction of capitalism's demise, also detailed in his seminal work Capitalism, Socialism and Democracy, which he published in 1942 during FDR's third term as president. This work argues that intellectuals eventually corrupt capitalism's natural process, and thereby contribute to the formation of a welfare state.

He sees this transition taking place in the state’s move towards corporatism in direct response to creative destruction's sometimes violent impact – that is, the social condition of the state exerting itself through corporate bodies. At the same time, he argues that political leaders in a democracy actually manipulate the electorate – eliminating any allowance for individual participation or common good.

Like many others, Schumpeter escaped Nazi Germany for the United States. He disdained the Soviet Union, and criticized Roosevelt’s New Deal, in which he viewed the failings of Keynes, his rival. Dying well before the computer and Internet era, Schumpeter's technological and cultural reference points are now well-removed from today's world.

Transparency as a key foundation of accountability might not have been readily apparent as something feasible in our complex, corporate economy. But if he could’ve comprehended the Internet as an enabling force, would he still propose the same road to demise?

Or would today's environment make him even more confident in his views?

Tuesday, October 21, 2008

Joe, Meet Wall Street

Within a day of each other, Senator Barack Obama and Treasury Secretary Hank Paulson made significant confrontations: the former with Samuel Wurzelbacher (aka "Joe the Plumber"), and the latter with the nation's largest banks.

Coincidence, irony or just the way forward?

In both cases, the message was identical: We're government, and we're here to help.

While the banks reportedly balked at first, they all fell into line in a matter of minutes.

Meanwhile, Joe, a fractional economic rounding error by comparison, stood firm: I don't need your help.

So, here we have it, the essence of today's economic debate: a fierce reprisal of the war between the proponents of John Maynard Keynes and those of the Milton Friedman. Except now it’s happening over weeks, not years – a sudden urgency before what amounts to a national referendum in 14 days.

As pertains to Wall Street, two questions bear consideration:

1. Is it possible to avoid systemic failure and not compromise the underlying system?
2. In taking taxpayer’s money, are banks undermining their core business models?

Desperate times call for desperate measures, argues the government. The risk-return of giving too-big-to-fail banks time to reassemble outweighs the slippery-slope of wider-scale intervention.

Maybe banks know their business models are junk, Joe would probably retort, if asked. Government is absorbing all their risk on my dime, and I'm worried the next administration might offer them even more cushion in exchange for more control.

Wall Street is shifting, and so too Main Street.

We'll know soon by how much.

Friday, October 17, 2008

Smart Money

Who is smart money? If it’s Wall Street’s biggest earners, then it has to be the hedge funds – right?

Wrong, according to their shareholders.

These fair-weather supporters are opting to flee, forcing managers to raise cash to meet large-scale redemptions.

It may not be the managers’ smarts in question (we suspect many would hope to be buying now), rather it’s their businesses’ design.

Specifically, the…
  • promise of absolute return.
  • immediate reporting to shareholders
  • high cost of leverage
  • dependency on short-selling (blame the SEC for this one)
  • cult of personality (commitment to an infallible guru)
  • high maintenance and performance fees
Mutual funds, on the other hand, boast the non-smart kind of money. At least that's been the typical view.

They're everything hedge funds aren't: mired in relative return; measured in quarters, sometimes years; unlevered; beset with anonymous managers; low cost.

But if we’re considering shareholder support as the best evidence of success, they’re in good stead by comparison.

Take the table below: it shows net inflows as a percentage of total assets. Notice the jump in the late 80s and early 90s – a portion of which shareholders invested for the long-term, and which is worth much more today despite the market’s gyrations.
While shareholder redemptions make headlines, the percentage amount compared with hedge funds is paltry.

Smart isn’t just good performance, it’s shareholder confidence in managers and the underlying business model.

New business models will, of course, emerge.

This just may take time.

Thursday, October 16, 2008

Why The Market Is So Volatile

The stock market is a discounting mechanism; it continuously prices a multitude of information.

This price discovery process encompasses vast networks of buyers and sellers, each deploying different criteria

Significant among these: time horizon. While some participants trade over narrow periods (minutes, hours, days), others invest for several years.

How the composition of these participants anticipates corporate health – cash flow, profitability, balance sheet strength – determines the market’s price level and its volatility, an assessment also including factors such as interest rates, exchange rates and commodity prices.

The common feature between current volatility and the market's last bout – the six years between 1997 and 2003 – is the alternative strategy universe (hedge funds, proprietary trading desks): then, its rapid emergence as a mass infusion of leveraged money, and now its purging.

Half or more of the market’s volume (and predominantly short-term in focus), this universe and its impact is much larger today, having become Wall Street's foundation.

One principle difference between then and now is the credit freeze. The other difference is uncertainty regarding government intervention: now, government's direct influence over capital allocation; in the months ahead, its potential weight in new taxes and regulation.

So, here we have it: on one hand, a re-composition of the market's participants; on the other, an adjustment to a new landscape.

Only when market participants finish realigning does this combustible combination defuse.

If the result is a shift toward longer-term timeframes, expect more measured responses to government action and the economy.

Tuesday, October 14, 2008

Recessions and the Stock Market

Since 1953 there have been nine recessions, averaging ten months in length.

Applying mid-month start- and endpoints to all nine, the S&P 500 gained an annualized average of 1.9%.

In four of these, the market dropped an average of 10%; in five, it gained 11%.

The average change from period start to period low is minus 18%; the 1973/75 recession recorded the steepest plunge at 39.2%.

Let's take November 15, 2007 as the starting point of the current recession. (It fits the negative GDP reading that quarter and inflections in other key data: employment, income, and corporate sales.)

From this point to the October 10th close (1451.15 to 899.22), the market shed 38.0%; bad, but not as bad as the 70s.

When will this current recession end? Of the nine, the two longest – '73/'75 and '81/'82 – lasted 16 months. A similar length puts the endpoint in March 2009.

How long, though, ultimately depends on balance between Wall Street and Main Street; the government’s now direct influence over capital allocation is about to test this.

From period low to recession end, the average gain is 23% (the market surged to half of this yesterday alone). In '73/'75, the market recovered 38%.

This recession's different – yes. But as bad as the Great Depression? That depends.

It all comes down to how government – especially the next administration – wields its considerable ownership: to what extent this sidelines market-based price discovery, which has so dramatically diminished economic volatility.

Monday, October 13, 2008

Transparency and Medicare Too

Transparency – the clarity of available information – crops up often these days.

When it comes to mortgage-related securities, it's the ability to price complex obligations; and for the institutions trading and investing in them, full disclosure of their exposure.

Had there been more of it, things might not have gotten quite so out of hand.

The consequence, however, is government now controlling – directly and indirectly – a large share of the country's capital allocation process.

Consider an industry where government already allots one in three dollars spent. And add to this zero transparency.

If there's a model for where things could go, think Medicare, a monolith boasting an $85 trillion unfunded liability (that’s $870,000 of additional liability per household).

Since government began inserting itself in 1965, health care has increased from 5% of the US economy to 17% – and is forecasted to rise to 25% by 2025.

Maybe this is why markets are so flustered: having to price an open-ended right to government-backed financing?

While a big Medicare fix is neither likely nor advisable (imagine the compromise), we should put hope in small breakthroughs; top among these: strong bipartisan support for access to claims data.

Covering 44 million people, Medicare processes over one billion claims per year; not dissimilar to the government dictating non-negotiable bid-ask spreads on a third of all stocks, and blocking all counterparty information from the marketplace.

Imagine if this were transparent; the same should hold for financial markets.

Friday, October 10, 2008

Be Careful What You Fix

I'm exhausted. How about you?

The four-week period ending today featured the highest number of 3+% market moves for any month-long period in the last 60 years.

Eleven in total: that’s an average of one big move every two trading days.

For the year, the market has averaged a 3% move every 12 days. The average since 1950 is once every nine months. In 27 of these years, no such day occurred the entire year.

Despite these gyrations, which have become more frequent the last quarter century, economic volatility has steadily declined, and is now the lowest ever.

The chart below shows this downtrend (rolling ten-year standard deviations of annual GDP) against spikes in the equity market.
We wonder whether all those Great Depression references aren't just a little exaggerated. Sure – the credit freeze has its perils. But as bad as it could be, it could ease soon enough without much lasting consequence to Main Street.

What the trigger is, and when it happens, no one really knows. When it does come, expect the enormous rally hinted at by today's massive swings (a thousand points from start to finish).

In contrast to Wall Street’s manic-depressive bouts these past two decades (let alone the past month or year), Main Street has become downright tranquil.

Should we worry that new capital constraints (higher taxes, more regulation) will reverse this relationship?

Would a Wall Street fix dismantle a potent shield over Main Street?

Let’s hope for rational judgment.

Sunday, October 5, 2008

Advantage, Long-Term

On Friday, October 3rd, President Bush signed in to law the Troubled Asset Relief Program ("TARP"), ending a tumultuous week. From its beginning to its end, the stock market plunged nine percent, a value loss of nearly $1 trillion dollars.

As badly as financials performed (-10%), five other industries performed worse.

Materials and energy – the worst two – accounted for 25% of the market's collapse, $240 billion in total. Meanwhile, consumer staples and health care – though down – outperformed the broad market by 7% and 5%, respectively.

The market might have moved beyond the rescue plan to focus instead on the worsening economic slowdown, but don't assume it's efficient, not that it ever was.

That's because a massive transition is underway among its participants. Until Lehman's demise and the SEC's suspension of short-selling, hedge funds accounted for one-third of trading volume (not including all that proprietary trading among Wall Street’s now-defunct bulge-bracket); many are currently sidelined, some even shuttering.

For the moment, high volatility is shortening the discount horizon; however, once things clear this could extend dramatically, especially as market turnover slows from its eye-popping 170% rate.

That's not to say sector rotation favoring a deep recession isn't misplaced, only that it may take longer than usual for the market to sort through this particular inflection: no two are exactly the same.

But as much confusion exists on the macro level, it's pure chaos among individual stocks.

For those taking a long-term view, your time has come.

Monday, September 29, 2008

Black Monday 2008

Today's 8.8% down-move marks the S&P 500's worst sell-off since Black Monday, 1987, when it collapsed 21%. (See table below: top-ten sell-offs since 1950)

Year-to-date, the market is now off 25%, and 29% from its all-time high of 1565.15 (October 9, 2007).

The possibility for a substantial bounce certainly exists. Since 1950, the market has closed down 6% or lower on nine separate occasions. In eight of these, it finished the year higher than that closing level for an average gain of 12%.

The ninth time occurred today.
Beware, however, one significant difference: in none of the eight previous sell-offs was the economy in recession.

Where the market goes from here depends on its participants rediscovering confidence in price discovery; Congress's next attempt at a rescue plan could help facilitate this.

Sunday, September 28, 2008

A September to Remember

Below, a breathtaking sequence of financial drama – still ongoing with Wachovia teetering; Hurricane Ike and abysmal economic data not included:

9/7: Fed nationalizes Fannie Mae, Freddie Mac
9/14: Fed refuses to rescue Lehman Brothers; Bank of America purchases Merrill Lynch
9/15: Lehman files for bankruptcy protection
9/16: Credit rating agencies downgrade AIG
9/17: Fed nationalizes AIG
9/19: Rescue plan proposed (three-page document)
9/21: Goldman Sachs, Morgan Stanley form bank holding structures
9/25: FDIC seizes Washington Mutual; JPMorgan purchases banking assets
9/28: Agreement reached on rescue plan (now 110 pages); vote due this week

The rescue plan's key details:
  • sellers: financial institutions, pension plans, local governments, community banks
  • purchase mechanisms: reverse auction, direct purchase (criteria not yet determined)
  • transactions posted online
  • financing: Treasury-issued debt (one giant carry-trade?)
  • proceeds (cash-flow, profits) go towards debt reduction
  • equity stakes in firms that benefit
  • compensation limits: no golden-parachutes, clawbacks in certain cases
  • option for firms to purchase insurance instead
  • oversight: bipartisan board and inspector general
  • five-year limit on recovering money spent; government can then force firms to pay for shortfall
  • government can make loan modifications on principal, interest rate, maturity
  • SEC has option to suspend mark-to-market accounting
  • $250 billion granted immediately; presidential request for next $100bn; Congressional right-of-refusal on final $350bn
Look to normalized interbank lending as a first sign of success.

Libor/Treasury spread in September…
…and since 2005
Let’s hope for calmer weeks ahead.

Friday, September 26, 2008

Trust the Network

The information network created Wall Street's turmoil; it can end it.

In the late 90s, the IT revolution's sudden emergence shifted the balance of power from the sell-side (financial intermediaries) to the buy-side (financial investors). At the same time, global socioeconomic upheaval opened numerous risk opportunities: Europe's single market and free trade across emerging economies.

Lush liquidity and imperfect regulation and oversight fueled a high-stakes battle.

In the years that followed, Wall Street fought to regain its information monopoly by forming massive proprietary trading and investment vehicles.

But as big as the Big-Five grew, they could never achieve the scale required to win.

The enemy: a disaggregated network of thousands of investment firms – some white-glove institutions (large fund complexes), others partnerships built to survive only a few years or months on exploiting market inefficiencies.

And this shift is not unique to Wall Street: Microsoft has battled this same economic force in its war against open source software; the same holds true for the media industry. It’s even happening in health care with consumer-information tools challenging the traditional value chain.

The force at play here is the Internet economy, and its notion that scale is amorphous.

On Wall Street, the information network acts through the financial markets. Lawmakers and regulators need to facilitate this by amending – especially now – capital restraints: taxes and regulation.

We restore confidence by addressing turmoil as an adjustment – not a crisis.

Anything less obstructs future gains from a new, powerful economic force.

Thursday, September 25, 2008

The Workforce as a True Asset

Investment banks feature highly productive workforces.

New hires navigate a rigorous interview process; many come directly from the world's best graduate and undergraduate programs.

Some might produce immediately, but most work through one, two or more years of intensive training and apprenticing.

Although this investment may not generate a return for several years, it can be substantial when it does – often magnifying over time.

While some workers create products – a structured security or research report – others transact, often with the firm's capital.

In both cases, they generate intellectual capital fundamental to the firm's current and future cash flow.

So, what does it mean if the workforce is a firm's primary investable, cash-generative asset? Should we capitalize it like any other asset?

Let's, for example, think of payroll (bonuses, in particular) as an amortization expense. Asset life could be the average employment term (say, 15 years; late 20s to early 40s), and the discount rate the firm's cost of capital (10% or higher due to elevated risk).

On the old model – balance sheet $100, capital $4, sales $4, and compensation $2 – we calculate a 15% increase in assets and leverage, which rises from 25 to 29. To compensate, a firm might have set aside additional capital. Though resulting in lower returns, it would have likely achieved a more balanced business-risk profile.

Big banks' rise-and-fall demonstrates how much going-concern value hinges on the workforce's output.

Future generations would be wise to heed this as an accounting reality.

Wednesday, September 24, 2008

Another Kind of Leverage

Though often expressed as a financial term, leverage also reflects how firms structure their operations. High fixed costs, debt-like corporate torques, allow capital-intensive firms to accelerate profits when sales levels increase and capital costs decrease.

Take two companies: "A" and "B". Both have an $80 cost base on $100 in sales. "A", however, has $60 in fixed costs and $20 in variable costs; "B" has the opposite mix. Because "B's" contribution margin – the percentage difference between sales and variable costs – is lower (40% versus 80%), it gains less profit on increasing sales.

However, "B", a labor-intensive firm, suffers less on declining sales growth since it can adjust more easily.

Because fixed costs include expenses on tangible assets such as property and equipment, financial analysts often measure the leverage effect as a depreciation-to-sales ratio. The following chart applies this to the overall economy as the ratio of fixed capital consumption to GDP.
After 1982, financial markets' rapid evolution shifted capital allocation decisions from private boardrooms to the open market: the stock market provides the best example, rising from 15% of GDP to over 130%.

Having increased tenfold in the period before this, leverage moderated.

Likewise, economic volatility abated, despite Wall Street’s typical gyrations.

Today’s lost confidence in financial markets risks not only making operating leverage costlier, but also forcing less transparent capital allocation decision-making.

If, also, the economy stalls, earnings prospects for capital-intensive firms would darken further, leaving open the question how less leveraged firms might compensate.

Monday, September 22, 2008

A Disturbing Lack of Confidence

By forcing bank holding structures onto Morgan Stanley and Goldman Sachs, the Fed accomplishes what it believes the markets would've done had the shorts stayed on, perhaps avoiding at least two big questions: Would either have been too big to fail? Would this have incited a cataclysmic run on everything financial?

Once again the Fed’s action speaks to an extreme lack of confidence in financial markets, occurring the same time Secretary Paulson hopes to assume unlimited power.

Because the market wasn't pricing the mortgage assets in question, this decision might be well-founded... or it might not. What if market activity was in fact accelerating price discovery that government action over the past year had stalled?

In Goldman and Morgan (and the bulge-brackets before them), short-sellers were targeting mispriced books-of-business, forcing potential buyers to play their hand.

The selling wasn’t random: it avoided agency-centered broker-dealers. Jeffries and Raymond James have outperformed both the big-boys and the market itself (strong support for the good old-fashioned notion of true intermediaries – not proprietary traders masquerading as intermediaries).

At the right price, we have to believe that buyers would have materialized (there certainly isn’t a lack of firepower ): What’s the point if we don’t have this confidence?

We'll never know what that level is, only that several large financial institutions couldn't withstand the anticipation.

In a world in competition for capital, our government’s election-year distrust of the financial system could be the highest price of all.

Saturday, September 20, 2008

Cost of Capital

Market turmoil is drawing attention to the financial system's core constituents: capital and liquidity.

Capital is money that a firm uses to invest in growth: an obligation to a lender (debt), direct investment in exchange for ownership (equity), or an obligation that converts into ownership (hybrid).

Liquidity reflects the firm's ability to pay for this in interest and dividends.

Because growth takes place over time, firms assume risk in the differential between money received (revenues) and money paid (expenses). To protect against this, firms will often retain excess profit (this differential after capital costs).

Depending on competitive positioning and market environment, firms pay lenders and owners more or less relative to each other – within and across industries.

Until now, the financial system has provided plentiful, inexpensive capital. If, however, risk levels remain elevated, lenders and owners will demand larger payments, which would stress liquidity as occurred this week on Wall Street.

Capital-intensive firms – those having a higher proportion of fixed costs to variable costs – hazard a challenging environment, while labor-intensive firms (many in service industries) may benefit.

The effect, though, won’t be uniform.

Investment banks, for example, would be nothing except for the intellectual property their workforce generates. This past week demonstrated the extent to which this service industry's labor (a variable cost and large component) consumes capital.

Expect higher capital costs to force top-to-bottom reassessment of industries and companies: punishing some thought to be high return-on-capital and favoring others actively managing down fixed costs.

Friday, September 19, 2008

Root Cause

The next stage in Wall Street’s transformation: sorting through the blame wars, at this point a Verdun of mass finger-pointing.

Much of this is political, coming ahead of a presidential election featuring starkly contrasting ideologies.

While greed, a broken public-private incentive behind home ownership, the Fed's liquidity push, poor regulation and credit-rating oversight are all contributing factors, the defining factor is neither financial, regulatory nor emotional: it's both technological and socioeconomic, and, ironically, extremely positive for the long-term.

In the late nineties, broadband Internet galvanized the US economy, and Wall Street, in particular.

Information advantages that sell-side firms had continuously monopolized suddenly shifted to the buy-side, establishing and advancing short-duration investment cycles (weeks, days, minutes).

At the same time, capital market reform sweeping across the globe extended the risk curve: new markets and new products translated into new opportunities for newly empowered money.

The effect snowballed during the 2000 to 2002 downturn, as alternative strategies flourished. Reacting quickly, the sell-side shifted to a proprietary model, at least among those who could (and were willing to) leverage themselves.

After 2003, spreads narrowed as markets stabilized; risk-takers compensated by doubling up on mortgage derivatives and other inexpensive financing.

It’s precisely the connection between these unprecedented root causes ten years ago and today’s drama that legislators need to respect.

More important than the remote probability of the same twin factors recurring, markets, in holding Wall Street to account, have already elevated transparency.

Rules that obstruct this adjustment process would trigger extreme carnage.

Thursday, September 18, 2008

And Then There Was One

Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley – all gone (or nearly gone ); the last one standing: Goldman Sachs.

Revered and reviled, Goldman invokes Wall Street’s ultimate image: money, power, arrogance – standards against which others define themselves.

During the 2000 to 2002 market downturn when investment banking revenues plummeted, Goldman transformed itself into a massive proprietary trading vehicle (indeed, the world’s largest hedge fund), taking advantage of cheap liquidity and directional markets. The chart below shows just how much this progressed as a percentage of total revenue.
Between 2001 and 2007, its risk exposure ballooned: leverage jumped from 17.1 to 26.2. Value-at-risk (“VaR”, the amount it could lose on a particular trading day) increased from $38 million to $138 million, a rate nearly twice the rise in its shareholder’s equity.

As of September 16 (its latest earnings statement), VaR stands another 30% higher at $181 million, but against a smaller capital base, and share price 50% lower and sinking.

How might the government perceive its demise: too big to fail, or best left to the markets? Is there a conflict of interest in the Treasury Secretary having been its chairman? (It would certainly be telling if Paulson, a banker by background, would decide on the fate of its current chairman, Lloyd Blankfein, a trader.)

Even in its darkest hour, it would seem improbable that Goldman would not pursue some sort of control position; perhaps its best option: going private, where it was prior to this ill-fated journey.

Tuesday, September 16, 2008

Confusing Crisis with Adjustment

No doubt, we’re traipsing through tumultuous times, but what’s got us amazed is that we’re not already much worse off. Consider the extent of the housing slump, now well into its third year, and the nosedive in financials, which for the most part began over a year ago.

Many are saying this is the worst crisis since the Great Depression, which would be terrible indeed: in the four years following the 1929 crash, the economy shrank by a quarter.

An identical occurrence today would put us at 1997 levels in 2012 – or 2011 or 2010 depending on your starting point.

With each Wall Street generation seemingly repeating the same mistakes – and each generation getting shorter and shorter – there could be good reason to be fearful, except that the global landscape is now completely different than 75 years ago (even ten years ago).

Now, capitalism motivates a much larger percentage of the world population, with local and transnational capital market infrastructures supporting this – and behind these, regulators and lawmakers, often in cross-border communication.

A vast worldwide network of investors – from large institutions to private individuals – directs capital flows according to market-driven risk-return metrics, including money into and out of US assets.

Wall Street might be in turmoil, but is Wall Street the complete global system? To what extent is this system already compensating, and at what cost?

We suspect the once-in-a-century phenomenon isn’t the crisis itself, but the adjustment process offsetting its worst effect.

Monday, September 15, 2008

Wall Street and the Economy

Since 1994 – as measured by the AMEX broker-dealer index (XBD) – the investment banking industry has suffered three major downturns, including the present one. The table below illustrates these both in terms of index performance and the corresponding change in real GDP (periods begin and end with XBD peaks and troughs).

The steepest index decline occurred in 1998, a whopping 91% on an annualized basis. Despite this, the economy grew by over 1% (4.7% annualized). Even during the market collapse of 2000 to 2002, which featured our last official recession, the economy still expanded.

Over the current downturn, the economy has likewise strengthened as of the most recent GDP reading (Q2 2008). If we consider this – as we should – through the current quarter (Q3), GDP would need to be 2.2% lower than last quarter in order to have contracted alongside the banking index.

That’s negative 8.8% annualized! After so many hundred-year events in the past few weeks (makes you wonder how valid our reference points are!), anything's possible – but likely?

More important, we see the current crisis as a striking example of how Wall Street and Main Street have evolved to a point where financial risk is sufficiently contained in the former.

Assuming lawmakers and regulators do not reverse this powerful dynamic, the great surprise of 2008 will be how little the latest “hundred-year” crisis disrupted the overall economy.

Sunday, September 14, 2008

Lehman's Demise

Could the big three – Goldman Sachs, Morgan Stanley and Merrill Lynch – be next? A year ago, they were trading at all-time highs, and this would have seemed preposterous.

Not so today. On similar balance sheet concerns, Merrill is down nearly 70% this year, and 82% from its January 2007 peak. At its current market cap ($26 billion), total collapse would not be incomprehensible; in just the past 3-1/2 months, market participants erased the equivalent in Lehman shares.

And the question doesn't just apply to the traditional bulge-brackets: UBS and Citigroup's misfortunes have not only bled tens of billions of dollars in shareholder value, but also eviscerated the universal banking model (okay, that depends on whether JP Morgan and its European counterparts intend to trump Sandy Weill as the modern-day Alexander).

With the exception of Goldman, each firm now trades at ten-year lows: a round-trip of several hundred billion dollars in aggregate – not including a multiple in ancillary effects throughout the financial system.

The iceberg might have been the housing bust, but mispriced risk and concentrated capital doomed these unsinkable ships from the get-go. Hedge-fund-happy bankers poured client profits (and shareholder dollars) into vast proprietary operations, completely transforming once agency-centered businesses.

The winners, and the new face of Wall Street: Raymond James, Jeffries and other traditionally-oriented intermediaries. This should be good news too for capital markets in desperate need of freer flowing money and more transparent risk pricing, though such an outcome may unfold all too gradually.

Wednesday, September 10, 2008

Taking on the Drug Supply Chain

In financial markets, a market-maker provides liquidity by standing ready to buy or sell a security at a quoted price. In return for assuming this risk, market participants compensate him with the bid-offer price spread (often negligible) and a commission. Though normally transparent, pricing can vary substantially based on the transaction size, and the dealer’s market knowledge (defined as market share).

In the prescription drug market, pharmacy benefit managers (PBMs) play a similar role. Because drugs are much less liquid than most securities (let's not forget complex derivatives), the spread and associated fees afforded PBMs are much greater: a combination of mark-ups and rebates.

While folks have transacted in securities for centuries, the prescription drug trade in its current form is only about two decades old – defined mainly as a generics and mail order-driven marketplace.

A dramatic agent of change, information technology has considerably expanded employers' potential bargaining power over recent years; now, mounting economic uncertainty is forcing decisive action.

On September 2nd, Caterpillar introduced a pilot project targeting full transparency across the supply chain. Aligned with Walmart's powerful retail network, the project strikes directly at spread-based pricing (AWP, MAC) and standard discount contracting.

If financial markets offer any evolutionary clues, this could open a substantial door into increased price competition (spread compression). As with broker-dealers, expect PBMs and other intermediaries to counter by continuing to invest in market knowledge and ancillary services as means of protecting pricing power.

Sunday, September 7, 2008

Is the Worst Over?

One shuts down its flagship fund; rumors swirl of an even bigger one closing, and the Feds take over two others that weren't supposed to be in the business to start with.

The first and second, Ospraie and Atticus, are what folks might call "traditional" hedge funds; both bet wrong – badly.

The latter two, Fannie Mae and Freddie Mac, are not ostensibly hedge funds, but speculated just as if they were, and suffered similar results. This included purchasing not only risky Alt-A and subprime mortgages, but also mortgage-backed securities. They then applied questionable accounting to hide the losses.

Now, both vanish completely into Washington's marbled halls and vast ledgers. Both will answer to folks whom we elect into office on a host of issues completely unrelated to their ability to manage complex financial institutions.

With so many high-profile speculators facing unprecedented losses, we know life cannot be easy for everyone else, especially as the seemingly safest institutions disclose deep dives into the same riptide.

At least the rules for the new landscape are clear: risk balances with return and accountability matters.

The question, though, is: Will conservatorship now convince the markets that the worst is over?

Because the game has switched from shareholders to taxpayers, we’ll be one of many watching the fall campaign for clues on what the new administration plans to do with the government's recent acquisitions.

Thursday, August 28, 2008

Happy Birthday, Mac!

Apple's Macintosh computer turns 25 in January.

Recently, O'Reilly News interviewed Andy Hertzfeld, an original designer. While he discusses fascinating points, it's the sheer change between now and then that's got us gobsmacked – not just for Mac itself, but the industry as well.

If we put ourselves in 1959 (25 years earlier), would there have been any possibility of imagining what subsequently transpired? This was even three years prior to the first work on ARPANET, the Internet's rudimentary predecessor, which researchers did not activate until 1969.

Is there any possibility today?

The original Mac – remember the 1984 Super Bowl? – featured 128 kilobytes of RAM. It came bundled with two applications, MacWrite and MacPaint, and introduced the graphical user interface (GUI) to the individual user.

Today's iMac features over 2,000,000 kilobytes of memory, and a variety of rich applications, from a Website design tool to movie editing.

Processing speed has also escalated: the 3GHz Intel Core Duo chip is about 1000 times faster than the original 8MHz Motorola chip. (Many, of course, might argue today's applications make it actually seem slower; after all, the in-flight computer used in the Apollo missions had just one kilobyte of RAM, but its software landed men on the moon.)

The future literally may be in the cloud; Google, Mr. Hertzfeld's current employer, is certainly betting on this. But to be so certain could well be taking the same chance as folks did on the mainframe in 1959.

Who's for Mac celebrating 50?

Wednesday, August 27, 2008

Biosimilars: A Debate for Everybody

For several years now, biopharmaceutical manufacturers have debated the possibility of follow-on ("generic") biologics; we'll call them biosimilars. Until 2006, legislators largely ignored it. But with rising prices and new product launches, the question of price competition has become too big to ignore.

The debate itself is important because it captures not only health care's tangled interests, but also ongoing economic shifts.

For drugmakers, biologics are no different than what SUVs were to US carmakers 20 years ago: an opportunity to supplement low margin, commoditized products (your standard bottle of pills; in our analogy, passenger cars). But how might biosimilars affect this? Indeed, might they redefine what is a generic and branded manufacturer?

The car analogy also works in how foreign manufacturers are hoping to position themselves. For example, BRIC-based companies seeing advantage in low-cost replication are pressing the WHO for guidelines.

For the supply chain, payers see biosimilars as a means toward price competition; pharmacy benefit managers see new, high margin services such as condition management, as well as new rebate opportunities, though providers would see the same for themselves; consumers see the potential for greater access and affordability.

Intertwined in the debate: IT initiatives that would enhance drug development and patient information, formulary strategies that would follow evidence-based medicine, and retail-based strategies that would alter how biologics are administered.

Most important, the debate has shifted ground from science (defining treatment) to economics (defining cost) – a language everyone can speak, and a window to transparency.

Thursday, August 21, 2008


Rankings matter on Wall Street: they establish pecking orders, targets to shoot at. So what does it mean when Wall Street itself is no longer king of the hill?

Since the dotcom meltdown, financials (of which Wall Street is a major component) have dominated the S&P 500 index, averaging about 20% of total market capitalization. Information technology companies such as Microsoft, IBM and Google have held the number two position at 16% (a four-point differential), and health care number three at just over 13% (seven points lower).

More impressive has been the gap separating financials from the lowest-ranking sector. In 2006, this peaked at 19 percentage-points, a dollar value of more than two trillion.

On May 20th (2008), this multi-year order rebalanced, when IT surpassed financials. Now 14 points ($1.6 trillion), the gap separating the top from bottom is the lowest it’s been this decade – 11.3 points ($1.3 trillion), if you measure against financials.

What if Wall Street's stumble is more than just a share price phenomenon? What if it marks an economic realignment – perhaps a more balanced period, with no single industry dominating the others?

Is there an emergent industry that would gain from this new context? What about health care, and the possibility for efficiency gains finally taking place? And what of the other industry categories: energy, materials and consumer staples (big winners over this period); telecommunications and consumer discretionary (big losers); and, utilities and industrials (more or less even)?

Tuesday, August 19, 2008

Understanding Opinion

We can't help ourselves. That innate curiosity which focuses our attention on what the neighbors are up to can drive some of us absolutely mad.

What you think they're doing versus what they're actually doing can lead to some pretty irrational behavior: for example, in economic terms, whether trying to match their spending in some way, or selling your home.

Now consider this on a much broader scale, in which the "neighbors" aren't the folks down the street, but faces on the TV screen or biographical sketches in newspapers or in cyberspace.

How much do expectations separate from reality and shape opinion on a regional or national scale? How well do we understand this?

This is the stuff of considerable academic thought, and, in 2006, the Nobel prize in economics when it came to inflation.

The Project for Excellence in Journalism recently published a study on the uneven connection between media coverage and economic events, which it also deemed insufficient in regard to public opinion.

Their analysis raises interesting considerations: one, how significant the economy is to public opinion; two, the implication that the media industry does not totally influence opinion; and three, the accuracy with which we measure opinion.

Just maybe the general public is, in fact, quite rational, and those local "neighbor events" mere outliers. Maybe, despite all our tools, we never quite know what current opinion is; after all, by the time we get around to analyzing it, it's already shifted.

Thursday, August 14, 2008

Less Friction

UBS recently announced a new strategic direction, one that effectively ends its tenure as a universal bank. The move now holds its investment bank independently accountable – no longer able to source cheap funds from its cash generative private bank and asset management franchises.

Will other universal banks soon follow, and likewise end cross-segment subsidization? How then will investment banking operations survive on costlier risk capital?

Since UBS first announced its purchase of Paine Webber on July 12, 2000, its shares have declined 19% in US dollar terms. Shares are down nearly 60% excluding the lavish currency effect. Over the same period, the S&P 500 is 13% lower.

By comparison, the AMEX broker-dealer index, featuring purer-play banks (asset management divisions partly subsidize some), is 37% higher. The relative effect underscores just how badly management got it wrong.

For the equally unfortunate Citigroup (down 51%), the UBS move might serve as the right template: a framework for more transparency in risk-taking, which itself probably means less risk-taking.

Once it balances with return, expect risk pricing to hold these large financial players to account, and capital markets to become more efficient as a result.

This more open and competitive environment ultimately will enhance the flow of assets between issuers and investors, unleashing capital that has become far too concentrated.

The investment banks themselves will survive, but on smaller fees, though with less volatile profit margins.

Wednesday, August 6, 2008

Following the Leader

The lead steer: it evokes our innate admiration, and often our imitation (conscious or unconscious). Think of the football team captain (bear with us here) or the celebrity fashionista; in the world of investing, it's the guru or gurus always knocking the ball out of the park.

Regardless of the market, someone will always have the hot-hand, and folks will look to that strategy for answers; and if not the portfolio managers themselves, then their shareholders.

The problem, though, with the "trend being your friend" is knowing when to exit, especially when the window is narrow, and everyone might try to jump at the same time.

Once again, we're finding ourselves picking up the pieces of momentum-based investing. Once again, we're realizing that the temptation to follow the lead steer can be too great for managers to stick to their own core competencies.

Over this past year, the number of folks who claim expertise on commodities, financial engineering and emerging markets would seem to have exploded. But are they truly expert enough to be throwing hundreds of billions of dollars around?

A market is made in the fact that some folks just don’t like the popular appeal of the football captain, and never will. Sooner or later, the hot hand cools, or freezes completely.

Tomorrow’s lead steer? It’s probably someone much less glamorous than the gunslingers of recent years – a quiet, disciplined investor who measures risk-adjusted return in years, instead of quarters, months or even days.

Friday, August 1, 2008

Patient-sponsored R&D

At what point do virtual communities challenge entrenched, real world businesses? The open source software movement would argue that that question is already obsolete, and newspapers, TV broadcasters and other traditional media would certainly bear witness.

But what about industries in which social media does not appear integral to the business model?

On July 29th, the Wall Street Journal featured a company called CollabRx. Neither a software developer nor a new media vendor, CollabRx instead links patients suffering life-threatening rare diseases with a network of researchers in diverse locations. By integrating research projects across a larger study group than economics would otherwise motivate drugmakers, it dramatically accelerates (theoretically at least) the development of new therapies.

Because users (patients and caregivers) pay a fee in return for a share of any future intellectual property, the company shifts control of the development process from a stand-alone drugmaker or research institution to the consumer.

Success depends on the degree to which the community collaborates, and the incentives that make this happen.

As Bristol-Myers and Roche up the ante on Big Pharma, CollabRx presents an alternative business model – likely significant considering the impact collaboration has had on siloed manufacturers in other industries.

More important than how and when this happens is the fact that tools now exist which place the consumer at the economic center of the R&D process.

Let's see whether "Old Pharma" ignores or integrates this dynamic.

Thursday, July 24, 2008

Social Opportunities

Which social opportunity is worth more: the ballgame with your buddies, or your profile in your alma mater's directory?

While taking considerably more time and money, the ballgame directly connects you, friends and acquaintances to a common experience.

A directory listing, by comparison, is basically costless. Though possibly translating into some sort of ROI, a person or small group ultimately dictates its capabilities. It’s their space after all – not yours.

What might this tell us about the value of social networks? Would a more compelling model be one that facilitates the individual's ability to seek-out social opportunities regardless of location?

It's worth keeping an eye on how Google and Facebook resolve their spat over Friend Connect, as well as other groups such as Bob Bickel's Ringside Networks whose open-source Social Application Server targets seamless connections among communities.

But the opening of walled gardens ultimately leads us to ask: who controls the individual's profile, especially as greater choice leads to more precise information?

What if someone could develop an electronic ID card that enables access to any social network: an identity that the individual controls, and which doesn’t appear under a Google, Microsoft, Amazon or Facebook brand?

Though something such as OpenID might represent the first steps, we suspect that the current debate on personal health records will contribute significantly to how this evolves.

Wednesday, July 23, 2008

Pain Enough?

The problem with something as complex as health care reform is that exact numbers can never really be exact. So many different factors come into play that it's almost pointless to provide any level of detail, except that the media craves it.

And so the New York Times has called attention to the Obama campaign pitch of $2,500 in premium savings for the typical family.

Health care reform is a messy topic for aspiring presidents: it involves hundreds of millions of dollars in lobbying, a tense public-private relationship, and a merry-go-round of who's to blame.

But at 16% of GDP, health care is becoming too big to ignore, and the electorate just might be unnerved enough to demand a major strategic review.

At the very least, both parties would agree that considerable inefficiencies bloat the system. Rather than a major federal overhaul, one approach might be targeting a series of non-compromised small-scale reforms: for example, force all payers to use the National Drug Code for biopharmaceutical reimbursement. This alone could save tens of billions in current and future dollars.

Whether during the next administration or future ones, the economic burden of not taking cost-savings steps will become too pressing to ignore.

Maybe now, major change – such as the cessation of employer-based coverage – is possible.

We suspect there isn’t quite enough pain just yet.

Monday, July 21, 2008

The Right Strategy?

What does Roche’s bid for the remaining shares in Genentech say about pricing power?

First, consider the Big Pharma business model of owning everything under the sun: it hasn’t worked. Since the last merger wave, the industry has destroyed immense value, and not just because of fewer drug approvals. Scale in-efficiencies are widespread: overlapping R&D, disjointed business areas and sagging culture, to name a few. (Since its 2000 peak, the industry has dropped 25% against the S&P 500.)

Second, consider the industry’s value shift away from price inflation to utilization. More prevalent chronic disease conditions due to an aging population and advances in diagnostics will accelerate the rate and intensity of treatments in years to come; also, add to this the likely enactment of a pathway enabling follow-on (“generic”) biologics.

For some manufacturers such as Roche, this – and the prospect of a new government less accepting of their policy positions – fortifies the urge to merge: a gambit for economic advantage.

They may also view combinations as hedges against a balance-of-power shift in favor of the supply chain, as has occurred for nonspecialty products.

(Let’s not forget the influence of bankers aiming to replenish depleted coffers.)

Instead, management should explore game-changing business designs that build flexibility, and, most important, improved communication with consumers and payers.

Coding Specialty

Although employer groups and health plans enjoy extensive data on self-administered drugs such as insulin and your standard bottle of pills, the same cannot be said for specialty pharmaceuticals.

specialty category represents 11% of pharmacy plan spending (a doubling from four years ago), and is growing at three times the industry average. Broadly d
efined as high-touch physician-administered medications (injected, infused and, in some cases, ingested), it encompasses most biologics, and also one-third of the industry pipeline. P
ractitioners expect personalized medicine and the shift of many illnesses from acute to chronic conditions to drive utilization over the long haul.

Data collection centers on drug coding practices.
Because specialty qualifies as a medical expense, the industry reimburses according to a different set of codes than for self-administered drugs, deemed a pharmacy expense.

Often misrepresenting both the drug and dosage, these "J-codes” can generate imprecise or misleading information.
In contrast, the National Drug Codes (NDCs) used for all other pharmaceuticals provide a more accurate level of detail, though largely the purview of pharmacy benefit managers.

As of January 2008, the Deficit Reduction Act of 2005 requires state Medicaid programs to recognize NDCs, but uptake has been slow, and a Medicare overhaul unlikely.

For now, information asymmetry favors manufacturers, but new specialty pharmacy management tools could shift this to the supply chain.

Friday, July 18, 2008

The Cancer in Public-Private Enterprise

Imagine a business where you and a partner or two are on the hook for millions of dollars in receivables, most of which is not collected for 60 days or more, and some of which is never collected at all. Now imagine that the person paying is not the person consuming, and that the level you bill at is often less than the level at which you purchase. Oh, and you're dealing in high-touch products that could kill or severely debilitate.

This is the business environment in which oncologists operate. Cancer care is a $90 billion industry growing about 10% a year, and likely to increase by even more as America grays and scores of new drugs come to market. (The NIH puts the total bill at $220 billion, including $130 billion in indirect costs.)

Beyond just the decades-long buy-and-bill practice and the government's decision to alter how it reimburses oncologists, the larger force at play here is the inefficiency of public-private enterprise.

Name another industry where pricing occurs irrespective of the marketplace.

And while community oncologists (about 84% of the market) should consolidate to regain purchasing power, and health plans and PBMs fight to position specialty pharmacy tools for better utilization, such strategic decisions cannot occur without regard to the government, the default price-setter in its influence of everything from reimbursement to claims adjudication.

Monday, July 14, 2008

Exit Strategies

Each decade features a particular brand of market volatility. Contributing factors have included an oil embargo, technical issues such as program trading, accounting scandals, housing supply-demand imbalances, and a credit squeeze.

The current version comes just a few years after the most volatile six-year period since before 1950. From 1997 to 2003 (March to March), the market – S&P 500 – averaged a 2%-or-more move every 8.1 days. In 2002, this pace accelerated to just under five days, or one day a week. (That year, the market also averaged a 3%-or-more move every 14.7 days!)

2008 is pacing at 7.4 days (26.6 days for 3% moves), and 7.6 days going back to July 2007. This follows no major moves the whole of 2004 and 2005, and only two in 2006.

Both versions occurred in this unique period of widely available instant information and communication. In fact, we might think of them as the beginning and end of a decade-long “trade” – the entrance and exit of aggressive short-term investment strategies.

While market conditions allowed this category to flourish during the first bout (who else could benefit as much during a three-year sell-off in extreme volatility), conditions now threaten many with extinction.