THE AMPHORA REPORT

Vol 1, 1 May 2010 www.amphora-alpha.com

IN THIS EDITION

HOW WOULD EINSTEIN VALUE FINANCIAL ASSETS?

Naturally, Einstein would have valued financial assets in relative terms. We use the classic childrens tale, Puss n Boots, to explain what this means.

THE ASSET PRICING IMPLICATIONS OF THE GREAT BAILOUT

By way of unconventional monetary policy and other extraordinary policymaker actions, the global financial system was successfully stabilised in early 2009. But how has the great bailout impacted relative asset prices? Which have become overvalued? Which still offer value? In this edition, we answer these questions in some detail while offering some practical investment strategy.
HOW WOULD EINSTEIN VALUE FINANCIAL ASSETS? In summer 2005 the Head of European Capital Markets at a bulge-bracket US investment bank asked me, in my role as the Head of European Interest Rate Strategy, to deliver a presentation to that years new Associates on the topic of international interest rate markets. Those who have gone through a typical Wall Street Associate training programme know how challenging and demanding these are. (For those who have not had the benefit of experience, Michael Lewis devotes much space to the Salomon Brothers training programme in his classic, Liars Poker.) However, they are not only challenging and demanding for the Associates. Those giving presentations are running businesses that need new Associates and there is always competition to attract the best. During the 1990s and 2000s, as investment banking became a more and more quantitative discipline, largely due to the explosive growth in derivatives markets, investment banks increasingly sought out graduates in physics and engineering, as the maths they required were similar to those used in building derivatives pricing models. So no surprise, the 2005 Associates class was chock full of physics and engineering graduates from the best universities, including Oxford and Cambridge in the UK, Ivy League institutions in the US and the IIM institutions 1 in India.
For those not familiar, the IIMs are business schools with a strong and growing reputation for turning out immensely bright, highly numerate graduates. They are arguably the most competitive business schools in the world, with some
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As such, I decided to prepare a presentation that would demonstrate how certain key principles of physics are reflected in various ways in the financial markets. A central part of the presentation was a demonstration that all financial assets, be they bonds, stocks, swap contracts or various derivatives thereof, cannot be properly priced without reference to interest rate markets. Also, I made the effort to inject a bit of humour, by reading from a famous childrens tale, Puss n Boots, and then asking the class how they would go about pricing some of the various assets described in the story, including the Puss. Some of the answers were quite sophisticated in their application of various mathematical techniques. But none was quite what I was looking for. This is because, in all cases, they implicitly assumed that the asset values were based on some notion of absolute value independent of the other assets in the story. Finally, I dropped a big hint: How many of you are familiar with Einsteins Theories of Relativity? Most hands went up. I continued, How do you think Einstein would go about pricing these assets? Most hands went down. Of those remaining, I called on one particularly eager Associate who then said something along the lines of, Einstein would argue that assets have value only in relation to other

230,000 students competing for a mere 1,200 places. Most major financial institutions now regularly recruit a portion of their annual Associate training classes from these schools.

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assets, rather than in absolute terms. Bingo! That was what I was waiting for. Assets are nothing more than legal claims on future cash flows of varying degrees of certainty; and that which is uncertain cannot be valued in an absolute sense, only in relation to something else. Einstein showed that the speed of light was the only constant in the universe against which all else could be measured. In financial markets, the only constant is the time value of money, as represented by the term structure of interest rates. Everything else is necessarily relative. By implication, no matter how mathematically sophisticated a pricing model may be, if it contains incorrect or unrealistic interest rate assumptions, it will misvalue assets. Looked at from a different angle, if a central bank sets interest rates at an inappropriate level, asset prices will become distorted and resources misallocated, with potentially severe economic consequences. The Great Bailout of the global financial system in 2008-09 may be comprised of many different parts some of which are still being withheld from the public in whole or in partand the specific government interventions taken may vary somewhat by country but in general they all represent various forms of fiscal and monetary stimulus and also state guarantees for certain financial assets and institutions. In a few cases there have been outright nationalisations of financial institutions, primarily banks, and even non-financial firms, including General Motors, for example. In those cases where there has been a specific government bailout or explicit guarantee it may appear rather straightforward to determine the impact of such action on the share prices of the firms in question. After all, had firms been allowed to fail, shareholders would have been wiped out. So in these cases, the current market value of the equity represents the apparent value of the bailout for shareholders. But then what of the bondholders? What would the recovery rate have been on the bonds of failed financial firms? It is difficult to make precise estimates, although given the leverage ratios involved, probably low indeed. Estimating the impact of the Great Bailout on financial asset prices becomes only more difficult as one broadens focus. For example, consider the impact of the US federal guarantee on money-market funds generally. Had the government not stepped into to provide this guarantee, then an incipient run on these funds in November 2008 would most probably have resulted in a failure of the entire financial system. What that would have done to financial asset prices is impossible to know, only that they would be far, far lower than they are today. Equally difficult would be to quantify the impact of the implied bailout for financial institutions that almost certainly remains in place should the financial system find itself facing another such crisis in future. All we can know for certain is that the prices of securities

issued by such firms are somewhat higher than they would otherwise be. The bottom line is that it is an impossible exercise to quantify the overall impact of the Great Bailout on the level of asset prices generally. However, what we can do is look around and locate certain distortions in relative prices which are the direct result of policymakers actions. Some of these distortions are large enough to have significant implications for investment strategy and asset allocation. Of all the actions that comprise the Great Bailout, none probably have had greater impact on relative asset prices than various measures, both conventional and unconventional, taken by the US Federal Reserve. These include the following: 1) A decline in short-term interest rates from around 5% to effectively zero 2) An increase in the size of the monetary base from $800bn to over $2tn 3) The outright purchase of federal agency (Fannie/Freddie/etc) and non-agency mortgagebacked securities now approaching $1.3tn in total 4) The acquisition of a comparatively small amount of highly risky, illiquid assets associated with certain failed financial firms, such as Bear Stearns and AIG 5) Various temporary liquidity facilities which have now largely been wound down The probable effect of these actions has been twofold: First, the level of interest rates generally is lower than it would otherwise be had the Fed not acted as above. Second, yield spreads between US Treasuries and other fixed income assets primarily mortgage-relatedheld on the Feds balance sheet are tighter than they would otherwise be, given the 2 substantial relative changes in holdings. Also important in this regard is that the government decided to outright nationalise the federal mortgage agencies Fannie Mae and Freddie Mac. Had such support not been forthcoming it is quite possible that both agencies would have defaulted on their debt in the face of rising interest costs and declining residential mortgage collateral values. It is hard to estimate what the residual (postdefault) value of such paper would be but given that residential property values are down some 40% from their highs, a 60% recovery rate would be a possible
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It could be argued that, as the Fed has now ended its scheduled programme of purchasing non-US Treasury securities, spreads for such securities now reflect a fair, free-market value. We disagree. Were the Fed to sell back into the market its holdings of some $1.3tn in these securities, we find it hard to imagine that spreads would remain mostly unchanged. Not only would spreads need to widen to help to absorb the supply; the signal this would send to the marketthat the Fed is no longer the buyer of last resort for such paperwould force a qualitative reassessment of the Feds willingness to provide a liquidity backstop in future. While moral hazard of this sort is difficult if not impossible to quantify, that does not mean that it does not exert a huge influence on financial asset prices, in particular those that the central bank has demonstrated are essential to its lender of last resort role.

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estimate. For a 10-year maturity bond, that would imply a fair spread to Treasuries of over 5%, far wider than the current spread of Fannie/Freddie bonds of only about 0.5%. Taken together, the impact on both the level of interest rates and the spread between US Treasuries and agency securities implies that the term structure of interest rates generally is nowhere near where it would have been had the Fed and the Treasury simply sat on the sidelines and allowed nature to take its course. As a result, what we are left with today is, quite clearly, artificial. But if the term structure of interest rates for Treasury and mortgage securities is to some extent artificial, what does this imply about financial asset prices generally? THE TIME VALUE OF MONEY AS THE UNIVERSAL REFERENCE FOR ASSET PRICING The time value of money is to financial asset pricing what the speed of light is to Einsteins theories of relativity: While not a constant in the physical sense, the time value of money, as represented by the term structure of interest rates, is the universal point of reference for discounting the future cash flows on which financial assets represent legal claims. Financial asset valuation models are therefore sensitive to interest rate assumptions, in particular when the cash flows are a) relatively far out in the future; and b) relatively certain. The shorter the time and the more uncertain the cash flows, the less sensitive a financial asset price will be to changes in the term structure of interest rates. To illustrate this point, consider two financial assets, a long-term government bond and a lottery ticket for tomorrows $10mn draw. As the cash flows accruing to the government bond are known in advance and extend far out into the future, the price of the bond will be highly sensitive to changes in the term structure of interest rates. However, even a large change in interest rates will not have much impact on the value of the lottery ticket. Not only is the cash flow only one day awaynot enough time for interest to accrueit is also unknown. Probability theory can estimate the value of the lottery ticket but, in practice, the payoff is so uncertain a binary outcome of either zero or $10mnthat the actual value of the ticket is really just a function of pure uncertainty independent of the term structure of interest rates. Imagine now that the relative certainties of financial asset cash flows are laid out on a spectrum, from the certain to the highly uncertain. It might look something like this:
Certain GBs = CBs = VEs = GEs = VC Uncertain

flows become gradually less sensitive to the term structure of interest rates. As such, investments in equities and venture capital might seem to be relatively insensitive to interest rates. However, it is frequently the case that when it comes to investments in growth equities and venture capital, the cash flows that really matterthat determine whether the investment is going to outperform or notare those at least a few years out in the future, perhaps even a decade or more. Due to the long duration of these cash flows, it would be a mistake to conclude that, just because they are relatively uncertain, these assets should not nevertheless be somewhat sensitive to interest rate assumptions. Half a century ago, several economists working independently developed the key elements of the Capital Asset Pricing Model (CAPM) which has provided the theoretical basis for risky-asset 3 valuation models up to the present day. In its simplest form the CAPM model calculates the expected return of a financial asset according to the following equation: E(Ri) = Rf + Bi(E(Rm) Rf) Where: E(Ri) is the expected rate of return; Rf is the risk-free interest rate; Bi is the sensitivity (risk) of the asset relative to the market for comparably risky assets; E(Rm) is the expected return of the market for comparably risky assets. While it is obvious that the interest rate Rf plays a role here, notice that, as the measures of risk Bi or E(Rm) approach zero, the expected return on the asset becomes a function entirely of the risk-free interest rate, normally assumed to be that on government bonds. But as Bi and E(Rm) rise, the expected return on the asset becomes less dependent on the risk-free interest rate. If, alternatively, E(Rm) is highly uncertain, the risk-free rate also becomes less relevant. Regardless, note how the model is based entirely on the concept of relative value: Assets are being valued relative to a risk-free asset and relative to the market for comparably risky assets. Now given that interest rate assumptions are going to have at least a modest impact on relative risky-asset valuations, note that, if the risk-free rate Rf is being held artificially low by the monetary authority, then this will have the effect of increasing the expected returns on risky relative to risk-free assets. In other words, risky assets in general will become fundamentally overvalued. Applied to
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Where GBs = government bonds; CBs = corporate bonds; VEs = value equities; GEs = growth equities; and VC = venture capital. As you move from left to right and the uncertainty as to the realised size of the cash flows becomes ever greater, the present values (prices) of the cash

William Sharpe, Henry Markowitz and Merton Miller jointly received the 1990 Nobel Prize in Economics for the CAPM, although several others also did essential work in this area. William Sharpe is also well known for his eponymous measure of risk-adjusted returns. In recent years, CAPM has come under increased scrutiny in part because it assumes that financial market risk is normally distributed. The 2008-09 credit crisis is just the latest example that this is not the case, although it may appear so from time to time.

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corporate bonds, this implies that, even absent any explicit or implied government support, spreads to government bonds will become too tight to compensate investors for the fundamental risks they are taking. And risky equities will become overvalued relative to bonds and to low-beta (low risk) equities. This implies that, for any given level of earnings, equity P/E ratios will be higher than they would otherwise be, such that investors end up paying more for shares than they can reasonably expect to get back (someday) in the form of actual, after-tax earnings. By implication, were interest rates allowed to adjust to their natural equilibrium, corporate credit spreads would most likely rise and share P/Es fall. Leaving the fundamentals aside for the moment, some might argue that stock market investment is not necessarily investment at all but rather a form of speculation and that what stock-market speculators are after is short-term capital gains rather than valuebased long-term earnings growth. Warren Buffet and other successful value investors would beg to differ. But Warren Buffett would probably be among the first to acknowledge that a substantial portion of stock market transactions represent the whims of speculators rather than the careful, systematic, valuedriven determinations of sensible, value-oriented investors. Indeed, it is the actions of the speculators which move prices to levels that are fundamentally unjustified which creates the very opportunities that value investors such as Warren Buffett seek to exploit. HOW DISTORTING INTEREST RATES CAUSES REAL ECONOMIC DAMAGE This leads us to another way in which the actions of the monetary authority can become so detrimental to the economy at large. By making it more difficult to value risky assets properly and by generally inflating the value of such assets beyond what fundamentals can justify, value investors will be less willing to invest in the market generally. Investment flows will become increasingly dominated by those who are really just speculating and chasing trends rather than making reasoned judgements about which companies offer the best potential long-term value. But the stock market does not exist in a vacuum. The valuations placed on stocks represent the abilities of companies to raise capital in the form of new shares or debt issues; to acquire other companies through M&A; to compensate their employees with shares or options thereon; in a word, to grow. If the stock market becomes overvalued, companies are liable to overinvest in their operations. If speculators rather than value investors are the primary force behind stock price trends, then economic resources generally are being allocated in an inefficient, haphazard way which leads to malinvestments. Such malinvestments will, over time, have the effect of reducing the overall economys potential growth rate, as they divert resources from other, more productive activities.

Consider the tech bubble for example. Notwithstanding the very real technological advances taking place in the 1990s, by 1997 the stock prices of tech firms began to rise out of line with any reasonable assumptions of economic reality. Value investors began to retreat from the market, leaving it more open to speculators. In the wake of the Asian crisis in 1997, reducing the attractiveness of emerging markets, these speculators moved more aggressively into tech stocks. When the Fed bailed out LTCM in 1998 and also eased monetary conditions briefly going into Y2K, speculators became even more aggressive. As tech stock prices rose and rose, these companies spent more and more on various expansion plans. Eventually, it all came crashing down and the malinvestments were exposed for what they were. Sure, there were real economic advances that had taken place but valuations, with some help from the Fed, had become so stretched that a bust become inevitable. To compensate for that bust, of course, the Fed eased policy even more aggressively than it had in the wake of the LTCM failure, with the entirely predictable consequence that new bubbles would form elsewhere, this time in residential and commercial real estate and in credit markets generally, leading to even greater malinvestments which have subsequently been exposed as such by a commensurately greater bust. As for where the next bubbles are now forming, we believe that the Fed and economic policymakers generally have spun a vast web of financial market distortions and systemic moral hazard that facilitates asset misallocations just about anywhere. As we have written before, financial history may not repeat but it certainly rhymes. INVESTMENT STRATEGY FOR A WORLD OF DISTORTED FINANCIAL ASSET PRICES For those who are concerned that the dramatic recoveries in risky asset markets over the past year are largely the manifestation of unsustainable, stimulus-fuelled bubbles of varying magnitude, the question then becomes, how does the defensive investor go about investing? Or merely go about preserving wealth? We think there are several investment and wealth preservation strategies worth considering. In general, these strategies require investors to underweight those assets which have the most potential to be distorted in value and to overweight those assets for which valuation metrics have been left reasonably intact. More specifically, these strategies require investors to underweight growth vs. value assets and also to underweight nominal vs. real assets. Recall that whereas in theory all financial asset valuations are potentially distorted by artificial manipulations of the term structure of interest rates, the greatest distortions are likely to manifest themselves in those assets with relatively long-dated but also relatively certain nominal cash flows. In this

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regard, investors should be particularly concerned about recent developments in sovereign debt markets and not only in the weaker euro-area members. The growing perception that government bond markets are not necessarily reliable stores of value given exponentially rising sovereign debt burdens is almost certain to weigh on the prices of sovereign obligations generally in the coming years. Essentially all western government bond markets are at risk. Investors should thus be particularly wary of longer dated government bonds but also other highquality fixed income assets. A problem then arises in that these assets are traditionally regarded as the standard, benchmark long-term stores of value. For

those simply looking to protect wealth, rather than to invest or speculate, what are the alternatives? We would argue that gold and other precious metals are attractive as substitute stores of value. Historically, they have held their value particularly well during periods in which central banks have chosen to follow unconventional policies, such as in the 1930s, and also when there have been major rebalancings of the global economy, such as during the 1970s. While conditions are certainly somewhat different today, there are enough parallels to make gold, silver, other metals and commodities generally attractive alternatives as stores of value.

AMPHORA: A lateral-handled, ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean.
JOHN BUTLER john.butler@amphora-alpha.com John Butler has 18 years' experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, quantitative strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences.
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