In my original post below, I talked about the concept that fraud is cyclical. It turns out there are words for it - the "bezzle" and "net psychic wealth" - coined by John Kenneth Galbraith. He explains it much more elegantly than I can:
“Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”
- John Kenneth Galbraith
So the "fraud is cyclical" thing is certainly not any unique insight of mine. In my post, I further distinguish between frauds perpetrated by management, frauds unknown to management, and unintentionally inflated results from murky data.
Original Post (1/19/2019)
I recently read Howard Mark’s “Mastering the Market Cycle”. It was particularly interesting to see how he reconciles common value investing believes like “can’t time the market”, “ignore the macro”, and so on with more acceptable topics like “where are we in the cycle”. I had always thought the differences are little more than semantics, but Howard Mark pointed out some subtle differences that I had not thought of.
Reading the book also had me thinking through cycles some more. Here are just some thoughts that I will elaborate in this post.
Why Cycles Do Die of Old Age
Bull markets die with the end of credit cycles, which die of old age.
Over the past 30 years debt to GDP ratio throughout the world has ballooned, meaning new borrowings drive an ever bigger share of spending.
Whenever someone take out a mortgage to build a new home - that stimulates the economy. You take out an auto loan to buy a new car, that stimulate the economy.
But how many mortgages and auto loans can I take on? How many houses and cars can you buy? TVs? If you just bought a new house this year, chances are you’re not about to buy another one next year. Not when you’re up to your neck in debt.
As time goes on we approach some natural limit on indebtedness, and new borrowing activity decreases. Instead of borrowing, we have to pay down debt. That means less spending in the economy, and less spending means less jobs are needed.
This may not be obvious to some – less borrowing and/or paying down debt may be prudent, but it causes the economy to contract.
So thus credit cycles do die of old age, and with that, spending and the associated bull markets die of old age.
Look at What Investors Do, Not What They Say. Oversupply of capital
Here’s maybe the most useful thing I learned from Mark’s book – in judging where we are in the cycle, it’s much better to judge investor behavior rather than asset valuation, or even investor sentiment as expressed through media.
Asset valuation is inevitably subjective (7x PE looks cheap but is that peak earning or not? Depends on if you think if a recession is coming soon right?).
Investor sentiment and news flow can also be misleading. News headlines and Twitter can be flooded with panicky takes, but if VC deals are still getting done at 20x revenue then it’s hard to say the market is in capitulation mode.
Much more reliable are investor actions, as expressed through lending terms, M&A terms, IPO terms.
What does this all mean for us now (December 2018)? The U.S. stock market has taken a beating; news flows are undoubtedly bearish (trade wars! Government shut downs!) And we have cyclicals like Goldman Sachs trading at 7x PE. Are we near bottom of the cycle? I would say hardly.
Masayoshi/Softbank’s Vision Fund is buying anything and everything with Saudi money. Companies are still doing large buybacks. Consumer staples are getting into marijuana space at high valuations. Amazon is still expanding into new industries everyday. These are not signs of capitulation.
Intuitively, ease of financing also implies lowers barriers to entry, excess capacity, and crowded competition in the underlying industries. This “creative destruction” is not good for investors.
Frauds (and false profits) are Also Cyclical
I think frauds are important triggers of financial crisis because the “you think you have money, but suddenly you don’t” effect triggers panics and sudden liquidity demands.
It’s no coincidence that scandals like Enron and Madoff get uncovered at end of the cycle. For one, eroding asset values force investors to take a cold hard look at their portfolio, and there frauds are uncovered. Second, the unveiling of fraud alert the market to huge losses, which leads to a more skeptical market and even more unveiling of frauds.
Frauds are cyclical. They may be discovered only after the fact, but some portion of an economy’s output will always be from questionable behaviors. More at top of cycle, less at bottom of cycle; less frequently discovered at the top, more uncovered near the bottom.
Frauds may have nothing to do with management’s integrity. Frauds can take place while senior managers are blissfully unaware, or even explicitly forbids it. The Wells Fargo scandal from a few years back - where low level branch employees create fake client accounts to meet aggressive sales goals – is an example.
As the economy expands and firms fight for market share, the pressure to improve performance naturally incentivizes all sorts of fraudulent or “push the envelope” behavior that inflates revenues.
Nor does inflated revenue and data need to come from intentional fraud. Ellen Pao’s “it’s all fake” tweet has an interesting discussion here.
Unlogged in devices can create confusion and inflate data. I personally have the experience of inflating advertising metrics recently. I played this videogame where I constantly have to play to level up my avatars. So I quickly learned the common practice of building a macro or bot to “auto-farm”. This game is free to play and depends on advertising revenue. So the company is likely selling overstated user metrics when pitching to advertisers (albeit unknowingly).
Nowadays entire business models are based on advertising revenue, which are based on unreliable user metrics. This inflated revenues and earnings will drop when the cycle ends - and not in a controlled, linear fashion that analysts tend to forecast in their models.
So the "fraud is cyclical" thing is certainly not any unique insight of mine. In my post, I further distinguish between frauds perpetrated by management, frauds unknown to management, and unintentionally inflated results from murky data.
Original Post (1/19/2019)
I recently read Howard Mark’s “Mastering the Market Cycle”. It was particularly interesting to see how he reconciles common value investing believes like “can’t time the market”, “ignore the macro”, and so on with more acceptable topics like “where are we in the cycle”. I had always thought the differences are little more than semantics, but Howard Mark pointed out some subtle differences that I had not thought of.
Reading the book also had me thinking through cycles some more. Here are just some thoughts that I will elaborate in this post.
- Why credit cycles do die of old age, and how lack of new borrowings alone would lead to recession.
- Instead of looking at asset prices and judge whether they are rich or cheap, look at capital provider’s behaviors. Are deals getting done at ridiculous terms?
- Thoughts on inflated earnings. While most investors are well aware of natural cyclicality, what’s less well understood are various degrees of fraud and “pushing the envelope” behaviors.
Why Cycles Do Die of Old Age
Bull markets die with the end of credit cycles, which die of old age.
Over the past 30 years debt to GDP ratio throughout the world has ballooned, meaning new borrowings drive an ever bigger share of spending.
Whenever someone take out a mortgage to build a new home - that stimulates the economy. You take out an auto loan to buy a new car, that stimulate the economy.
But how many mortgages and auto loans can I take on? How many houses and cars can you buy? TVs? If you just bought a new house this year, chances are you’re not about to buy another one next year. Not when you’re up to your neck in debt.
As time goes on we approach some natural limit on indebtedness, and new borrowing activity decreases. Instead of borrowing, we have to pay down debt. That means less spending in the economy, and less spending means less jobs are needed.
This may not be obvious to some – less borrowing and/or paying down debt may be prudent, but it causes the economy to contract.
So thus credit cycles do die of old age, and with that, spending and the associated bull markets die of old age.
Look at What Investors Do, Not What They Say. Oversupply of capital
Here’s maybe the most useful thing I learned from Mark’s book – in judging where we are in the cycle, it’s much better to judge investor behavior rather than asset valuation, or even investor sentiment as expressed through media.
Asset valuation is inevitably subjective (7x PE looks cheap but is that peak earning or not? Depends on if you think if a recession is coming soon right?).
Investor sentiment and news flow can also be misleading. News headlines and Twitter can be flooded with panicky takes, but if VC deals are still getting done at 20x revenue then it’s hard to say the market is in capitulation mode.
Much more reliable are investor actions, as expressed through lending terms, M&A terms, IPO terms.
What does this all mean for us now (December 2018)? The U.S. stock market has taken a beating; news flows are undoubtedly bearish (trade wars! Government shut downs!) And we have cyclicals like Goldman Sachs trading at 7x PE. Are we near bottom of the cycle? I would say hardly.
Masayoshi/Softbank’s Vision Fund is buying anything and everything with Saudi money. Companies are still doing large buybacks. Consumer staples are getting into marijuana space at high valuations. Amazon is still expanding into new industries everyday. These are not signs of capitulation.
Intuitively, ease of financing also implies lowers barriers to entry, excess capacity, and crowded competition in the underlying industries. This “creative destruction” is not good for investors.
Frauds (and false profits) are Also Cyclical
I think frauds are important triggers of financial crisis because the “you think you have money, but suddenly you don’t” effect triggers panics and sudden liquidity demands.
It’s no coincidence that scandals like Enron and Madoff get uncovered at end of the cycle. For one, eroding asset values force investors to take a cold hard look at their portfolio, and there frauds are uncovered. Second, the unveiling of fraud alert the market to huge losses, which leads to a more skeptical market and even more unveiling of frauds.
Frauds are cyclical. They may be discovered only after the fact, but some portion of an economy’s output will always be from questionable behaviors. More at top of cycle, less at bottom of cycle; less frequently discovered at the top, more uncovered near the bottom.
Frauds may have nothing to do with management’s integrity. Frauds can take place while senior managers are blissfully unaware, or even explicitly forbids it. The Wells Fargo scandal from a few years back - where low level branch employees create fake client accounts to meet aggressive sales goals – is an example.
As the economy expands and firms fight for market share, the pressure to improve performance naturally incentivizes all sorts of fraudulent or “push the envelope” behavior that inflates revenues.
Nor does inflated revenue and data need to come from intentional fraud. Ellen Pao’s “it’s all fake” tweet has an interesting discussion here.
It's all true: Everything is fake. Also mobile user counts are fake. No one has figured out how to count logged-out mobile users, as I learned at reddit. Every time someone switches cell towers, it looks like another user and inflates company user metrics https://t.co/tk1PKuvLL6— Ellen K. Pao (@ekp) December 27, 2018
Unlogged in devices can create confusion and inflate data. I personally have the experience of inflating advertising metrics recently. I played this videogame where I constantly have to play to level up my avatars. So I quickly learned the common practice of building a macro or bot to “auto-farm”. This game is free to play and depends on advertising revenue. So the company is likely selling overstated user metrics when pitching to advertisers (albeit unknowingly).
Nowadays entire business models are based on advertising revenue, which are based on unreliable user metrics. This inflated revenues and earnings will drop when the cycle ends - and not in a controlled, linear fashion that analysts tend to forecast in their models.
