Out of Sight - Out of Mind: The Way The Markets Like It

A: Have you ever noticed that the markets sometimes act with the instincts of a 6-month old baby? For the longest time I have waited for the markets to reflect some sign of 'object permanence'. The stock markets are an irrational near term discounting mechanism that continuously prices 'in' and prices 'out' the perceived value of any one company's future growth prospects - that's one way I look at the markets, and a definition you probably won't see in any book. The key to this mechanism is the availability of information at hand regarding business conditions, earnings potential, clarity, confidence, and willingness to accept what is out of sight (i.e. takeover potential, hiding losses, accounting tactics, etc). The market generally is not very good at getting right this out of sight acceptance thing. Enron's offshore entities that hid losses and Worldcom's inflated accounting entries are two examples of companies that the markets first completely overlooked what was hiding out of sight - only to later find out and crush investors as the scandal is revealed. How does this happen over and over again? Because executives whose fiduciary responsibility is to the shareholders know all to well that it is easier for markets to accept the damaging information 'later', rather than 'sooner'. Maintain/increase confidence, and the stock will rise.

Here are the most common examples of how our 'out of sight, out of mind' system works:

1) Economic Data - ever notice how the BLS issues 'negative revisions' to nonfarm payroll unemployment statistics almost every month? How could this be? How could they tell us for 9 straight months, AUG 2008 - APRIL 2009, that the data is 'x' yet one month later announce that the previously reported data was really 'x minus y'. How do they get away with it? Well, if they announced the real bad data at first, the markets may not like that - as markets move based on analyst estimates! Its easier to report better data today, and revise it lower later on. The reason is because markets look AHEAD, not behind, and as a future discounting mechanism it is easier to accept negative data when it was revised lower for a date that has already came and went!

Via Floyd Norris at NY Times:

Robert Barbera, the chief economist of ITG, points out a more disturbing trend: The Labor Department keeps concluding that its initial estimates were too optimistic. Here are the total job losses reported for recent months, as originally reported and as shown in the latest revisions.

August 2008: Initially 84,000, revised to 175,000

September 2008: Initially 159,000, revised to 321,000

October 2008: Initially 240,000, revised to 380,000

November 2008: Initially 533,000, revised to 597,000

December 2008: Initially 524,000, revised to 681,000

January 2009: Initially 598,000, revised to 655,000

February 2009: Initially 651,000, as released today.

On average, from August through January, the first estimate was too optimistic by 112,000 jobs.

JAN - revised again to -741,000
FEB - revised down to -681,000
MAR - revised down to -652,000
APR - revised down to -519,000

May/June are preliminary and yet to be revised. Out of sight, out of mind! Yet markets continue to move on BLS data releases, mostly in a positive way on signs of deceleration of job losses. As the truth comes out later, who cares what happened in the past because the markets are forward-looking! Don't even get me started on the birth/death model that has miraculously added 1,348,000 jobs to our nonfarm payroll stats since April of 2008; source here at bls.gov!

Now, I hear what your saying: the agency doesn't have all the data yet and has every right to fine tune reports in the future when more information is collected. Fine, so why is the bias always to the positive side? Why don't we see a pattern of worse than expected data released today, that is later revised downward a month later? I think we all know the answer to this one!

2) Off-Balance Sheet Vehicles - when you hear terms like 'SPVs', 'QSPEs', 'VIEs' and 'SIVs', you get a bit cautious because you know the banks are using these vehicles to park deteriorating/mismarked assets off their balance sheet. The hope is that out of sight, out of mind will kick in and create the illusion that the company is strong. While Enron got caught setting up offshore entities with different tax codes and methods of hiding losses, the goal was the same - out of sight, out of mind and maybe the market wont care. Confidence is restored, the stock goes up.

Now we have a situation where banks are using special purpose vehicles (SPVs) and structured investment vehicles (SIVs, ironically invented by Citigroup in 1988 - Citi reportedly had over $1trln parked in off balance vehicles). Why would they do that? What would these assets do to their balance sheet if they were on the balance sheet? Would the bank capital ratios need to be recomputed? Would writedowns have to be taken? Would confidence in the company erode? Would the stock price fall?

John Carney reports:

"The SIVs were off-balance sheet entities that owned long term debt and were funded with short-term debt. It's very possible that instead of buying credit default swaps on its mortgage backed securities, Citi was just selling them to the SIVs it managed. Since these were off-balance sheet, Citi wouldn't have faced the capital requirement constraints that often prompted other banks to buy credit default swaps. Citi could lend and securitize, then sell off any extra inventory into its own SIVs, freeing up the capital it got from the SIV to make more loans. Lather, rinse, repeat."

Citi isn't the only one, as BAC is estimated to have $150Bln in off-balance sheet assets that will have to come on by Q1 2010. Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month. The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

3) Estimated Global Credit Losses - an easy one. Start out with low estimates, gradually increase them, and hold off for as long as possible on disclosing an estimate that may rattle markets. If you revise your loss estimates higher with time, the negative impact will be muted and the hope is that the markets completely overlook the most recent revisions because of a change in psychology on the short term nature of the markets.

IMF is the latest example here and the latest update was an upward revision to estimates for global credit losses from initially $1Trln, then to $2.2Trln, and finally the most recent update to a staggering $4.1Trln. If its raised again, Im sure nobody will care anymore unless object permanence is learned by the markets. But if they came out originally and said $4.1Trln, rest assured, markets would have reacted way more dramatically at that time.

Feel free to add more datasets or instances where we seem to kick the can down the road, to worry about the real data later on rather than today. The purpose of this post is not to scare, not to offer doom & gloom (in fact, Ive noted many times since NOV 2008 how less bearish I have been since this process started), but to keep it real and to be cognizant of what was done to keep us out of a much more severe situation - especially in regards to the banks and their M2M/Off-Balance sheet accounting tactics. Just because they are out of sight, doesn't necessarily mean they are out of mind. By the way, has anyone checked in on the GSEs lately? Since being put into conservatorship, we don't really hear much about them or the total losses they may accumulate for taxpayers. Yet, the 23% gain taxpayers received from GS warrants gets full attention! Kind of mis-represents the bigger picture if you ask me.

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