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