The Hutch Report

The science of why we repeat mistakes

By | Economics, Finance, Psychology

History has shown us that we have made many, many mistakes as a society. It has also demonstrated that we tend to repeat previous mistakes made, despite our better judgement. “But why do so many people make the same errors over and over again?” This was the question asked in an article published in The Atlantic.

Procedural memory or Process memory is a part of your long-term memory. It is responsible for knowing how to do things. It is considered a subset of, what is sometimes referred to as, your subconscious memory. Memory is basically nothing more than the record left by a learning process. Thus, memory depends on learning. But learning also depends on memory.  The knowledge stored in your memory provides the framework to which you link new knowledge by association.

When we do something repetitively it gets recorded into our neural pathways. The brain is not able to tell whether or not we are forming a good habit or a bad habit. Our neural pathways are therefore created for both positive and negative behaviours, depending on where you place your focus. Our brains see a repeated action, whatever it may be,  and creates a pattern. It automates that action appropriately for the next time. This allows us to save energy. 

A study by Johns Hopkins, published in the Journal of Current Biology, showed that a subject’s attention towards a previously reward-associated stimuli was positively correlated with the release of dopamine. “Dopamine released within the caudate and putamen is known to underlie habit learning and the expression of habitual behaviours.” This means that there is evidence that our brains are wired to pay attention to things that were once rewarding, even if they aren’t anymore.

We tend to fall victim to a number of human biases that dominate the direction of our thinking. The Ego Effect, or Egocentric Bias can lead us to keep making the same mistakes over and over again. Example, someone who is highly skilled in a certain expertise may struggle to imagine the perspective of others who are more unfamiliar with it. 

In 1987 we experienced Black Monday in the US as the stock market fell precipitously. As Investopedia recounts, “There were some warning signs of excesses that were similar to excesses at previous inflection points. Economic growth had slowed while inflation was rearing its head. The strong dollar was putting pressure on U.S. exports. The stock market and economy were diverging for the first time in the bull market, and, as a result, valuations climbed to excessive levels, with the overall market’s price-earnings ratio climbing above 20. Future estimates for earnings were trending lower, but stocks were unaffected.”

During the savings and loan crisis, the US experienced the failure of 1,043 out of the 3,234 S&L banks from 1986 to 1995. It is believed that the failure began with inflation that started in the 1960s, which led to Paul Volker, U.S. Central Bank Chairman at the time, to raise interest rates. Mortgage rates evenutally topped out at 18.45%. This helped bring on a recession which saw the beginning of the S&L crisis. Deregulation of the industry, combined with regulatory tolerance, and fraud worsened the crisis.

During the 1990s, we experienced a Finnish, Swedish and British banking crisis. In 1997, we experienced the Asian financial crisis. 1998 saw the Russian financial crisis, followed by the Ecuador and Argentinian financial crises in 1998-1999. 

In 2008, we experienced a financial crisis that ravaged the economy and engulfed the country and the world. The government and the Central Bank intervened with a number of bailout programs, which saved the banks, stabilised the financial system and corporate America. Not surprisingly, the combination of regulatory tolerance and fraud allowed the banks freedom to do as they wished, and worsened the crisis…..once again.

Having the Central Banks and Governments backstop every poor practice perpetrated by financial institutions has, time and time again, created a situation of “moral hazard.” This essentially means that if you are confident somebody will bail you out, you will have a tendency to risk as much as you possible can. 

In addition, financial institutions are looking for that dopamine hit. As we previously described from the Johns Hopkins study, our brains are wired to pay attention to things that were once rewarding to us. It is then understandable how greedy bankers will keep trying to identify those high risk, high payoff investments despite the risk and dangers.  

Government, Central Banks and Regulatory authorities tend to fall prey to the Ego Effect bias. They believe that they are smarter than everyone else, and have a hard time to understand how the general population would not see things the way they do. It is all under their control!

So, we can see how not only have we not learned from our past mistakes, we continue to make them. Looking at the present economic situation, the level of asset prices and the bravado of the current Central Bankers, you can expect another crisis to arise, which will most likely be more severe than the last. Why? Simply because they have shown us that they are not capable of learning from past mistakes. 

Does this mean that humans are not capable of learning from their mistakes? No, we certainly are.  It just takes effort and a large amount of humility. 

It may not seem that way at the moment, but in an increasingly complex and uncertain world which we live, people and organizations that embrace failure and create a strong culture around learning from their mistakes will ultimately thrive. Hopefully we’ll learn from our mistakes following the next once-in-a-lifetime crisis!

The Hutch Report

Your financial illiteracy is good for banks

By | Education, Finance

One of the fallacies of education is that if somebody has a list of impressive academic achievements, they are highly knowledgeable and intelligent. Yet knowledge does not equate to intelligence. Knowledge is the collection of skills and information a person has acquired through education and experience. Intelligence is the ability to apply that knowledge. Equally, just because someone lacks knowledge of a particular subject doesn’t mean they can’t apply their intelligence to help solve problems.

The chasm that exists between knowledge and intelligence is no clearer than in the field of personal finance, as Americans face a record $13 trillion in debt. Although the current Covid pandemic did take many by surprise, a recent article in Time magazine highlights: 

“While some face new challenges resulting from loss of income or uncertainty for the future, for many the current economic crisis only exacerbates already present stressors related to monthly bill payments, consumer debt balances, lack of emergency savings, or even just putting food on the table.”

Basic math skills is a requirement for all public schooling, yet the ability to use standard addition, subtraction, multiplication and division to solve problems seems to be lost when it comes to dealing with money. Colleges may make students take biology, history, and other classes as general education requirements, but learning anything about saving, investing, and how financial markets work is purely an option.

In a previous article (Are you educated?) we highlighted the current weaknesses in the education system and the need to rethink methods and curruculum that may be more suited and effective in today’s fast changing world. It maybe important to now ask, “Should financial literacy be an educational requirement?”

You would think the answer would be a resounding “yes” but this is not the case. There are a large number of businesses that thrive on keeping the population financially illiterate. In their book: Simple: Conquering the Crisis of Complexity, Irene Etzkorn and Alan Siegel point out that “banks, credit card companies, insurers and other types of businesses find ways to make money from the fine print nobody can read or understand,” and that “lawyers have inundated us with mind-numbing disclaimers, disclosures, terms, instructions, amendments and amendments to amendments” to “avoid lawsuits or other potential problems.”

Every time a bank’s client uses their debit card, write a check or withdraw funds, the balance in their bank account goes down. According to the Center for Responsible Lending, “Banks collected more than $11.68 billion in 2019 through abusive overdraft practices that drain consumers’ checking accounts.” 

Not understanding personal finance means that most clients don’t understand the fees they are charged, how credit card interest charges accumulate, how to construct or stick to a budget, and so many more facets of basic money management. Some are lacking in knowledge, some in intelligence and those that lack in both are a windfall for financial institutions.  In finance, as in healthcare, when people don’t know what they are paying, service providers have no real incentive to lower costs.

The financial industry has made it a practice to make sure that investing is very complicated. They have a tendency and flair for developing the most complex names possible (even the guys selling these products are not entirely sure of what they mean), examples such as collateralised mortgage obligations, leveraged index funds, credit default swaps, or synthetic CDOs. As Mark Hanna put it in The Wolf of Wall Street, “The name of the game: moving the money from your client’s pocket to your pocket.”

Boris Vallée, a PhD in Finance from HEC Paris, points out that, “The fact that banks use persuasion techniques, by giving products magical names such as ‘Unicorn’ or ‘Elixir’ in an environment where we should be thinking rationally is illustrative of their targeted strategy.”

Banks are a business and expect to make profits but there is a good argument to show that they have taken this way too far. They don’t call them “predatory banks” for nothing. 

The growing wealth inequality gap and the increasing level of personal debt may have some ringing the alarm bells to make some changes. 

A new report from the Council for Economic Education found that the number of states that require a high school student to take a personal finance course — either a standalone class or integrated into other coursework — in order to graduate has risen to 21.

According to a 2019 report by Montana State University researchers Carly Urban and Christiana Stoddard, financial education decreases the likelihood of holding credit card balances, and the education reduces higher-cost private loan amounts for borrowers. 

This bodes well for future generations, however, what is the solution for the current portion of the population that left school years ago, financially illiterate and mired in debt? That is not immediately clear as household debt surged in 2019, marking the biggest annual increase since just before the financial crisis, according to the New York Federal Reserve. 

Do Profits Matter?

By | Finance, Startups

This question is starting to be asked once again. In this recent NYT article, “A Hard Lesson in Silicon Valley: Profits Matter” they write, 

“Start-up investors are warning of a reckoning after the stumbles of some high-profile “unicorns.” Now turning a profit is in.”

Apparently high profile VC Fred Wilson at Union Square Ventures has begun to sound the alarm in a recent blog post titled “The Great Public Market Reckoning”. In it he argues that “the narrative that had driven start-up hype and valuations for the last decade was now falling apart.” One in which he was of course a part of. 

The article goes on to say,

“For the last decade, young tech companies were fuelled by a wave of venture capital-funded excess, which encouraged fast growth above all else. But now some investors and start-ups are beginning to rethink that mantra and instead invoke turning a profit and generating “positive unit economics” as their new priorities.”

But why do profits suddenly matter again? Well profits always matter when the enthusiasm and the thirst of investor greed suddenly begins to turn to caution. This change is once again being driven by the fact that the high-profile “unicorns” (the start-ups that were valued at $1 billion and above in the private markets) are not attracting the investor interest just as they reach the stock market. 

The truth is, in the long run profits always matter. If you are an early stage investor, or even a later stage investor in a money losing startup, your principle concern is your exit. Sure, your investment on paper may have increased exponentially as the valuations of these startups have hit dizzying levels, but in order to get paid you need to either attract additional financing through the private market or unload all your shares to the public market in the form of an IPO. 

At some point the valuations get to stupid levels, as we recently saw with WeWork. The investment community has begun to, once again, wake up to what is really valuable. A company with no profits, is not sustainable, and a company that is not sustainable eventually see their value drop to zero, as we are currently witnessing with WeWork. 

The Hutch ReportWeWork had been hoping to raise as much as $4 billion from its stock market IPO. In addition to the roughly $13 billion it has already raised from private investors. Another $6 billion in loans from big banks such as JP Morgan was predicated on the completion of a successful float. In preparation for the IPO WeWork was being valued at a ridiculous sum of $47 billion. WeWork formally withdrew the prospectus for its initial public offering, capping a botched fundraising effort that cost the top executive his job.

As we previously stated that if you have no access to the public market then you need to attract new loans or investments from the private market. Getting new financing is now critical for WeWork. The company lost $690 million in the first six months. Even with $2.5 billion in cash as of June 30 at the current burn rate, the company could run out of money by mid-2020, according to analysts. 

But haven’t we heard this all before? Yes, we have. We saw this clearly during the 1999 boom bust period of the internet. In fact, it is almost a carbon copy.

In a May 19, 1999, Wall Street Journal article entitled “Companies Chose to Rethink A Quaint Concept: Profits,” they asked the same question, “Profits matter. Or do they?” In it they write;

“James Borkowski always thought so, until he started listening to venture capitalists. “The attitude is almost antiprofit,” marvels Mr. Borkowski, executive vice president of Industrial Microwave Systems Inc. He says that his two-year-old company originally planned to become profitable in the year 2000. “But our financial advisers told us not to be profitable too quickly,” he says. So the company is projecting losses until 2001.”

“In this marketplace,” Mr. Borkowski says, “the more money you lose, the more valuable you are.”

Sound familiar? During the dot com crash, many online shopping companies, such as, Webvan, eToys and, eventually failed and shut down. 

Webvan went public in late 1999 on little more than hope. The stock doubled on its first day and the company quickly earned a $6 billion valuation, even though it had less than $5 million in revenue and cost over $27 to fulfill an order. The company flamed out quickly; going bankrupt in 2001. eToys and likewise failed swiftly. debuted on February 9 of 2000 and declared bankruptcy less than 300 days later. eToys took a bit longer to fail, going public in May of 1999 and declaring bankruptcy at the end of February in 2001.

Although the valuations are small in comparison to today, these were high profile examples of the time, of greed gone amok. 

So why did the Venture Capital world and corporate bankers not learn an lessons from this era? Well, actually they have been well aware of the lessons. They just made a conscious decision to disregard them and ride the wave while greed was still vibrant. 

Fred Wilson remembers the 1999 bust vividly. He knows first hand what it feels like when there is a fire and everybody is running for the exits at the same time. He apparently did learn some lessons as this time he prefers to be the one at the exit sounding the alarm.

The Hutch Report

The Game of Financial Market Predictions

By | Finance, Psychology

As humans have evolved, the ability to predict events days, months or years into the future has never been relevant to survival. Rather, our DNA has been equipped with the fight or flight response. It is our quick ability to react to the event once it has happened that keeps us safe. 

Speaking on a panel at the 2018 NeuroLeadership Summit, social cognitive neuroscientist Kevin Ochsner said, “Our brains evolved to manage the needs of the now and of the not-too-distant future—your immediate environment, and short-term goals for food, water, shelter, and child-rearing.”

Although the world has evolved, humans still carry the same neural architecture as our early ancestors, which means that our brains are still inept at predicting future events. The closest we get is our ability at using sensory data to foresee events in the immediate future, as in microseconds. This enables us to predict the trajectory of a fast-moving baseball which enables us to catch it. 

In his fascinating documentary series, “The Brain”, Stanford Neuroscientist Dr. David Eagleman explains how in practice predictability is impossible. He demonstrates this by dropping a single ping pong ball into a container of one hundred and fifty ping pong balls. It is possible to correctly identify where the ball will land but as it sets off a chain reaction of movement with the other balls the situation becomes more complex. He states, “Any error in the initial prediction, no matter how small, becomes magnified as balls collide and bounce off the sides and trigger other balls. Soon it becomes completely impossible to make any kind of prediction about how the balls will end up. The balls have no choice in the direction they move. They have no freedom to do it differently, and yet the system is completely impossible to predict.”

A human’s thoughts, feelings and decisions emerge from the innumerable interactions in the brain. In comparison to the activity of one hundred and fifty ping pong balls, the brain has billions of times more interaction every second and never stops during a lifetime. In addition, each individual’s brain is embedded in a world of other people’s brains. Dr. Eagleman goes on to say, “the neurons of every human on the planet fire, interact and influence each other creating a system of unimaginable complexity. This means that even though brains follow predictable rules, in practice, it will always be impossible to know exactly where any of us are going.”

Nassim Taleb developed a line of argument throughout his previous books, Fooled by Randomness, The Black Swan and Antifragile,  that the defining characteristic of future change is that it is impossible, and pointless, to try to predict it. Instead,  he argues, it is essential to make peace with uncertainty, randomness and volatility. Those who do not — who insist not only on trying to predict the future, but also on somehow trying to manage it — he disparagingly calls “fragilistas.”  

So if predictions are impossible, what makes such a large number of financial professionals believe they have the ability to identify, as in Dr. Eagleman’s demonstration, the correct outcome of the millions of interactions that are set off from the chain reaction of one event? 

The human brain values certainty in a very similar manner to how it values food, sex, and social connection. Certainty offers a perceived control over the environment that is in itself inherently rewarding, the brain treats uncertainty, and the inability to predict the future, as a source of deep discomfort.

This is essentially why viewers continue to tune into their favorite financial tv personalities, in the hopes that they will describe the future and give them a greater sense of certainty. The main certainty on behalf of the financial tv personalities is that regardless of their faulty predictions, they are protected by a number of disclaimers at the end of the show that viewers tend to disregard.

The Financial Times looked at the number of countries that the IMF expected to be in recession for every year since 1991 and compared it with the number of economies that turned out to have actually contracted. Over the last 27 years, the IMF predicted every October that an average of five economies will contract the following year. In practice, an average of 26 have contracted. The difficulty in getting forecasts right is not unique to the IMF. “All macroeconomic forecasters are poor at predicting downturns,” David Turner, head of the economics department at the OECD told the Financial Times.

The past is littered with a multitude of failed predictions over the years made by economists, financial analysts, TV financial personalities, or the Federal Reserve. 

Who can forget on March 11, 2008, Mad Money host Jim Cramer told a viewer who wrote into his show, “Bear Stearns was fine!” right before the stock absolutely collapsed. The stock was trading at $62 per share. Just 5 days later, the firm was picked up by JPMorgan Chase for $2 per share. Yet, Jim Cramer is still on CNBC shelling out predictions daily to a mass of viewers eager for some kind of certainty.  

In the past, there have been correct predictions. Although with no real timing accuracy, they can be considered a lucky guess, since none have been able to replicate the predictions that made them famous.

Elaine Garzarelli became a start with her prediction of the 1987 crash. Since then, her record was mixed. For instance, on July 23, 1996, she told clients that US stocks could fall 15% to 20% from peaks reached earlier that summer. The Dow Jones industrial average closed that day at 5,346.55, and had risen 45% by Nov 1997.

Elaine Garzarelli

Meredith Whitney catapulted to fame after her prescient October 2007 report on Citigroup Inc. and put this previously unknown analyst on the cover of Fortune magazine. Following shortly after her ascent to prediction stardom, she predicted an “as yet unrealised” meltdown in municipal bonds in a 2010 interview on “60 Minutes.” A short-lived hedge fund followed, but the fund lost money and closed in 2015 amid a legal dispute with its anchor investor.

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Meredith Whitney

Paul Tudor Jones also called the 1987 crash, yet last year predicted that the US 10-year Treasury yield would rise to a “conservative” 3.75 percent by the end of 2018. The result? It closed the year at 2.43 percent and has since dropped to 1.73 percent. However, the ability to make predictions should not be confused with one’s ability to react and trade off of events. It is the trading ability of PTJ, his ability to react to situations, and trade accordingly that has made him wealthy.

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Paul Tudor Jones 1987

Bob Johansen, author of Leaders Make the Future: Ten New Leadership Skills for an Uncertain World, states that the first step is to strive not for certainty, but for clarity. Given that the future is inherently unpredictable, we can never be certain about what the future will bring. 

If we really had the ability to forecast future events, there would be no such thing as an unforeseen crisis!

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The joy of earning billions…and paying no taxes!

By | Finance, Politics

Our previous article focused on the ways in which companies are moving away from generally accepted accounting principles (GAAP) and towards non-GAAP adjustments in order to manipulate their balance sheets in a way that suits them best. 

These new methods of clever accounting have far ranging effects as we have seen, in spite of new tax laws set up by the Trump administration, corporate tax avoidance remains rampant. 

According to a new report by the “Institute on Taxation and Economic Policy,” it was found that 60 profitable Fortune 500 companies managed to avoid all Federal Income Taxes in 2018. The companies that managed to avoid paying the taxes were not distinct to one segment of the economy but represented a wide range of segments. 

Included in the report were examples such as computer maker International Business Machines (IBM) which earned $500 million in U.S. income and received a federal income tax rebate of $342 million. The retail giant Amazon reported $11 billion of U.S. income and claimed a federal income tax rebate of $129 million. The streaming service Netflix paid no federal income tax on $856 million of U.S. income. Beer maker Molson Coors enjoyed $1.3 billion of U.S. income in 2018 and received a federal income tax rebate of $22.9 million. Automaker General Motors reported a negative tax rate on $4.3 billion of income.

60 Companies Avoiding All Federal Income Taxes in 2018

U.S. Income and Federal Tax figures in millions of dollars.
Company U.S. Income Federal Tax Effective Tax Rate Industry
Activision Blizzard
Computers, office equip, software, data
AECOM Technology
Engineering & construction
Alaska Air Group
Retail & wholesale trade
Utilities, gas and electric
American Electric Power
Utilities, gas and electric
Miscellaneous services
Arrow Electronics
Retail & wholesale trade
Arthur Gallagher
Atmos Energy
Utilities, gas and electric
Avis Budget Group
Motor vehicles and parts
Oil, gas & pipelines
Cliffs Natural Resources
Oil, gas & pipelines
CMS Energy
Utilities, gas and electric
Industrial machinery
Delta Air Lines
Devon Energy
Oil, gas & pipelines
Dominion Resources
Utilities, gas and electric
DTE Energy
Utilities, gas and electric
Duke Energy
Utilities, gas and electric
Eli Lilly
Pharmaceuticals & medical products
EOG Resources
Oil, gas & pipelines
Utilities, gas and electric
Publishing, printing
General Motors
Motor vehicles and parts
Goodyear Tire & Rubber
Motor vehicles and parts
Oil, gas & pipelines
Honeywell International
Industrial machinery
International Business Machines
Computers, office equip, software, data
JetBlue Airways
Kinder Morgan
Oil, gas & pipelines
MDU Resources
Oil, gas & pipelines
MGM Resorts International
Miscellaneous services
Molson Coors
Food & beverages & tobacco
Retail & wholesale trade
Occidental Petroleum
Oil, gas & pipelines
Owens Corning
Miscellaneous manufacturing
Penske Automotive Group
Motor vehicles and parts
Performance Food Group
Retail & wholesale trade
Pioneer Natural Resources
Oil, gas & pipelines
Pitney Bowes
Computers, office equip, software, data
Utilities, gas and electric
Principal Financial
Prudential Financial
Public Service Enterprise Group
Utilities, gas and electric
Miscellaneous manufacturing
Miscellaneous services
Rockwell Collins
Aerospace & defense
Ryder System
Computers, office equip, software, data
Retail & wholesale trade
Industrial machinery
Tech Data
Retail & wholesale trade
Trinity Industries
Miscellaneous manufacturing
Utilities, gas and electric
United States Steel
Metals & metal products
Electronics, electrical equipment
Wisconsin Energy
Utilities, gas and electric
Xcel Energy
Utilities, gas and electric
Source: Institute on Taxation and Economic Policy analysis of SEC filings 

The loop holes and tax breaks used by these companies are varied and range from accelerated depreciation, stock options, and energy tax subsidies to name just a few. 

One of the most egregious loopholes in the tax code, known as the stock option loophole, allows companies to deduct millions or billions from their taxable income for compensating executives in the form of stock options. Corporations can take these deductions even though granting stock options costs them nothing. 

In a report produced in 2016, Citizens for Tax Justice (CTJ) reviewed five years of corporate filings and found this loophole allowed companies to annually avoid an average $13 billion in taxes. It should also be highlighted that the average sum corporations are currently avoiding could be understated because not all corporations report information about stock options.

The ITEP report also pointed this out as they stated, “In many cases, the company’s disclosures don’t fully clarify which tax breaks were used.“ Therefore, analysis of the balance sheet does not always lead to the true picture of a companies financial health. 

“All data cited in this report come from the 10-K annual financial filings published by these companies. In many cases, the company’s disclosures don’t fully clarify which tax breaks were used. For example, Chevron’s annual report for 2018 discloses that unspecified “tax credits” reduced the company’s income taxes by $163 million.”

They go on to say that despite these companies managing to avoid paying their share of taxes, there is nothing illegal about what they are doing. They are simply taking advantage of legal tax breaks that have been provided to them in order for them to shelter a large portion of their earnings from Federal taxes. There are, however, a number of moral and ethical questions that can be raised. 

If these companies are to be reigned in the only true change will come from sustainable tax reform which only the government can accomplish. The big problem facing the government as an institution is as the years pass, the debt and deficits grow, the working population pays a larger and larger portion of taxes as the public’s confidence in elected officials continues to weaken. 

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Mind the GAAP!

By | Finance, Markets

With the earnings season upon us we now go through the same dog and pony show. Companies report earnings, then the success of those earnings are based mainly on whether or not they beat consensus analyst’s estimates. Curiously enough, many often beat by one penny. What methods do they possibly use to beat by a penny per share? 

Prior to earnings, analysts tend to be busy estimating what earnings they think will be reported. Their estimates are based on guidance from the company itself, economic conditions and their own independent models and valuation techniques.

Companies prepare their accounting using generally accepted accounting principles, also referred to as GAAP. GAAP, are a set of rules that encompass the details, complexities, and legalities of business and corporate accounting. GAAP are controlled by the Financial Accounting Standards Board (FASB), a non-governmental entity. The FASB creates specific guidelines that company accountants should follow when compiling and reporting information for financial statements or auditing purposes. GAAP is not law, and there is nothing illegal about violations of its rules unless those violations happen to coincide with other laws. Today, all 50 state governments prepare their financial reports according to GAAP. While a little less than half of them officially require local governments to adhere to GAAP.

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However, more and more, companies are finding that by following a standardized set of GAAP rules, their earnings often come out less than attractive. So, over the years corporate accountants have become more and more creative through the use of “non-GAAP” methods to improve their bottom lines. 

A study published by Audit Analytics noted that 96 percent of S&P 500 companies used non-GAAP measures in earnings releases during the fourth quarter of 2016. In addition, a study published by FactSet indicated that for the first quarter of 2017, 63 percent of the companies in the Dow Jones Industrial Average reported non-GAAP earnings per share and that, on average, the difference between the GAAP and non-GAAP earnings per share was approximately 54 percent. The most common adjustments were found to be restructuring charges, acquisition-related items, stock compensation costs, and, to a lesser extent, debt costs and legal costs. 

As companies battle to present themselves as profitable, non-GAAP measures are becoming the norm as the disparity between GAAP and non-GAAP results grows larger and larger. So if you think you are going to get the true story from a company’s statements or earnings reports, think again. 

Off-balance sheet financing is another method of non-GAAP financial engineering. A business tries to keep certain assets and liabilities off its balance sheet in order to present to the investment community a cleaner balance sheet than would otherwise be the case. It does so by engaging in transactions that are designed to shift the legal ownership of certain transactions to other entities. The transactions are designed to sidestep the reporting requirements of the applicable accounting framework, such as GAAP or IFRS. So, therefore, considered non-GAAP.

Off-balance sheet financing played an important role in the Lehman Brothers bankruptcy. Through the use of off-balance sheet entity ‘Repo 105’, Lehman was able to move $50 billion of debt off of their balance sheet, making them appear more financially stable before the end of the quarter. Since it was classified as a repurchase agreement, it was ‘bought back’ after the reporting period. When the debt was originally moved off-balance sheet, the bank recorded the debt as a ‘sale’ and booked the $50 billion as revenue. This type of accounting manipulation contributed to the largest bankruptcy in U.S. history, wiping out the life savings of thousands of employees of the bank. 

Adjusted EBITDA is another non-GAAP financial measure that has gained a lot of popularity. Speaking on Jim Grant’s Current Yield Podcast, Adam Cohen, founder of Covenant Review, stated, “Some version of adjusted EBITDA is quite common, but we are seeing things turn into absolute fantasy land.” He took a recent example using the company WeWork, currently valued at roughly $47 Billion, with a stated annualized revenue of $2.5 billion. Cohen explained that the WeWork 2017 income statement started with a net loss of $933 Million. Once they got themselves to adjusted EBITDA, they reduced that to a loss of $193 Million, however since they wanted to sell a bond yield, this wasn’t good enough, so they invented something called “adjusted EBITDA before growth investments” but that still wasn’t good enough, so they invented a third version called “Community adjusted EBITDA,” which at what point they achieved a positive $233 Million community adjusted EBITDA. That is a $1.1 Billion swing from net loss to profit, which is more than the amount of revenues they booked that year. 

As an update to this example, the Financial Times just reported on March 26th, 2019, “WeWork bond prices slipped on Tuesday after the provider of shared office space said that its losses had more than doubled from a year earlier, as the company ploughed money into a breakneck expansion that has captivated the real estate industry.”

So, as a word of caution to those investing in the next potential Lehman, as all these fairy tale companies go public, and as the earnings season takes off,  “MIND THE GAAP.”

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The Fate of Blockchain

By | Cryptocurrency, Finance, Technology

Nasdaq reported today that they are investing in blockchain technology, and pushing for crypto and blockchain adoption. According to an official press release, Symbiont successfully closed a $20m Series B funding round. Nasdaq Ventures led the round which also included investors such as Mike Novogratz’s Galaxy Digital, Citi and Raptor Group among others.

Adena Friedman, President, and CEO of Nasdaq commented, “It is difficult to ignore the huge amount that investors, including some of the most sophisticated global investors, have poured into digital currencies in recent years. The invention itself is a tremendous demonstration of genius and creativity, and it deserves an opportunity to find a sustainable future in our economy …

At Nasdaq, we are working to help cryptocurrencies gain investors’ trust by offering our technology for trade matching, clearing, and trade integrity to start-up exchanges. We have also invested in ErisX, an institutional marketplace for cryptocurrency spot and futures. While this year will be another proving ground for cryptocurrencies, we believe digital currencies will have a role in the future. The extent of its impact will depend on the evolution of regulation and broader institutional adoption.”

The MIT Technology Review recently stated that the blockchain will become more useful, however, they also believe that blockchains will start to become boring this year. After the Great Crypto Bull Run of 2017 and the monumental crash of 2018, blockchain technology won’t make as much noise in 2019.

The blockchain enthusiasts are still working towards gaining world adoption for the technology, however as often cited, the level of investment into the technology should not be taken as a sign of its inevitable success. If that were the case the fate of so many grandiose startups in the 1999 – 2000 boom would have turned out quite different considering the level of investment that went into many of them. A leading venture capitalist told me once, “the graveyard is littered with many brilliant technologies.”

If google trends is any indication then interest in bitcoin and blockchain have been declining, or at least for the moment.

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The Hutch Report

On this past Wednesday, January 23, 2019, VanEck, the firm that had sought SEC’s approval to trade Bitcoin ETF on the CBOE exchange, withdrew its application. Analysts and crypto followers believed that the launch of a regulated Bitcoin ETF would attract billions of dollars in investments and saw these initial moves as a positive step towards global adoption. Yet, now that they have withdrawn their application, the news is being spun as something positive for the crypto industry, or at least according to NewsBTC

As the great baseball-playing philosopher, Yogi Berra once said, “It’s tough to make predictions, especially about the future.” Nassim Taleb views those trying to predict the future as simply “charlatans.” The problem is that almost all forecasters work within the parameters of the Gaussian bell curve, which ignores large deviations and thus fails to take account of “Black Swans”. Taleb defines a Black Swan as an event that is unexpected, has an extreme impact and is made to seem predictable by explanations concocted afterwards. It can be both positive and negative. 

One of these so called deviations could be the advances of Quantum Computing, as we previously wrote about here, or it could be something not yet determined. 

The simple fact is that you have two groups — interested participants and non-interested participants. The interested participants will keep investing time and funds in order to realise the original objective of creating a decentralised peer-to-peer network where no single institution or person controls it. The non-interested participants will only adopt the technology once they believe it is in their advantage to do so and it becomes as simple as handing a friend a dollar bill.


The Hutch Report

The New Economic Hitmen

By | Economics, Finance, Politics

John Perkins original book, “Confessions of an Economic Hitman” and his current book, “New Confessions of an Economic Hitman” brought to light some of the strategies the US has used over the years in order to gain control of foreign reserves that American companies may want to seize, such as oil. 

According to Perkins, the method of achieving this end was to use external consultants such as the one he worked for. They would arrange large loans for those countries via the World Bank and its partner organizations. However, the governments in question never received the money. Instead, the money would be transferred, directly or indirectly, to American companies, including construction firms like Halliburton or suppliers like General Electric. These American entities would then launch infrastructure projects which may have included power grids, or industrial parks and highways. These projects generated huge profits. However, not surprisingly, those profits went to the American companies and a few rich local familes. In the end, these countries that were already weighed down by huge debts just saw their debts grow larger, which in turn pressured the already poor and middle class. 

Typically, a developed country with a dictator that sits on a perch makes for a soft target. Dictators are often propped up by failed systems like corrupt police force and military. They are usually the most eager to redeem their images so if you can take photos with them signing agreements about huge infrastructure projects it will help soften their soily images.  Therefore, they are happy to stand on the podium and tell their ill-informed, semi-literate populace about the development the government is bringing to their country. 

As an example, in the 70s, large loans were provided to build a power grid in Panama. The real goal was to force the then Dictator Omar Torrijos into a situation where he owed the US a lot of money in order to have something to blackmail him with because at that point, his bankrupt country would be beholden to them. As Africans would say, you hold both the yam and the knife. In 1977, Torrijos signed a deal with the US, which guaranteed that the government of Panama would have full control of the Panama Canal starting 1999. In 1981, he was killed in a car crash.

Omar Torrijos

Looking at the situation today with the number of sanctions and tariffs being thrown around one has to wonder who the principle targets of the current administration are. Russia? The truth is, Russia and the US have been playing spy games on each other for years. The real targets are the emerging economies. “I have no doubt that there are economic hitmen targeting emerging economies like Turkey’s,” Perkins said in an interview to the Turkish based Anadolu Agency. But Turkey is not the only country where the US has imposed sanctions and tariffs. Currently, sanctioned countries include the Balkans, Belarus, Burma, Cote D’Ivoire (Ivory Coast), Cuba, Democratic Republic of Congo, Iran, Iraq, Liberia, North Korea, Sudan, Syria, and Zimbabwe.

In today’s globalised world economic hitmen are no longer only US based. Today they may come from any number of other countries, including Russia and China. Globalisation has created huge opportunities for economic hitmen around the planet.

Trump’s administration sees infrastructure as one of the key areas to boost US economy. However, the recently published Infrastructure plan has been criticised for lack of money and is highly dependent on private capital. The US is already running large deficits and the national debt now currently stands at $21.8 trillion. 

China, with its strong infrastructure achievements and the largest amount of foreign exchange reserves (China has by far the largest foreign currency reserves with over two and a half times more than the second largest reserve holder, Japan. When China and Hong Kong reserves are considered together, the total is $3.6 trillion), is constantly looking for low-risk long-term investment projects to achieve asset preservation and appreciation. By targeting the US, China could balance its foreign exchange levels while accelerating the rejuvenation of American infrastructure. This would also transform China into a job creator in the US. 

The Hutch Report

The Hong Kong–Zhuhai–Macao Bridge, 55 kilometres long.

China is currently employing this strategy throughout Africa along with their One Belt, One Road initiative. China has been the largest trading partner of Tanzania for many years with some 350,000 Tanzanians doing jobs related to trade with China. Also Chinese companies have built a number of mega projects in Tanzania, including roads and bridges, creating about 150,000 jobs. 

Interestingly, on his last trip to the continent just before being replaced, Rex Tillerson said that African countries should be careful not to forfeit their sovereignty when they accept loans from China, the continent’s biggest trading partner.

Would Trump be open to outsourcing the development of the US infrastructure to Chinese firms? The short term boost to Trump’s reputation may blind him to the longer term complications. Could the US itself become a target of the economic hitmen?

The Hutch Report

The Deadly Market Sin – Complacency

By | Finance

What may go wrong if you are right?

The debate around the stock market’s performance continues to rage on. On one side the argument is that the market gains are justified because of explosive company earnings, Trump’s tax cuts or that the US markets are the only game in town. The competing view is that nothing has been fixed since 2007 and this is just all makeup on a pig. Low interest rates and company buybacks are fueling the drive for better returns. It is believed that it is all a slow motion train wreck ready to collapse. 

The purpose of this piece is not to add anything new to the debate but to highlight some issues that could arise in the event of the return of extreme volatility. Bear and Bull calls that appear initially correct could suddenly violently flip in a second as any number of unforseen events suddenly appear out of nowhere. Understanding historically how some of these events have been brought on may help dampen any future surprises.

The collapse of the Internet bubble, perhaps one of the largest financial fiascoes in U.S. history, came after a three-year period, starting in January 1997, when investors would buy almost anything even vaguely associated with the Internet, regardless of valuation. Investors ignored huge current company losses and were willing to pay 100 times expected earnings in fiscal 2002. They were provoked by bullish reports from sell-side securities analysts and market forecasts from IT research firms, such as IDC, Gartner and Forrester Research.

There are many of us who were around during the dot com bubble of 1999 to 2001 and lived the collapse of so many high flying overvalued stocks with huge cash burns and no profitability. The claim at the time was that it was a “new world.” Profitability did not matter. Eye balls mattered. As long as you had large traffic flows to your site you could worrry about profitability later.

All this activity did influence the economy and everything was firing on all cylinders. This held true for a while as long as investors kept throwing money at these wild west startups. The day the financing dried up, so did the company’s prospects of continuing as a going concern. The darlings of the day including,,, GeoCities,, or all but disappeared. This meant that these and thousands of companies like them ran out of cash and fired all their employees.  

Even if you are paying attention and think you understand the valuations you may be mistaken. The problem today is that companies and accountants are coming up with all kinds of clever ways to mask the true financial state of a company. This means that more and more professional and individual investors are not looking deeply enough into the details, as it takes more and more effort. Besides, it is not in reason to have to become an accounting forensic scientist just to figure out a company’s profitability. 

Jim Grant’s excellent “Current Yield Podcast” highlights the current environment of financial reporting in his show “Read the Footnotes,” and “Loan Sharks,” where for example they discuss how WeWork came up with different adjusted EBITA to suit their purpose. Fundamental analysis is usually how financial analysts make their judgements on a stock. If the company beats the analysts estimates it could rise considerably. If that analysis is flawed then the stocks are moving on false premises. Eventually stocks will always revert to their fundamental values, which indeed they did in 2001 to 2003.

What does this have to do with today’s market? A new report by the Wall Street Journal highlighted that a record number of IPOs, or 83% of US listed IPOs over the first three quarters of 2018, were companies that lost money in the 12 month prior to their going public. However, there are still many more that appear to have impressive balance sheets until their true financial state is exposed. Lurking within the financial statements and communications of public companies is a troubling trend. Alternative metrics, once used sparingly, have become increasingly ubiquitous and more detached from reality.

In 2011, Groupon Inc. announced plans for a highly anticipated initial public offering. But enthusiasm for the offering waned when the U.S. Securities and Exchange Commission (SEC) issued a comment letter questioning Groupon’s use of a profit metric it called “adjusted consolidated segment operating income.” It was believed that no company had ever used that metric before; it was intended to measure operating profit without including marketing expenses, stock-based compensation, and acquisition-related costs. Management argued that a $420 million loss from operations reported on its 2010 income statement should really be considered a $60 million gain.

The financial crisis of 2007-2008 that led to a decline in stocks was different. It began in 2007 with a crisis in the subprime mortgage market in the United States, fuelled by the Fed, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally.

When this crisis hit and volatiliy exploded so did trading volumes. We remember trading on a few different plaftorms during this period only to see them seize up from the volumes daily. You could be correct on a trade but find yourself not able to get out. 

Then this showed up:

SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets

Commission Also Takes Steps to Increase Market Transparency and Liquidity



Washington, D.C., Sept. 19, 2008 — The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. The U.K. FSA took similar action yesterday.

They changed the rules of the game. A large number of traders were caught holding short positions in financial stocks having to scramble to get out of them. A massive short squeeze erupted. 

Just when investors and traders had positioned themselves for larger gains on the short side, the Fed stepped in with extraordinary monetary policy adjustments which included never before seen bailouts. Investors that never fully understood the old adage “don’t fight the Fed” paid dearly. 

Readers may be aware of some of these facts but it is essential to highlight that even though you may be correct in your trading or investment decisions and thesis, you are working with a dynamic system that has the leverage to change the rules to its advantage. Many of these adjustements could put the trader and investor at an extreme disadvange. We advise you to listen to the RealVision interview with Marc Cohodes as his experience with Goldman Sachs during this time illustrates this perfectly. 

In 1971 the New York Stock exchange incorporated as a non-profit. The change to for profit status was organizational and the result of a transaction first approved in April 2005 by the New York Stock Exchange governing board. In March 2006 the New York Stock Exchange, a non-profit corporation, merged with Archipelago Holdings, Inc. into a new organization NYSE Group, Inc. as a publicly traded and for-profit company.  In April 2007 the company in a stock swap transaction combined with Euronext, the European stock exchange, becoming NYSE Euronext.

Interestingly enough, we began to see the advent of high frequency trading. One of the ways exchanges such as the NYSE make money are by allowing big-deal firms to install their computers closer to the actual exchange, so their electronic trade requests will arrive milliseconds earlier than competitors. High frequency and algorithmic trading now accounts for a very large percentage of total exchange trading volume.

The May 6, 2010, Flash Crash, also known as the Crash of 2:45, the 2010 Flash Crash or simply the Flash Crash, was a United States trillion-dollar stock market crash, which started at 2:32 p.m. EDT and lasted for approximately 36 minutes. 

The Chief Economist of the Commodity Futures Trading Commission and several academic economists published a working paper containing a review and empirical analysis of trade data from the Flash Crash. They concluded the following:

“Based on our analysis, we believe that High Frequency Traders exhibit trading patterns inconsistent with the traditional definition of market making. Specifically, High Frequency Traders aggressively trade in the direction of price changes. This activity comprises a large percentage of total trading volume, but does not result in a significant accumulation of inventory. As a result, whether under normal market conditions or during periods of high volatility, High Frequency Traders are not willing to accumulate large positions or absorb large losses. Moreover, their contribution to higher trading volumes may be mistaken for liquidity by Fundamental Traders. Finally, when rebalancing their positions, High Frequency Traders may compete for liquidity and amplify price volatility.”

Traders and investors that still believe that we have free markets may get a rude awakening. Aside from the famous flash crash, we are still not able to forecast how these algorithm trading bots will react in the case of a market event or Black Swan. 

So as an investor or trader you may be holding a short position or long position and be correct in your analysis only to find the profitable company you have been invested in has just declared bankruptcy, or have your trading platform seizes up under the massive volume hitting the markets due to a shock to the market, rendering you helpless, have your brokers suddenly adjust all margins putting you at a severe disadvantage, have the Fed step in with a nuclear option not yet known, have the SEC ban short selling or suddently watch in horror as prices tank as most of the market’s liquidity disappears because a number of large program trading algorithms have been turned off. Complacency in these markets in any form can be deadly. 

The Hutch Report

The Ghostly Budget

By | Economics, Finance, Politics

It appears that the dark halls of the US Military Complex could teach Trump, Cohen and Manafort  a few things about shadow budgets and hiding money.

Anybody reading this may have come across a story that grazed a few pages a year ago. However, surprisingly it didn’t seem to make more noise among the public than it did at the time. The story involved some unsupported adjustments, or spending by the US army that amounted to roughly $21 trillion. That number is not a typo. If true, it would mean that the US army had spent an unauthorized amount that would equal the current sum of the national debt. Even though the story may not have created a very large public disturbance, it did put a few people in the Pentagon into action. We wanted to find out where the trail was leading. 

For those not familiar with the case, it all started when Dr. Mark Skidmore, a PH.D. in economics and Professor and Morris Chair in State and Local Government Finance and Policy at the Michigan State University, was listening to an interview with Catherine Austin Fitts, former assistant secretary of Housing and Urban Development. In the interview as Skidmore explained “Fitts refered to a report that had come out in 2016 by the Office of the Inspector General (responsible for providing some accountability and tracking of financial activity of the Federal Government).” The report indicated that in fiscal 2015, the US army (with a budget of roughly $122 billion) had adjustments of $6.5 trillion. Because of Dr. Skidmore’s experience and knowledge base, he had some serious doubts about the quoted figure and assumed they must have meant $6.5 billion. He looked at the report himself and to his surprise found that it was not an error. 

This prompted Dr. Skidmore to suggest to Fitts to investigate the issue further.  So during the summer, two MSU graduate students searched government websites, especially the website of the Office of Inspector General (OIG), looking for similar documents dating to 1998. What they found was far beyond what they expected to find. They found documents indicating a total $21 trillion in undocumented adjustments over the 1998-2015 period, of which $11 trillion were directly linked to the US Army.

Dr. Skidmore’s work was able to show that there was something very broken within the budget process. By October 5, 2017 they suddenly discovered that the link to the original OIG report “Army General Fund Adjustments Not Adequately Documented or Supported” of July 26, 2016 had been disabled. Within several days, the links to other OIG documents that had been identified in their search were also disabled. However, Dr. Skidmore and his team had the foresight to copy the July 2016 report and all other relevant OIG-reports in advance and re-post them (The original government documents and a report describing the issue can be found here).

On December 7, 2017, Pentagon officials announced that the Defence Department was beginning the first agency wide financial audit in its history, 

By June 2018, Dr. Skidmore wrote the following update:

“In late May 2018, a graduate student at Michigan State University found on the OIG website the most recent report for the DoD, which summarizes unsupported adjustments for fiscal year 2017. However, this document differs from all previous reports in that all the numbers relating to the unsupported adjustments were redacted. That is, all the relevant information was blacked out.”

So is this situation just over exaggerated with hyperbole and blacked out documents for more dramatic effect? Governmental departments are extraordinarily inefficient organizations. It often requires a number of documents to be signed off before one can order some additional pencils. 

Could such an inefficient department have the smarts and tools to be able to disguise such a massive amount of money from the taxpayers eyes? Well here are some other incidents which shows they never stop short of giving it their best try. 

December 5, 2016, The Washington Post reported that the Pentagon had buried an internal study that exposed $125 billion in administrative waste in its business operations amid fears Congress would use the findings as an excuse to slash the defence budget.

February 5, 2018, a leading accounting firm said in an internal audit obtained by POLITICO, that one of the Pentagon’s largest agencies couldn’t account for hundreds of millions of dollars’ worth of spending, (curiously just as President Donald Trump was proposing a boost in the military budget.)

On August 13, 2018, President Donald Trump signed a military budget boosting the Pentagon’s spending by $82 billion in the next year—a spending increase that dwarfs the entire military budgets of most other nations on Earth. (Russia, for example, will spend an estimated $61 billion on its military this year). With the increased spending included in this year’s National Defense Authorization Act (NDAA), the Pentagon will get to spend more than $700 billion next year. The budget hike was a priority for Trump and was approved by Congress as part of a March spending deal that saw spending on both defense and domestic programs hiked by about $165 billion—smashing through Obama-era spending caps.

On September 17, 2018, it was reported that the Pentagon had massively overestimated, for the second fiscal year in a row, how much its new retirement system would cost.

All that is required is a quick search of the Pentagon and their funding requirements to discover that this is a game that has gone on for a long time. There seems to be a budget for some and a black budget for others in the government.  In the end, it is the taxpayers that are flipping the bill for all the spending. In a Dec. 8 Forbes column that he co-authored with Laurence Kotlikoff, Skidmore said the “gargantuan nature” of the undocumented federal spending “should be a great concern to all taxpayers.”

The fact that these previous reports along with the revelations of Dr. Skidmore and Catherine Austin Fitts have not caused people to become enraged is surprising. This just seems to show that the general public view towards the current levels of greed and corruption are still complacent.  Although the US dollar as a reserve currency may allow the government to get away with many of their spending habits and shadow budget operations for the moment, the day it’s removed will cause some serious repercussions. 

We can already see many signs of the international community getting frustrated with strong arm tactics by the US and adjusting appropriately in order not to be held hostage anymore by the US dollar reserve status.

Reuters recently reported, 

“The U.S. dollar’s share of currency reserves reported to the International Monetary Fund fell in first quarter of 2018 to a fresh four-year low, while euro, yuan and sterling’s shares of reserves increased.” 

It is no longer a matter of if, but when.