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Author: junkman02 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35367  
Subject: Re: Price-Risk versus Information-Risk Date: 3/24/2009 10:58 PM
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This is a re-post of the previous. There are enough small mistakes and infelicities in the previous that it annoys me to re-read it. This is not to say that I did not put effort into editing the original version before I posted, only that I have a hard time seeing those annoyances until I've gained the distance of time. Then I groan and regret. If TMF allowed us to edit our own posts, things would be better. Almost nothing I write merits re-editing and re-posting. But I feel strongly about the point I'm trying to make (about info-risk vs. price-risk) and the example seems like a good one, although the role of other factors (1) cannot be discounted.
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A couple weeks ago, when uncertainties about then, triple-AAA-rated GE's future were heightened, their debt was being priced lower by the bond market to yield as much as 10% (for the obvious reason that the market was discounting possible ratings cuts). Now that those cuts have been confirmed and GE has been whacked by the rating houses (down to AA+ by S&P, and further down to Aa2 by Moody's), the bond market is expressing its approval of those moves by pricing GE's debt higher than before, thus now offering a lower yield.

Does that make sense?

Well, actually, it does according to observers like Justin Mamis in his The Nature of Risk. There he argues: "Information serves to relieve anxiety". What has happened is the usual trade-off between price-risk and information risk. When investors know less, they are willing to pay less. When investors know more, they are willing to pay more. But this question has to be asked: What is the more that they know now that they couldn't have known then? The impending rating cuts were obvious. The bond market, by its pricing, said so, and comparative work done with yield-curves by a potential investor would have confirmed the "correctness" of that pricing, as well as suggested the correct way to have bet (2) that investing situation.

Have GE's financials materially changed? Has the economy materially changed? Uncertainties about both still abound. The major difference is that before the would-be investor in GE's was being offered a price-discount to assume information-risk. Now that the supposed information-risk has been removed, the price-discount has been removed. Thus, the would-be investor in GE's (or any issuer's) debt has to ask: Which is the better time to buy? When there seems to be information-risk, or when there seems to be price-risk? How each person answers (3) that question is for each to decide.

Charlie
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(1) I do realize the Fed and Treasury's quantitative easings have an explanatory role in how GE's debt is currently being priced, as also the company's own actions to bolster balance sheets by selling assets, etc. But the main point of my tale hold true. "Price-risk vs. information-risk" plays itself out, time and time again, in all markets, because it is people who make markets. How people's hopes, fears, and greeds play out in their financial decision making hasn't changed throughout the centuries that there have been buyers, and sellers, and markets. Then and now, people fear that they don't know enough to make a good decision when, in fact, as much as can be known is already known by how prices are being set. The market discounts information, not always correctly, but that's what markets do: They price information. Understanding how people "price" those prices with their emotions is the insight that market psychology can offer.

(2) All of investing is making bets, one after another, in a disciplined, data-motivated manner about things that can never be fully known. However, the participants in those bets, the human beings on each side of a trade, i.e., the sellers and buyers, are fairly easy to read. This is why the psychology of investors and of investing matters more than the mathematics of investors and of investing, and this is why shrewd, market observers like Justin Mamis and Marty Whitman are worth reading. Each, in his own way, directs attention from what the numbers are to what the numbers mean.

(3) It still takes a 3rd order polynomial to plot a trend-line for a yield curve of GE's debt, instead of the 2nd order that is more typical of a normal yield-curve. And the short-end is very steep for reasons that would need to be explained. But the easy, obvious bargains of past weeks are gone. And whether buying then, or now, makes sense is still a matter of uncertainty that can be reduced, but not resolved, by proper due-diligence (and, of course, proper position-sizing).
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