I’m fascinated at the degree of hatred for high frequency trading [HFT] among my fellow portfolio managers, particularly those that live in the Baltimore area.  I have my own techniques for dealing with them: discretionary reserve orders, and not trading much.  If you are a longer-term investor, the games that exist in buying and selling in the short-run don’t matter much.  In my opinion, HFT milks short-term traders the most.

But I have my own solution to high frequency trading: revamp all markets such that there is one auction per second in the trading day.  Auctions happen at the top of each second: 9:30:00.000000… 9:30:01.000000… … 16:00:00.000000.  Additionally, orders still standing at the start of any second may not be cancelled for the next second.

Auctions once per second.  Click, click, click, click…  23,401 auctions per day offers more than enough flexibility to buyers and sellers.  No truly economic commerce would be hindered by such an arrangement.

Why would anyone argue with this?  It splits the difference, and brings order to markets where many are presently skeptical of the validity of the markets.

I’m open to other ideas here.  I toss this out as a way of making markets more transparent.  Transparency aids validity, which aids legitimacy, eventually.

Dr. Jeff Miller wrote an interesting question the other day:

“Why does a Shiller disciple care about profit margins?“

Now, I am not a disciple of Dr. Shiller, I disagree with him on many issues, Trills for an example.  When Shiller talks, odds are 50-50 that I agree, which makes him interesting to me, unlike Bernanke and Krugman who I almost always disagree with, and James Grant and Caroline Baum, who I almost always agree with.  Someone who agrees with me and disagrees with me equally is interesting, because he makes me think harder.

And with his cyclically-adjusted price-earnings [CAPE] ratio, I was a reluctant partial convert.  Consider this piece.

There are a couple ways to answer the question:

1. Most stocks are cheap on a forward P/E basis, less so on a trailing P/E basis, and still less so on a P/B or P/S basis.  The difference between P/E and P/S is profit margin — E/S.
2. Consider the critiques from Dr. John Hussman, who awaits the reset that will come if/when profit margins get competed down.
3. My answer: we should care about it a little, for the above reasons.  But labor is no longer scarce, which leads to higher profit margins for a time while wages are depressed.

My view is that profit margins will not revert to mean for many years, until the increase in capitalist labor is absorbed.  Until then economic results will be poor those that labor on the low end — you have got a lot of new competition.

As I wrote earlier:

A reason to consider the validity of the CAPE is twofold: it has a huge similarity to Tobin’s Q-ratio, which compares market capitalization to replacement cost.  It also has a similarity to Michael Alexander’s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).  It’s a Price-to-Adjusted Book value ratio as I see it.

The CAPE has value as a proxy.  It mirrors overall market value pretty well, like other fundamental ratios.

But I don’t agree, at least in part because profit margins should remain high, until readily obtainable labor is less scarce.  Getting there could be a long time.  Profit margins could remain high for a long time as a result, leaving  markets in a limbo zone, where it treads water as underlying value builds.

So profit margins should remain high for now.  Once labor is scarce globally,  and companies must pay more to get more or better quality labor, then will profit margins come under stress.

One of the problems with many politicians, journalists, financial analysts, economists, etc., is that they don’t think systematically.  Go back to late 2006, when I wrote my piece Wrecking Ball Looms for Big Housing Spec, which was regarding the coming subprime crisis.  (Note: my editor often retitled my pieces; my original title was more circumspect.)  Or read my piece in mid-2005 regarding the impending unwind of leverage and prices in residential real estate, Real Estate’s Top Looms.  Both of those are inside the wall at RealMoney.  Apologies if you can’t read them.

At the beginning of the crisis, most economists, including the present Fed Chairman, said that problems ere limited, because they only affected limited areas of the residential real estate market.  Now, part of that response reveals that the Fed and other regulators beneath them had not been doing their jobs, because it is well-known now that underwriting quality of all residential mortgage lending had deteriorated.

When an economic system is overleveraged, with leverage that is layered, such that a domino effect can occur, small failures can have disproportionate results.  It is almost like the economic system during the bull phase self-organizes for the largest possible failure.  (Note: self-organizing systems do not always optimize for the long term.  Think: what other ideas could that invalidate?)

An overlevered residential real estate system had the possibility of a self-reinforcing decline in prices, once prices started declining nationally.  Now we face a still-overlevered residential real estate sector with a lot of the market inverted, where people owe more than the house is worth, though pockets on the low end of prices show recovery in some areas of the US.

Little things are important.  Some people say, “How can Greece pose so much risk to the rest of Europe?  It’s economy is so small relative to the rest of Europe.  Well, that’s where the leverage comes in again.

Core Eurozone banks have lent to Greek entities, and those banks are not well-capitalized.  If Greece left the Eurozone, and repaid loans in depreciated New Drachma, it would lead to a crisis in confidence regarding loans made to Spain, Portugal, and Italy.  The exposure of core Eurozone banks is significant, to the point where it could cause a broader crisis.

Little things are important where the system has been optimized; where something near perfection is needed to insure the proper performance of the over-evolved system where many entities are playing for a slice of the cash flow, and most have over-borrowed, and overpaid.

The optimized scenario is akin to the dominoes being set up, and they are beautiful, but woe betide the one who knocks over a domino.  (Note: as a kid, I would build domino structures, but would leave out every tenth domino, in order to create something where if I made a mistake, only a little would fall down.  The last dominoes were added with the greatest care.)

There are some worries in the US over European exposure.  I don’t think that is likely, except with some of the biggest banks.  Maybe that could spill over, but I doubt it.  If it does spill over, it will prove that the biggest banks should be broken up.  My favored way is to regulate banks like insurers.  You can do business across state lines, but you are tightly regulated by your state.  Much better than what we have currently.

Survivable systems exist when adequate returns are earned without high leverage.  That may sound vague, but vague is often the best we can do in economics.

When debts are complex, aim for simplicity.  Complex systems tend to die.  Simple systems survive.  This is a rule of value investing, measure simplicity versus reward.  Complexity has a price; avoid it unless well compensated for it.

This book has just been released.  I got an early copy.  The book is interesting enough that I would like to do a Q&A with the author, and I have contacted the PR flack to do so.

To the review:

Would you like to understand the mindsets of a variety of successful hedge fund managers?  This book will give that to you, but there is a catch: you will also learn how these managers developed, and this is a big plus.

Most of the managers went through rigorous experiences that made them far more effective at evaluating risk and return potentials.   Have you been through anything similar to that?  If not, you might read this very interesting set of accounts, but then realize that you don’t have the personality/skills necessary to replicate what they have done.  Don’t feel bad, most people don’t have that.

A large part of what makes hedge fund managers successful is their willingness to limit their activity to areas where they have genuine expertise.  They gain insight beyond most into areas where they are experts in discerning value.

This book does not give you a formula for how to make money; instead, it gives you lessons in the characters of those that have made a lot of money for themselves and their clients.  What are they like?

Among their many attributes, they are:

• Driven/competitive — though I have known my share of failures in investing that have that attribute.
• Lifelong learners, like Buffett and Munger — though I have known some really bright people who know a lot about investing/finance who add little to an investment process.
• Opportunistic — they recognize what their best opportunities are, and pursue them to the exclusion of others.
• Focused — they develop an edge, and try to be “best in class,” whether in mathematics of the markets, understanding the legal rights of different types of securities, understanding industry dynamics, accounting nuances, etc.
• Patient — if opportunities are not promising, don’t do much.  It’s like being an intelligent underwriter — when your competitors are giving away the store, don’t write business, spend time sharpening your skills.  Study what could go wrong, and see if there is a way to take advantage of the situation.
• Team-builders — They develop talented teams/cultures and motivate them to excellence.
• Sensible — They know when to be doggedly persistent, and know when to admit defeat.

Now, no hedge fund manager has all of these, but the best have most of them.

Contents

The book covers nine managers/firms:

1. Ray Dalio — Bridgewater
2. Pierre LaGrange & Tim Wong — MAN Group / AHL
3. John Paulson — Paulson & Co.
4. Marc Lasry and Sonia Gardner — Avenue Capital Group
5. David Tepper — Appaloosa Management
6. William A. Ackman — Pershing Square Capital Management
7. Daniel Loeb — Third Point
8. James Chanos — Kynikos Associates LP
9. Boaz Weinstein, Saba Capital Management

About the Author

Her name is Maneet Ahuja, and is a producer for CNBC, specializing in covering hedge funds.  That’s how she gained the contacts in order to write the book.  Business Insider did a profile on her, and you can find it here.

Quibbles

The book needs something to tie it together and give it depth, otherwise the book is only “Meet these nine nifty hedge fund managers that I have gotten to know.”  That’s a serious deficiency; even a single chapter at the front or back would have enriched the book, making it more general and cohesive.

I also think there would have been better choices for those that wrote the foreword (Mohamed El-Erian) and the afterword (Myron Scholes).  The former is an accomplished investor, but is not an expert on hedge funds.  Myron Scholes is an accomplished academic, has worked for hedge funds, but is still not an expert on them.

Who would benefit from this book: If you want to learn about what type of people these nine hedge fund managers are, and read anecdotes about some of their best and worst trades, this would be a book you would enjoy.  If you want to, you can buy the book here: The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds.

Full disclosure: The book was sent to me out of the blue; did not ask for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

So, what do I write about at the Aleph Blog?  I write about a lot of things.  That’s a strength, and a weakness.  A weakness, because not everyone cares about a lot of things and if I shift to cover an area that is unusual, readers may not care.

It’s a strength, in the same sense that most of the best athletes could do well at a wide number of games.  I follow a wide number of themes in the financial markets and economics.  I like to think that I bring more perspective to a wide umber of issues because:

• I have been trained in neoclassical economic theory, and I reject it.
• I have been trained in modern portfolio theory, and I reject it.
• I’ve worked in most areas of the financial markets, and have seen similar events happen in different markets.
• I have quantitative skills, but I have spent a lot of time of economic history.
• Having practiced as an actuary, I have additional skills analyzing liability structures, which are underanalyzed.

My perspective is different.  I don’t expect you to agree with me, because some of my views are “out there,” and I know that when I write it.  I sometimes write things knowing that there is no way that these will be adopted, absent major changes to society.  I write those, knowing that radical change is not impossible, and when change happens, they will need sensible guidelines.

So what have I written about?  From my categories:

I write about economics, stocks and bonds. That’s me.  I want to describe what is going on and how it affects those holding fixed claims (bonds), and variable claims (stocks).

After that, I write about portfolio management and value investing — how do we manage the assets that we own?

The next group is the guts of the market: how does government and Fed policy affect things?  How do insurance, real estate, and derivatives affect our lives?

Beyond those, I write about many things, and I appreciate that you read me.  Your time is valuable; thanks for reading me.

My Performance

My greatest fear when starting up my firm was that after having a great 10-year run with my own assets (and for an employer), that I would go cold when I started managing assets for others.  That is what has happened, with underperformance of 9%+ versus the S&P 500 over the last 16 months.  This is my worst sustained performance over the last 20 years.

I don’t think my methods are poor, nor am I planning on changing.  Every investment method goes through dry times; I have to live through this.

So what will I do?  I will persist in the strategies that have done so well for me  over the last 20 years.  I will continue to do value investing.

I don’t know that it will work, but I think it will.  Value investing is the reliable weak signal amid a lot of investment noise.

And so I act and invest.  My time is coming, and thanks for reading me.

Eurozone

• If Greece Quits Euro, Its Ruin Will Be Pointless http://t.co/2DotggME Suggests Greece will face more pain if leaves E-zone than stays $$ May 17, 2012
• Experts Try to Chart Path for Exit From Currency http://t.co/dtIAoo3g Let’s see, where is that manual for unscrambling eggs? Mmm… $$ May 17, 2012
• On the E-zone: the politicians, like sorcerer’s apprentices, thought they could reshape Europe; end up fighting forces beyond their power $$ May 17, 2012
• The Running of the Bank Depositors http://t.co/WC7aN5LP Governments r smaller than economies, which r smaller than cultures $$ #fightgravity May 17, 2012
• Governments are smaller than economies, which are smaller than cultures.  The Eurozone is a huge experiment that igno… http://t.co/YUqGTSLN May 17, 2012
• Greek President Told Banks Anxious as Deposits Pulled http://t.co/mx5626V2 If u thot u faced a conversion 2 new drachmas, ud w/d euros2 $$ May 16, 2012
• ECB Said to Stick to Current Crisis Stance as Tools Reviewed http://t.co/vSKBTnax No worries; ECB policies r meeting the challenge $$ May 16, 2012
• Bet on Greek Bonds Paid Off for ‘Vulture Fund’ http://t.co/nrka09y7 While Greece is in disarray, makes full pmt2 hedge fund Dart Management May 15, 2012
• Lightning Strike Delays Hollande Trip http://t.co/G0hgIGsP Weird, but he gets to Germany anyway to have a disagreement w/Merkel $$ May 15, 2012
• Hazardous Greek-Exit Scenario http://t.co/LZooTMlf WSJ goes through the steps and effects of an orderly Greek exit, should there b1 $$ May 15, 2012
• European Officials Warn Greece http://t.co/WJ4Wmk5B No way to kick Greece out; what do you do if they refuse to pay? $$ #enduredefault May 14, 2012

Rest of the World

• Hugo Chávez’s Enemy No. 1 http://t.co/LtdZXcM7 Henrique Capriles, governor of Miranda state & candidate selected by the united opposition May 19, 2012
• Kolatch Bullish on Argentina’s Debt http://t.co/8dfUoRdv When someone is willing to cheat others, he is more likely to cheat you $$ #FTL May 17, 2012
• Iranian Rapper Fears for His Life After Fatwa http://t.co/AD27SHZY Interesting how killing ceases 2b murder after cleric issues fatwa $$ May 16, 2012

Bond Markets

• US insurers seek $300 mln cat bond cover http://t.co/rNw0b4hu There’s a hard property reinsurance market, so alternatives r attractive $$ May 18, 2012
• Junk-Debt ETFs Set Markets ’Abuzz’ After Record Trades http://t.co/Zzq4BHV2 New ways of putting biggish HY positions on/off quietly $$ May 18, 2012
• @Fullcarry @munilass At least the Treasury yield curve is “out of this world.” Have long Tsys on as a hedge in my bond strat, when2punt? $$ May 17, 2012
• Every two years, the annual shareholder filing for the iShares Trust, which holds the big bond ETFs, doubles in size: now 20MB $$ May 15, 2012
• RT @Munisrgood: @munilass More room to go. If you subscribe to Hoisington’s predictions, (I do to an extent) 30 yr tsy could be 75-100 l … May 15, 2012
• +1 Needle in red zone $$ RT @groditi: HY CEF wavg premium 15%; min -8.27 max 67.3%; +1.1stdevs; sample-size: $11B (40 funds) #YieldChase May 14, 2012
• Euro-Zone Fears Drive Bund Yield to Record Low http://t.co/sNntlOYU Opposite risk: Germany might leave EZone; ECB actions disliked $$ May 14, 2012
• Euro Officials Begin to Weigh Greek Exit as Euro Weakens http://t.co/nERx6dAG Note the shift, indicates the bailouts may b over 4Greece $$ May 14, 2012

Elderly Poverty

• See pg 26 4 details http://t.co/NnS2Jyo2 Figure is low IMO b/c 25% “don’t know” what they have saved. They r prob below $50K, so ~60% <$50K May 17, 2012
• Report says “Overall, slightly more than one-third have saved less than $50,000.” http://t.co/NnS2Jyo2 Still thought the % was higher, ~50% May 17, 2012
• Same here RT @ballenmo: @AlephBlog @fundmyfund 20%? I’m surprised the number is so low. May 17, 2012
• +1 that’s what I think RT @fundmyfund: @AlephBlog 20% of 50 and 60 yr old dont have 50K to their name, not to mention saved for retirement May 17, 2012
• Expected worse RT @MoneyMag_Penny 20% of workers in 50s & 60s have saved less than $50,000 for retirement: Transmerica http://t.co/PqWIm74w May 17, 2012

JP Morgan

• Lawrence Lindsey: Why Washington Hates Jamie Dimon http://t.co/dZEzVnOq Not a diplomat & does not perform kowtows to politicians $$ $JPM May 18, 2012
• For JP Morgan Trader, From ‘Caveman’ to ‘Whale’ http://t.co/U2iXH2uJ It is often dangerous to win, next step is try to win big & fail $$ May 17, 2012
• Romney Vowing Dodd-Frank Repeal Hits JPMorgan Risky Trades http://t.co/Y9aMyHR0 Tough sell; existing law had enuf pwr, but regs didn’t use May 14, 2012
• The core problems with JPMorgan’s failed trades http://t.co/HktxLRnq When that illiquid, putting positions into runoff only solution $$ May 14, 2012
• Dimon Fortress Breached as Push From Hedging to Betting Blows Up http://t.co/Rc5TXU9E $JPM too big relative 2market; hard2mark prices $$ May 14, 2012
• Bank Order Led to Losing Trades http://t.co/00llzrIO $JPM ‘s Efforts2Shield Itself From European Market Fallout Prompted Disastrous Bets May 12, 2012

Buffett & Newspapers

• Why Warren Buffett is buying newspapers http://t.co/a6qVZAet It certainly isn’t for economic reasons; he overpaid, plain & simple. $$ $BRK.B May 18, 2012
• Warren Buffett buys into ‘declining’ newspapers http://t.co/BYmAmiZT $MEG does have TV and data businesses, not sure how much that helps. May 17, 2012
• Berkshire Buys Media General Newspapers for $142 Million http://t.co/ISIniNZG add in a $400 million term loan with an rate of 10.5% $$ May 17, 2012

(As an aside, if you read any of my comments on Buffett, newspapers, and Media General, I made the mistake of think that he had bought Media General, when he bought most of their newspapers, a portion of the company, and lent them $400 million at 10.5% with a first priority of payment in bankruptcy.  Now that I realize my mistake, I can’t say whether Buffett got a good, bad, or indifferent deal.  Apologies for the mistake.)

US Economy

• ‘One Recession Away’ From Next Bull Market – John Mauldin http://t.co/WwOL8nj7 5 min interview, short-term bearish, long-term bullish $$ May 17, 2012
• Paul Krugman’s Simple — or Is It Simplistic? — Reasoning http://t.co/0lmcAVSQ Is there any level of govt spending or debt that is2much? May 17, 2012
• North Dakota Tops US States in Credit Ranking as Florida Rises http://t.co/cttmsatF Amazing what energy & the influx of elderly will do $$ May 17, 2012
• North Dakota Tops Alaska in Oil Output http://t.co/Ulo7jzcU The US potentially has more hydrocarbons than Saudi Arabia. TX, ND, AK $$ May 17, 2012
• RE: @bloombergview The two papers look pretty good, but would the bureaucracy have the guts to rein in a boom based o… http://t.co/mvScOD74 May 16, 2012
• Tom Frost: The Big Danger With Big Banks http://t.co/414ZAkTV Fine, but it was mortgage lending that led the crisis, not invt banking $$ May 16, 2012
• When I used to mix sound, there was a knob on my board called “contour.” That’s what QE is to the Fed.  When I would … http://t.co/DC0O0kjS May 17, 2012
• Midwest Sees a Sand Rush http://t.co/815yYdBQ Fracking Spurs Demand for the Stuff, Sparking a Mining Boom—& Vexing Some #midwestboom $$ May 14, 2012

US Politics, Regulation, and Culture

• SEC Probes Role of Hedge Fund in CDOs http://t.co/wMUFuoPt Don’t forget the blame due the yield hogs 4 their inadequate due diligence $$ May 17, 2012
• Dental Abuse Seen Driven by Private Equity Investments http://t.co/QzEb161T Long article on unscrupulous dentists that harm poor kids 4 $$ May 17, 2012
• The creeping disaster for USPS is that as they cut services, they become irrelevant. The internet changes everything… http://t.co/ION20cep May 17, 2012
• School-Test Backlash Grows http://t.co/RIiaRg1Z Some Parents, Teachers & Boards Rebel, Saying Education Is Being Stifled $$ #room4both May 16, 2012
• Please apply the same logic to the liberal justices of the court, who have flouted the Constitution for far longer. http://t.co/gEsZGazC May 16, 2012
• Jerry Brown vs. Chris Christie http://t.co/T0uyb6iC More states r realizing that the road2fiscal hell is paved w/progressive intentions May 15, 2012
• California Deficit Swells to $16 Billion, Governor Says http://t.co/LJT9Dl1s & http://t.co/2Rg8E98K CA in self-reinforcing neg spiral $$ May 14, 2012
• Obama Hits Romney on Bain as He Raises Wall Street Money http://t.co/09M2hhHK “The pot calls the kettle black.” $$ (has 2ba better phrase) May 14, 2012
• Midnight Was Movie Hour, Nap Time in New York Air Tower http://t.co/cNT0C080 Long piece; parts of the FAA r seriously messed up $$ #unions May 12, 2012
• Trouble in Coal Country for Obama http://t.co/dJoko2Aj If persists, could mean Obama wins popvote, Romney win the election $$ #kingcoal May 12, 2012

Companies

• Tsst… $COP is no longer in the refining biz, it spun of $PSX which is.  FD: +COP, +PSX $$ Oh, and selling the comp… http://t.co/LxFTP91s May 17, 2012
• Facebook ($FB) announces that they will no longer accept General Motors ($GM) cars in exchange 4 advertising exposure $$ #lamejoke May 15, 2012
• Avon Shares Tumble After Coty Pulls Bid http://t.co/SVZ4zZgN Coty might b better off creating the parts of $AVP it wants organically $$ May 15, 2012
• Margin Call: The Most Exposed http://t.co/4v2IsU16 Interesting what CEOs have borrowed against shares of the companies that they run $$ May 15, 2012
• Yahoo CEO’s resignation spotlights tech action http://t.co/mUF19hRa We keep the board of $YHOO around 2make that of $HPQ happy. FD +HPQ May 14, 2012

Miscellaneous

• Paper Plane Champ Watches His Record Fly, Fly Away http://t.co/zdPMR62e Division of labor in design & tossing-> paper airplane record $$ May 18, 2012
• @ReformedBroker You really had lunch w/Mauldin? Cool, I know he is friends w/ @ritholtz ; I just reviewed his recent “Little Book.” $$ May 17, 2012
• When people get 2 deep into a sliver of knowledge, they get dumb RT @jasonzweigwsj: is your sense of self an illusion? http://t.co/PHUXLmdB May 17, 2012
• 5. They sometimes bring specialized knowledge of the topic at hand. 6. They tend to write for users, not reviewers o… http://t.co/T3oElbxQ May 17, 2012
• Going for Gold—or Whatever http://t.co/F6kSto8O Secret to an Aging Olympian’s Endurance: Don’t Let Training Get in the Way of Fun $$ May 16, 2012
• When you show up DD, you usually make me smile $$ RT @DoubleDeuce: Wisdom: “try to convince, don’t gripe” by @AlephBlog http://t.co/kDwSKgYJ May 15, 2012
• ‘Trigger-Happy’ Investors Boost IPO Insurance Through Litigation http://t.co/GQKdNia3 Looks like Errors & Omissions coverage applied 2IPOs May 14, 2012

Two years ago, I was at a board meeting for a nonprofit that I serve, and during a break, one of the older gentlemen made a statement that the big problem with America is that we don’t make anything anymore.  I suggested to him that many services enhance and replace the need for some goods.

Now, I don’t have a Facebook account, and I have no intent of getting one.  But I must have been thinking about Facebook as an investment, because I asked him, “What about something like Facebook then?  Doesn’t that have value?  It’s profitable, and current estimates say it might be worth $25-50 billion dollars.”  He replied that Facebook was emblematic of what was wrong with our economy, because it doesn’t produce anything, and consumes a lot of productive time in the process.  I had to call the meeting back to order, so I had to leave it there.

Today, with the Facebook IPO, I heard on the radio a number of times, “We don’t make anything anymore.”  From politicians, “We need manufacturing jobs.”  When Governor Martin O’Malley spoke to the Baltimore CFA Society two weeks ago, he sounded the theme of manufacturing jobs as well.  Afterward, I spoke with a Deputy Secretary at the Maryland Department of Business & Economic Development, and in passing mentioned that I owned part of a manufacturer operating in Maryland.  He asked me for the name, and when I mentioned it, he said, ‘I visited there two weeks ago.  Great firm!”

I know it is a great firm, but I also know that it costs Maryland and the Federal Government to encourage manufacturing.  I see the pro-rata deductions on my personal taxes, and wonder at why we care so much about manufacturing.

When I go places with my kids, I sometimes point out to them business parks where light industrial work goes on.  We are very good today at hiding where things get made, and so people think that factories don’t exist.  We have ordinances on noise, pollution, etc., and most of these entities have moved outside the big cities where the land values are cheaper.

So part of my answer here is that we are still making things here in America.  We just don’t notice it.

America is an amazing place.  The breadth of resources that can be extracted, the crops that are grown, the amazing division of labor, the level of technological innovation, and the relative degree of freedom to pursue any of these is astounding.

We make a lot of things.  We just do it with far fewer people than we used to.

And that is the great increase in manufacturing productivity. We don’t need as many people to makes things as we used to.  That’s a good thing, so people can be released to more productive uses.

Labor productivity is a squishy thing, though.  Measuring labor productivity in manufacturing is relatively easy, because the output and its value is easily measured.

With services, the same calculation can be done: output/revenue per worker, but it doesn’t have the same punch, because goods produced have mostly the same quality, but the quality of services varies widely.

But maybe we can look at this a different way.  Even though it is not easily measurable, what if the right thing to value is not production, but happiness, health, or freedom?

Services provide value, or people would not pay for them.  Facebook exists because it allows people flexibility and facility of communicating with many people.  It makes money from ads that are targeted off of data collected from users.

Many people like using Facebook.  It is a large part of their lives.  For most it is not a part of their work, but a part of their recreation.  Recreation is valuable, and people use their extra time as suits them best.  Keeping “friends” informed on what you are doing and thinking has subjective value to those who do it.

Services make life easier, and sometimes make manufacturing more productive.  The consultant that reviews a factory’s activities, and submits a report to enhance productivity did not make anything, but made producing things less expensive.

Having more people employed in services is not a weakness.  As productivity increases, we need fewer people for extraction and production, and this is true globally.  Manufacturing employment is falling globally.  So is agricultural employment.  As a result, we have many people available to tailor services that make our lives richer.  We don’t just need goods; we need help.  In that way, the service economy is not a waste, but closer to what we need than “goods.”

I know this is not erudite, complete, whatever.  I am comfortable (absent major war), that the “lack of manufacturing” in America is not true, and even if true, is not a problem.  So relax, and enjoy the good life you have in America, with all the help that is available at a price.

It was late 1993, and I knew that we could make a lot of money if I sold floating-rate Guaranteed Investment Contracts.  Let me quote an earlier piece:

My goal as an actuarial businessman was to make profits with modest risk for my ultimate owners, who were the mutual policyholders.  Once I faced a situation where there might be easy profits — writing floating rate GICs.  So, I went to my models and tried to figure out how we could make money safely while our interest rates would shift every three months.  I came to the conclusion that there was no safe way to do so, and so I walked into the office of my boss and told him so.  He surprised me by supporting my thesis, and in his usual back-of-the-envelope way, explained to me in a few minutes why it had to be so.

A few weeks later, he informed me that an actuary from Goldman Sachs (yes), would be dropping by to tell about one of their new derivative contracts that would enable us to write floating rate GICs profitably.  The meeting day came, and I validated the expectations of my boss.  The year was 1993.  I asked the actuary from Goldman what happens if the yield curve inverts.  He answered honestly, “This strategy blows up when the yield curve inverts.”  Score a small victory for me.  I gave myself points for avoiding trendy bad ideas.  Over the next twelve months, two major insurers and one investment bank would announce billion-dollar blowups from following that strategy.

After the blowups, I went back to the buyers of floating-rate GICs, and asked them if they would accept a lower spread over LIBOR.  The response was a firm “no.”  So much for that market.

Those few players in that market had mispriced the risk.  Is it any surprise that they got a lot of volume?

Here’s another example:

Two years after that, I was at the Society of Actuaries annual meeting, where I met a well-known actuary who had worked inside the corporate actuarial area of the Equitable during the critical years.  I.e., he watched and analyzed the assets and the liabilities as they arose.  The conversation went something like this:

David: What was it like working inside the Equitable during that period of fast growth?

Corporate Actuary: It was amazing.  It took everything we could do to stay on top of it, and still we fell behind.

D: Didn’t you think that perhaps you were offering guaranteed rates that were too attractive?

C: We wondered about it, but with money coming in, everyone felt great about the growth.  We simply had to find ways to productively deploy all of the cash flow.

D: But wait.  Didn’t the investment department have a difficult time investing all of the proceeds?  With that much money coming in, the likelihood of making severe errors would be high.

C: Were you a bug on the wall at our meetings?  Yes, that is exactly what happened.  The money came in faster than we could invest it prudently.

D: Wow.  I thought that was what happened, but it amazes me to hear it confirmed.

They offered free options, and surprise, investors took them up on them.  They couldn’t make enough to fund the promises, and undertook a risky strategy in the late 80s that I called “double or nothing.”  The strategy failed, and they almost went broke, except that AXA bought them, pumped in a little capital, and then the real estate market turned.

What’s my point here?  Twofold: one, rapid growth in financial institutions is rarely a good thing; it usually means that an error has been made.  Two, there is a barrier in many financial decisions, where responsible parties are loath to cry foul until it is way past obvious, because the cost of being wrong is high.

Long Term Capital Management became large relative to the markets that they “arbitraged.”  Anytime you can feel yourself moving the market, it is time to stop.

There was a correlation crisis in the CDO market in 2005.  For those with access to RealMoney, I wrote about it here.  Some quants with clever ideas, much like the current JPM fiasco, thought that they could hedge mezzanine against subordinated.  True when the trade is small, wrong when the trade is big.

Beyond that, we have the brain-dead example of AIG.  They dominated the market for AAA subprime mortgage insurance.  It was free money, until it wasn’t.  If you have a large share of a market where there are no barriers to entry, you should stop and ask why you are the only smart one.

The problem with becoming large relative to the market, is that you begin distorting the price signals of the market.  If you have a large long position and the price starts to fall, it is easy to justify purchases, because your internal model indicates that it is cheap.  But every model has weaknesses, consider the examples listed above.  Anytime you get a large fraction of the market’s volume, you should stop, and re-evaluate.  You’re probably doing something wrong.

Markets by their nature invite diversity, and do not admit anyone to dominate them except under abnormal circumstances.

So, if you find yourself growing large relative to your market, calm down, and re-evaluate your positions, before they get large enough to bite you.

There will be elderly poor.  Look at page 26 of this PDF.  I interpret those that don’t know or declined as being well below $50K in assets.  That means 60% of those reaching “retirement age” will have less than two years income stored up.

That said I feel more sorry for younger workers who have to pay high amounts into Social Security/Medicare, and they will not get out of program what they put in.  There’s a longish article here, excerpting from a recently released book on the topic.  In general, the older you are, the sweeter the deal was for those who received payments from Social Security, at least until 2026 when benefits will be cut by 25%, or taxes raised.

What this means is that in aggregate, Americans don’t save enough, particularly the Baby Boomers, of which I am one, but not a negligent one.

We are heading for elderly poverty/work for a large portion of Americans.  I suspect that many older people will continue to work, solving their problem but taking jobs from those who are younger.

This should be no surprise.  Incomes should be declining for lower skilled people in the US, because there are more people who can do that work abroad.  My advice to all readers is to make sure you cannot be obsoleted by foreigners.

One more note: don’t expect the asset markets to bail you out.  Returns to financial assets will do poorly as so many begin to sell them to pay for living expenses, whether directly as individuals, or indirectly as defined benefit plans pay retirement benefits.

This is on top of the problem that when high-quality long interest rates are so low, it is typically a bad time to try to make money in financial assets, because returns on risky assets are typically only 0-2% percent higher than the yield on long BBB/Baa debt over the long run.

All for now…

May is a tough month for me, because I have to submit reports for the nonprofits that I work with, and this year is worse, because I have a moderate injury that I need  to see a doctor about, but can’t until next week, because of the schedule.

But I do want to say a few things about the JP Morgan news.  First, JP Morgan should be broken up, whether state by state, or by Federal reserve district, with an investment bank spun off as well.

Second, after we have been through 2008, why do we care about a piddling $2Billion+ loss?  JP Morgan’s balance sheet can handle far more than that, and come back kicking.

Third, there are a lot of people who are mindlessly asking for the reinstatement of Glass-Stegall, without realizing that the repeal had little to do with the crisis.  Most of the losses at banks sprang from bad lending on residential mortgages, not trading.  Also, if regulators had been more fastidious about asset quality and leverage, it also might not have happened, but who dares to oppose a boom?

My point of view is that states are better at regulating financials than the federal government.  It is far harder to co-opt 50 regulators than one.

Decentralized government, where power is limited, is far harder to corrupt than centralized governments like India, China, Russia, Greece, etc.

Fourth, when a bank engages in a complex trade, and is a large portion of the market, it is asking for trouble.  Companies have problems when they become the market for financial promises.  Markets work well when there are a large number of players, with no one dominating.  Financial markets with a dominant player have a problem because it becomes difficult for the dominant player to discern the right price.  They don’t want to set it too low, because it makes their own financials look bad.  That skewed incentive can harm economic truth, and the company as well.

Being a monopolist or an oligopolist is not as easy as the textbooks would say, at least for long-term transactions.  When there is no free market to validate your pricing against, how does an oligopolist come up with an economic price?  It can’t do so.

We get on shaky ground when anyone becomes dominant in a market of promises.  Initially the accounting is flexible enough that losses do not occur on bad lending, but eventually the bad/negative net cash flows crush the firm.  This is why I never invest in novel financial companies.