The Aleph Blog

Social Security Troubles

We have known for many years that Social Security’s Disability Trust Fund was in far worse  shape than the Retirement Trust Fund, which is also not in good shape.  The rolls for Social Security Disability have risen dramatically since 2009, with many applying for disability amid a time where jobs are hard to find.  Personally, I think that people should plan for their own possible disability, and it not be something that the government covers.

That said, the disability trust fund will run out of money in 2016.  The most likely result in my opinion, is that  the disability trust fund will borrow from the the retirement trust fund, accelerating the insolvency of the retirement trust fund, currently scheduled to make a change to payments in 2026, when it has only one year of payments left in the trust fund, and will have to pro-rate all payments, so that the payments will be made from existing tax payments plus assets on hand.  This means that social security retirement and disability payments will be cut by around 27%.

The politics of this is complicated, and I don’t pretend to have an absolute answer to how this will all work out.  My past dealings with these issues indicate that if the problem can be deferred, it will be deferred.   Borrowing from the retirement trust fund ruffles few feathers, and allows politicians 10 years or so of breathing room, after whichthey may have resigned or retired.

At some point in the future the following phrase will be common: “You got what you deserved, because you trusted the government.”  Add in the troubles at Medicare, where the trust fund also will run out before 2020.

If you are relying on Social Security, you are in a bad spot,  Either taxes will be raised, or benefits will be cut, either across-the-board, or selectively.

This will be a fight, as most other things in our government budget are, and there is no telling how it will turn out.  There is only one certain thing: if we had dealt with this 25-35 years ago, we would not be in this pickle now.  Shame on our parents’ generation, and shame on us, if you are over age 35.  More guilt to those who are older.

Redacted Version of the July 2014 FOMC Statement

June 2014July 2014Comments
Information received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months.Information received since the Federal Open Market Committee met in June indicates that growth in economic activity rebounded in the second quarter.This is another overestimate by the FOMC.
Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated.Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources. More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow.Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.No real change

 

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.No change.  Funny that they don’t call their tapering a “restraint.”
Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.Inflation has moved somewhat closer to the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.Finally notes that inflation has risen.  TIPS are showing slightly higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.60%, up 0.14% from June.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.Adds in inflation, also changes measure of the labor market to broaden it from “conditions” to “indicators,” not that that will help much.

They can’t truly affect the labor markets in any effective way.

The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.CPI is at 2.1% now, yoy.  They shade up their view on inflation’s amount and persistence.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month.In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in August, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $10 billion per month rather than $15 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than $20 billion per month.Reduces the purchase rate by $5 billion each on Treasuries and MBS.  No big deal.

 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.No change.  But it has almost no impact on interest rates on the long end, which are rallying into a weakening global economy.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change. Useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetingsNo change.  Says that purchases will likely continue to decline if the economy continues to improve.
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.No change.
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.No change.  Monetary policy is like jazz; we make it up as we go.  Also note that progress can be expected progress – presumably that means looking at the change in forward expectations for inflation, etc.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No change.  Its standards for raising Fed funds are arbitrary.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.Plosser dissents.  Finally someone with a little courage.
 Voting against was Charles I. Plosser who objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.Thank you, Mr. Plosser.  The end to easing is coming, but what will happen when it starts to bite?

 

Comments

  • The two main points of this FOMC statement are: 1)  The Fed recognizes that inflation has risen, and is likely to persist. 2)   Despite lower unemployment levels, labor market conditions are still pretty punk.  Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Markets don’t move much on the news.  Really, not a lot here.
  • Small $10 B/month taper.  Equities and long bonds both rise.  Commodity prices rise.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC needs to chop the “dead wood” out of its statement.  Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do?  I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

Book Review: Surveillance Nation

Surveillance NationAfter I married my wife, I met her cousin and his wife, who was a Marxist.  Oddly, I found we had a lot of areas of agreement, because we both distrusted the powers that be.  In the same manner, what does a libertarian like me have to do with liberals like those who write for “The Nation?”

The answer is a lot.  There is a tendency for the political middle of the US to simply trust the politicians, assuming they are doing good. It is more accurate to assume that they are pursuing the goals of the ek=lite in the US.   The Wealthy will do well; the rest of us, meh.

We  need to be concerned about what data the government gathers on us, because it may infringe upon our constitutional rights.  Personally, I would end the CIA, NSA, and FBI.  Let chaos pursue us, and after that, let’s figure out what security we need.

I do not trust our government.  There is too much power, and too little transparency.

As for this book, it was prescient with respect to the US government collecting data on average citizens.  We live in an era when our actions are no longer private, unless we are rich enough and clever enough to conceal it.

I highly recommend this book.  It points out the errors of the US government as it aims toward secrecy, when it should disclose the information.

Quibbles

As time goes on the arguments verge from arguing for the common man, to arguing for the different man.

Summary

Many people would benefit from this book.  It will teach you about how we are all losing our freedom of speech bit-by-bit.  If you want to, you can buy it here: Surveillance Nation.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

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.

 

The Best of the Aleph Blog, Part 25

In my view, these were my best posts written between February and April 2013:

Wall Street Hates You

I have a saying, “Don’t buy what someone wants to sell you. Buy what you have researched.”

And so I would tell everyone: don’t give brokers discretion over you accounts, and don’t let them convince you to buy unusual bonds, or obscure securities of any sort.  By unusual bonds, I mean structured notes, and eminent men like Joshua Brown and Larry Swedroe encourage the same thing: Don’t buy them.

The Education of a Mortgage Bond Manager, Part III

Why being careful with credit ratings is smart.

The Education of a Mortgage Bond Manager, Part IV

Be wary of odd asset classes; they are odd for a reason.

The Education of a Mortgage Bond Manager, Part V

Where I do odd things in order to serve my client.

The Education of a Mortgage Bond Manager, Part VI

The Education of a Mortgage Bond Manager, Part VII

The Education of a Mortgage Bond Manager, Part IX

Odd stuff, but particularly insightful into some of the perverse dynamics inside investment departments.

The Education of a Mortgage Bond Manager, Part VIII

How I led the successful effort to modify the Maryland Life Insurance Investment Law, and acted for the good of the public.

The Education of a Mortgage Bond Manager, Part X (The End)

Where I explain the odd bits of being portfolio manager, while succeeding with structured bonds amid difficult markets.

Berkshire Hathaway & Variable Annuities

I explain the good, bad, and ugly off of Berkshire Hathaway’s reinsurance deal with CIGNA.

Advice to Two Readers

Where I opine on some Sears bonds, and also on flu pandemic risk at RGA.

What I Would & Would Not Teach College Students About Finance

Mostly, I would teach them to think broadly, and realize the most of the complex investment math is easy to get wrong.

My Theory of Asset Pricing

My replacement for MPT using contingent claims theory.

On Insurance Investing, Part 4

On finding companies with conservative insurance reserving

On Insurance Investing, Part 5

On the squishy stuff, where there are no hard guidelines.

On Time Horizons

People shorten and lengthen their time horizons at the wrong time.

The Education of an Investment Risk Manager, Part IV

On two odd situations inside a life insurance company.

The Education of an Investment Risk Manager, Part V

On how we replaced a manager of managers.

Value Investing Flavors

Explains how there are many ways to do value investing.

Classic: Using Investment Advice, Part 1

Classic: Using Investment Advice, Part 2

Classic: Using Investment Advice, Part 3

Classic: Using Investment Advice, Part 4 [Tread Warily on Media Stock Tips]

Understand yourself, understand the advisor, understand the counsel that is offered, and finally, we wary of what you here through the media, including me.

Classic: Avoid the Dangers of Data-Mining, Part 1

Classic: Avoid the Dangers of Data-Mining, Part 2

There are many ways to torture the data to make it confess what you want to hear.  Avoid that.

Classic: The Fundamentals of Market Tops

Where I explain what conditions are like when market tops are near.

At the Towson University Investment Group’s International Market Summit, Part 5

Where I answer the question: Where does academic theory fail in finance and in economics?

Classic: Separating Weak Holders From the Strong

Classic: Get to Know the Holders’ Hands, Part 1

Classic: Get to Know the Holders’ Hands, Part 2

Articles that explain the fundamental  basis that underlies technical analysis.

Classic: The Long and Short of Trend Investing

How to play trends without getting skinned.

Full Disclosure: long RGA and BRK/B

Of Faith and Markets

Here’s another letter from a reader.  If reading about my faith turns you off, stop reading now, because this will be thicker than usual.

Hi David,

 I’ve just started reading your blog, and greatly enjoy it. I noticed you integrated your faith with your perception of the world and economics/policy. I am a Christian who is attracted to the wonder of the financial markets. So many individuals making so many decisions being affected in so many ways; it can be overwhelming. My question regards how you view financial markets within your faith.

 I was originally going to work at an internship at a hedge fund in 2008. I thought it’d be the dream: making big money! But that summer, when all hell broke lose, the hedge fund closed down before I could even start. Fast forward six years, and I’m working in corporate finance at a non-financial company – nothing to do with the markets. I want to jump back in, but not as a trader. I feel there was some Divine Providence in how I’ve perceived my “close call” with the trading world. I’m currently trying to understand how I can approach careers involving the financial markets that don’t force me to leave my faith at home. How do you approach the world of finance with your faith?

 Thank you so much for taking the time to read this, and God Bless.

 

Dear Friend,

I went through a similar experience early in my Christian walk, because sadly, I ran into some Evangelicals who denigrated earning money – Evangelical Leftists were more common in the late ‘70s.  Thus, I turned against Finance though I was good at it.  My Master’s thesis anticipated price and earnings momentum, and most quantitative long-short equity hedge funds.  Too bad for me; I aimed at doing development work in the Third World.  As it was, when I figured out that development economics tended to inhibit growth, and its opposite encouraged it, I gave up.  I started a career in finance as an actuary.

When I did that, I realized that I must do many things:

Be a good example to those around me.

  • Be friendly and pleasant to my co-workers.
  • Oppose fraudulent practices.
  • Be honest with those with whom I dealt.
  • Apologize when I sin or make mistakes.
  • Avoid bad language.  That not only means foul language, but also cruel language, even if it is technically clean.
  • Work hard.
  • Learn, learn, and learn.  A dirty secret about Evangelical Christians is that we read more than non-Christians, and have more Ph.Ds per capita.  Okay, the Jews have us beat there, and badly.
  • Avoid working on the Lord’s Day [Sunday].
  • Don’t be afraid about using the Bible as an analogy or as an example.  After all, people cite all manner of garbage as authorities, and the Bible is not permitted?  Is it because the Bible claims universal authority that people want to ban it?  Yes, that is why.  No one wants the Owner of the Earth to remind us of His claims.
  • I was always honest with coworkers about my faith in moments where it was natural, but I never beat them over the head with it.
  • Love your coworkers, and those with whom you interact.
  • Avoid investments in companies that have sinful goals — gambling, illicit sex, etc.  Also avoid companies that try to cheat people.

Practically, the most important thing is to be honest, keep your word, aim for competence, and be faithful in your dealings with others.

Any vocation can be pursued in a worldly or Christian way – most of it is the attitude that you bring to it.  “Whatever you do, do it heartily, as unto the Lord.”

One final note: one time, I was given a very hard time by a boss who was under a lot of pressure.  Nominally, I was his assistant, and so the rest of the team was amazed with what he put me through, while I largely kept a good attitude (it was not perfect).  One of my co-workers, a Christian, came to me privately and asked how I was doing.  I said that I was fine.  She knew me well, and said that she was praying for me, and that the entire staff was astounded that I would put up with what the boss was doing.  I told her that he was the boss, under a lot of pressure, and that if I pushed back, it could do a lot of harm to all of us.  I was not doing it for me.

It made an impression on the staff, and though they liked me, when the boss left six weeks later, they chose me to run the unit.  Truth, management above chose me, but without their support and love, I would not have been half the leader that I was.

So, serve for the good of others, and you will succeed.  “Love your neighbor as yourself.” [Lev 19:18]

Sincerely,

 

David

On Returns-Based Style Analysis

Sometime in the next few weeks, I am going to dig into my pre-2003 [pre-RealMoney] files and see if there is anything there to share with readers.  Most of my best stories I have already told in my various series.  The one I will tell tonight I don’t think I have told.

In 1994, we had a problem at Provident Mutual’s Pension Division.  Our main external equity manager was having a very lousy year as value managers that focused on absolute yield were getting taken to the cleaners.  This was after a few years of poor performance — the joke was, given the great performance of the past, “Hey, can you develop the 19-year track record?”  (The last 5 years as a group were horrid, but the previous 14 were great.)

Aside: there aren’t many absolute yield managers in equities today.  Back when dividend yields were higher, and corporate bond yields were higher, both absolute and relative yield managers flourished as interest rates and dividend yields crested in the early 1980s, and the stocks paying high dividends got bid up as interest rates fell, much as the same thing happened to zero coupon and other noncallable long duration bonds.

The process started with a call from a manager of managers who proposed that we start up “multiple manger funds,” where we would be the manager of managers.

This offered several advantages:

  • It offered us an easy out with our long-held failing manager, because we are not firing them, just making them a portion of the assets in the value fund.
  • It would make eliminating them easier in a second step, with less PR damage.
  • It would make us look like we were taking action and control in a new way for our clients. (They loved it.)
  • As it was, we did a good job selecting managers, and the funds performed well.
  • We could negotiate lower fees with the managers,
  • It gave us a great marketing story.
  • Our margins and growth improved.

I was critical to the process, being the only member of the team with investment expertise.  Everyone else was a marketer or the divisional head.  (I take that back, one member of the marketing area was genuinely sharp with investments.)  After we chose the managers, I set the allocations.

Now onto tonight’s topic (what a long intro): At the beginning of our relationship with the manager of managers, they did a traditional holdings-based analysis of how a manager managed assets.  About one year into the process, they introduced returns-based style analysis.

Though the Wikipedia article just cited has a bevy of errors, it will still give you a flavor for what it is.  Let me give my own explanation:

It takes a lot of effort and wisdom to look at quarterly portfolio snapshots and analyze what a manager is doing.  You almost have to be as wise as the manager himself to analyze it, but many fund analysts developed the skill.

But returns-based style analysis offered the holy grail: we can understand what the manager is doing simply by comparing the returns of the manager versus returns on  variety of asset indexes, using constrained multiple regression.

The idea was this: the returns of a manager are equal to his alpha versus a composite index that best fits his performance.  Since we were dealing with long-only managers, the weights on the index components could not be negative.

The practical upshot to the manager of mangers was: “Whoopee!  We can analyze every manager under the sun just by looking at their return patterns.  No more time-consuming work.”

After the first meeting with the manager of managers, I expressed my doubts, and asked for a special meeting with their quants.  A week later, I had a meeting with a few members of their staff, of which one was the quant, a nice lady 10 years my junior, who I felt sorry for.  She started her presentation at a very basic level, and asked “Do you have any questions?”  I asked, “Isn’t this just an quadratic optimization problem where you are choosing weights on the convex hull?”  She paused, and said, “Oh, so you *do* understand this.”  The meeting ended son after that — we agreed on the math, and in math, there is no magic.

But that placed me on the warpath; I genuinely felt the advice we were getting had declined in value.  I wrote a 16-page report to our manager explaining why returns-based style analysis was inferior.

  • There is no way to correctly estimate error bounds, because of nonlinear constraints.  (Note: two years later, I guy came up with an approximate way to do it in an article in the Financial Analysts Journal.  I called him, and we had a great talk.  That said, approximate is approximate, and I haven’t seen any adopt it.)
  • Because many of the indexes are highly correlated with each other, small differences in manager returns make a huge difference in the weight calculated for each index.
  • If a manager is changing investments because he senses a factor like market cap size or valuation is cheap, it will get interpreted as a change in his index, and will not come out as alpha, but as beta.
  • If I don’t believe that the CAPM and MPT are valid, why should I believe this monstrosity?
  • And more… I hope I find my 16-page paper in my files.

After six more months we terminated the manager of managers, and hired a better one.

  • Lower fees
  • Lower fees from managers (they had greater bargaining power)
  • We reduced our fees to clients
  • Better marketing name
  • Holdings based manager analysis

After that, things were much better, and we continued to grow.

My years at Provident Mutual were exceedingly fruitful — this was just one of many areas where my efforts paid off well.

All that said, there is no way to fix returns-based style analysis.  It is a bogus concept and needs to be abandoned.  Those who use it do not grasp the limits of econometrics, and are Sorcerer’s apprentices.

PS — Need I mention that the originator of the idea, Bill Sharpe, is not all that sharp with econometrics?  He’s a bright guy, but it is not his strong suit.

PPS — there are not many actuaries with a background in econometrics.  That is why I have written this.

Balancing Quality Against Valuation

A letter from a reader:

Hi David,

I am XXX, from India. I started reading your blog since few months. Few of the things i learnt, and much more are really complex for me to understand, the learning is ON.

Somehow i decided that ” being good value investor and control the behaviour” is a gift of long practice and learning. So it takes time and for me the learning is still in lower phase. I am in middle of understanding Financial statements.

But before that i want to invest and enjoy the power of compounding. Till now i used Mutual Fund, Fixed Deposit (bank) for my wealth creation. As part of my milestone, i want to go ahead with shares for my Kids education and retirement.

I like to Buy Consumer staples like Nestle india, Gillete India, Glaxo Smith india which are past compounders. Given a India’s Economic growth and Population growth, I foresee these socks can do well. But it is already at very high PE (Nestle – 42, GSk consumer- 39, GSK pharma – 52, Gillette -141). I don’t foresee any panic selling on these stocks. What i will do? how i do buy Quality business with good valuation?

Kindly guide.

thanks for sharing such wonderful posts.

Dear Friend,

You have described the optimal situation: buy businesses that have well-protected boundaries, and buy them cheap.  I wish I could do that.  Everyone would like to do that.

But that is where judgment comes in.  I would rather own cyclical businesses with competent and honest management  teams, than own high growth businesses at very high multiples of earnings.  I would also rather own slow growth businesses at modest multiples of earnings.  Ask yourself: where am I getting a reliable stream of earnings and growth relative to what I am paying for the stock?

In general, with growth stocks, never pay more than 2 times the earnings growth rate  for the P/E of the company.

Often you have to look at companies that are neglected, and I would like to recommend a book to you: Investing in India.  The author avoids highly valued companies in India, and aims to invest in companies that are fair to outside minority, passive shareholders.

Look at more stocks than just the highest quality stocks, and look at the valuation tradeoff between highest quality stocks, and lower quality stocks.  Most value investors accept the lower quality stocks, if their ability to produce value relative to their price is better than that of higher quality stocks.

All that said, part of the question is how long will the high quality stocks have a significant advantage.  In the US, on average, that advantage has not been long.  Maybe things are different in India, but maybe not.  Be careful.  Remember, the cardinal virtue of value investing is having  a margin of safety, not cheapness.

Sincerely,

David

Book Review: Panic, Prosperity, and Progress

PPP I love economic history books, and I believe that most investors should read economic history.  History offers a broader paradigm for analyzing investment situations than mathematical models do.

Mark Twain is overquoted on this, but only because he deserves to be quoted:
“History doesn’t repeat itself, but it does rhyme.”

You can get a lot of insights into the present by reading this book.  So many disasters occurred because people presumed that the future would be much like the past, and they ended up being the ones that took the large losses.

Further, this book will point out that how an asset is held will make a difference in its future performance.  When there is not a lot of debt behind an asset, there may be good prospects.  But when there is a lot of debt behind an asset, prospects are not so good because those that own the asset are relying on the asset to perform.  Those who own an asset free and clear may get hurt if the price falls, but they won’t be ruined like the guy who has borrowed to own it.

This book takes on every major systemic crisis from the Tulip Bubble to the recent Housing/Banking crisis.  This is my bread & butter, but I learned things in many of the chapters regarding things I thought I knew well.  Truly, a great book.

What Could Have Made the Book Better

Financial crises don’t appear out of nowhere.  Leaving aside war on your home soil, plague, famine, communism, etc., there is usually a boom that gives way to a bust.  In some of his chapters, he could have spent more time describing the boom that led to the bust.  This is important, because readers need to learn intuitively that the boom-bust cycle is normal. NORMAL!

Ignore the economists who think they can control the economy.  They can’t do it, and this book helps to say that.  Economists are always behind the curve.  Politicians are even further behind the curve.  Regulators are still further behind the curve, and usually do the wrong thing during crises as a result.

The author could have done more to suggest how individuals and policymakers should respond to financial crises.  Better to have a book that advises us, than one that just reports.

Quibbles

On pages 421-422, he shows that he doesn’t get securitization, and blames the rating agencies, who were forced to rate novel debt for which they did not have a good model because the regulators outsourced credit risk measurement to them.

Summary

Most people would benefit from this book.  It will teach you about financial crises and their aftermath.  If you want to, you can buy it here: Panic, Prosperity, and Progress: Five Centuries of History and the Markets (Wiley Trading) (Hardback) – Common.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

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.

 

Book Review: Reducing the Risk of Black Swans

71e0AKDi3XL This is a very short book. I read the whole thing in 40 minutes.  It has one main idea: what if you could create a less variable portfolio that returns as much as the traditional 60% S&P 500, 40% Barclays Aggregate blend?  Wouldn’t you want that?

Most of us would want that.  I would want earning more at the same level of volatility as the market, but that is another matter.

The authors take us through a variety of backtests, showing us portfolios that did well in the past, if you had invested in them.

They show how investors could have done better by tilting their portfolios toward value socks, small stocks, and international stocks, eventually showing a portfolio invested 60% in 5-year Treasuries, and 40% in stocks that tilt small, value, and international.

Voila! Same returns, with less volatility than the 60% S&P 500, 40% Barclays Aggregate blend.

But there is a catch here.  This is the past being amplified — will the future be the same?  Value stocks are undervalued on average, and small stocks outperform on average, but what if you are in an environment like now, where small stocks are overvalued, value is neutral to undervalued?  Tilt to value, yes, but maybe don’t tilt small.

Also, with yields so low on five-year Treasuries at 1.65%, that should be reflected into the future for the strategy, so maybe the amount of bonds should be reduced?

The biggest weakness that the book has, and this is true of many books, is that it follows a mean-variance framework.  The market is far more volatile than a normal distribution, with crises happening far more frequently than a normal distribution would anticipate.

Quibbles

Investing is not a science; it is an art.  Our principles are vague and subject to many forces beyond our recognition and control.

They make the rookie mistake of describing the calculation of long-term investment returns as a arithmetic mean (Page 16).  Pros do a geometric mean, which calculates the continuously compounded average return of a buy-and hold investor.

On page 18, their explanation of correlation is weak.  That said, even great publications like The Economist have blown that in the past, then using my explanation of correlation verbatim (back in the mid-90s).

Summary

This is a good book as it teaches you to tilt you portfolios to value and small companies on average.  The person who would benefit most from this book is someone who wants to get more out of his investments, but doesn’t want to spend a lot of time on it.  If you want to, you can buy it here: Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

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.

Understanding Insurance Float

Warren Buffett has made such an impression on value investors and insurance investors, that they think that float is magic.  Write insurance, gain float, invest cleverly against the float, and make tons of money.

Now, the insurance industry in general has been a great place to invest, but we need to think about float differently.  Float is composed of two things: claim reserves and premium reserves.

  • Claim reserves are the assets set aside to satisfy all claims that likely will be made as of the current date.
  • Premium reserves are the assets set aside representing prepaid premiums that have not been earned yet.

Claim reserves can be long, short or in-between.  Last night’s article dealt with long claim reserves — asbestos, environmental, etc.  Those reserves can be invested in stocks, real estate, long bonds, etc.  But most claim reserves are pretty short, like a year or so for most personal insurance auto & home claims — those typically get settled in a year.

The there are classes of insurance business that are in-between — workers comp, D&O, E&O, commercial liability, business continuation, etc.  Investing the claim reserves should reflect the length of time it will take until ultimate payoff.

The premium reserves are very short.  If premiums are paid annually, the average period for the premium reserves is half a year.  If premiums are paid more frequently, the average period for the float falls, but the premiums rise disproportionately to reflect the insurance company’s desire to have the full year’s premium on hand.  It usually makes sense for policyholders to pay at the longest period allowed — thus, thinking about premium reserves as having a  duration of half a year on average makes sense.  Except auto — make that a quarter of a year.

Earnings financed by float should be divided into two pieces — non-speculative, and speculative.  The non-speculative returns on float reflect what can be earned by investing in high quality bonds that match the time period over which the float will exist.  Short for premium reserves, longer for claim reserves.  So, the value of float is this:

Present value of (investment earnings of high quality duration-matched assets plus underwriting gains [or minus losses]).

This is a squishy calculation, because we do not know:

  • the number of years to calculate it over
  • future underwriting gains or losses

The speculative earnings from float come from assuming that float will stay at the same levels or grow over many years, and so the insurer invests more aggressively, assuming that float will be a permanent or growing thing.  He speculates by financing stocks or whole businesses using the float that could reduce, or that could become more expensive.

How could that happen? P&C insurance often gets very competitive, and the cost of maintaining float in a soft underwriting environment is considerable.  Also note the claim reserves mean that the company took a loss.  That the company earns something while waiting to pay the loss does not help much.  Far better that there were fewer losses and less float.

Smart P&C insurance companies reduce underwriting in soft markets, and in such a time, float will shrink.  Let aggressive companies undercharge for bad business, and let them choke on it, while we make a little less money.

Well-run insurers let float shrink – they don’t depend on float being the same, much less growing.  If it does grow, great!  But don’t invest assuming it will always be there or grow forever.  That way lies madness.

Berkshire Hathaway has benefited from intelligent underwriting and intelligent investment over a long period.  That is not normal for insurance companies.  That is why it has done so well.  Float is a handmaiden to good results, but not worth the attention paid to it.  After all, all insurance companies have float, but none have done as well as Berkshire Hathaway.  Better you should focus on underwriting earnings rather than float.

Underwriting insurance produces premium float.  Underwriting bad business produces claim reserve float.  Float is not an unmitigated good.  Good underwriting is an unmitigated good.  So focus on underwriting, and not float.

=-=-=-=-=-=-=-=-=-=-=-===-

Berkshire Hathaway has been in the fortunate position of having had wise underwriters, and and ability to expand into new markets for many years.  Guess what, that was AIG up until 2003 or so.  After that, they could not find more profitable markets to underwrite, and results began to deteriorate.  They ran up against the limits of their ecosystem.

Buffett is a brighter man than Greenberg; he can consider a greater realm of possibilities in how to run an insurance conglomerate, and the results have been better.  All that said, there is only so much insurance to underwrite in the world, and big insurers will eventually run out of places to write insurance profitably.

All that said — float is a sideshow.  Focus on profitable underwriting — that is what drives the best insurers.

 

 

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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