The Aleph Blog

For public companies in the US, what is the breakdown by state and then by sector, as measured by market capitalization:

Quite a graph.  Some states are like the US Average Sector mix, and some are very different. This set of two graphs will tell the story:

These are broad generalizations, but why are do some states have a set of publicly traded companies like or unlike the national average?

• Larger states tend to have larger cities, which nurture more diverse business ecosystems.
• States with notable educational institutions tend to produce more diverse business ecosystems.
• Some state cultures are more entrepreneurial, and tend to produce more diverse business ecosystems.
• Some states, because of the natural resources that they were endowed with, tend to have more companies in the area of the resources involved.  That seems to be especially true when it comes to the energy sector, which explains Wyoming, Oklahoma, and Texas.
• Much can be blamed on historical accident.  Why should Delaware have DuPont, except that that is where the founder lived and worked.
• Or, why should Nebraska be so big in financials?  Who could have expected 40 years ago that Warren Buffett’s Berkshire Hathaway would prosper so much, and that Warren would not move the business to a larger city?  But Buffett believed that it was an advantage to be away from Wall Street; it aids in independence of thought.
• That retailing marvel, Dillard’s Wal-Mart, is based in Bentonville, Arkansas, because the founder started it there.  Again, he could have moved, but the initial genius of Wal-Mart was focusing on under-served rural areas, without attracting competition from larger retailers.  Then when their purchasing power exceeded that of the legacy retailers, they competed against them directly in the major cities.
• To toss out one more, Green Mountain Coffee Roasters is based in Vermont, far from where coffee is grown, but that is where the company started, and the culture of the state that they initially served, Vermont,  helped shape the company that it became.
• The utility industry is space-limited, and is mostly regulated by the states, at least in terms of delivery to local clients.  Thus a state like New Mexico has PNM Resources, which mostly provides electricity and natural gas in New Mexico and Texas.  Similarly, North Dakota has MDU Resources which serves North Dakota, and parts of South Dakota, Wyoming and Montana.  Same for South Dakota, with Northwestern Corp, and Black Hills Corp.
• Then there are network effects, sometimes aided by regulation.  Nevada has the lion’s share of the gambling industry.  Regulation allowed for it, but once it got started, it became a destination for it, fixing it the minds of those that like to gamble.  Even as gambling regulations have declined in many states, it would be very difficult to dislodge Nevada’s first mover advantage.  The same logic applies to Wall Street, though New York State has a diverse economy.

Disclaimer and Summary

Now, remember the limitations here.  Private companies are equally important in the US, and so is the non-profit sector.  The reason that I work with the publicly traded companies, is that the data is readily available, and there is an easy summary statistic that is a proxy of the long-term value of the firm, equity market capitalization.  Maybe I should have used enterprise value, but I think that would have given undue weight to financials.

There are other ways to define value to society, each with its own set of flaws and data dirtiness problems.  This is just one simple way of trying to show the diversity of business in the US, segmented by sector and state.

One final note: I had to have a size cutoff in my study.  I used companies that had a market cap greater than $125 million on 2 September 2010.

More to come in Part 2.

Does it matter who controls the businesses of the country?  Does it matter who regulates the businesses of the economy?  Should these people be smart or dumb?

One cost of the meddling that the Fed and Treasury have done through the bailouts is that dumb people are left in place.  People who mismanaged their firms still manage them, and regulators that misregulated are still in their jobs.  Both are rescued by taxpayer largess, but it reveals another hidden cost of bailouts — they make us less competitive/effective as a nation, because we do not let  firms fail, and we don’t fire regulators that were negligent, including the Fed.

The optimal outcome would be for bright managers to buy failed firms out of bankruptcy, and for failed regulators to be replaced with new ones that have a chance of doing things differently.  Aside from that, if you never fire regulators for failure, you will never motivate them to do what is right.

And this is true of most meddling by the Fed or the Treasury, picking favorites, not letting bad firms or regulators fail.  This extends to QE.  If you need lower rates in order to survive, you probably don’t deserve to.  All a lower rate structure does, if the government or Fed is forcing it, is encourage investment in lower yielding investments, because they can be financed cheaply for now.  This is an aspect of the liquidity trap, and the Fed is deepening it with their policies.

Remember, there is no evidence that QE works.  It has not helped Japan; it may have harmed Japan.

What I have found interesting over the last week are the number of discordant voices that are not in favor of QE or fiscal stimulus.  Here are some examples:

• Consider what John Taylor and Richard Berner have to say in this article.
• Listen to what Trichet has to say about government debt.  He says that the failure to cut debt has led to Japan’s malaise.
• David Goldman questions QE here, suggesting that the US will fare worse with that strategy than Japan.
• Or consider Raghuram Rajan, who in this article argues that low rates encourage speculation in risky assets, which may not result in growth in the long run, which is similar to the arguments of Fed dissenter Thomas Hoenig, who is also cited in the article, and me .  The difference that I have with Hoenig is that the economy is not strong here, and he thinks things are pretty good.  Hoenig thinks that low rates are hindering growth because banks sit back and make risk-free profits lending to the Treasury, and I agree with that.  It would be more stimulative of private sector lending to raise Fed funds to 1.5%, because then banks could not make money in Treasuries without taking a lot of interest rate risk.  They would have to go out and make real loans, or shrink their balance sheets.  Either would be good.
• For an odd pro-QE view, Thomas Palley argues something complex, suggesting that Fed funds should be raised to promote saving and restrain speculation, while QE should be used to depress mortgage rates and state general obligation bonds.  I disagree, because we have too many houses, and state governments are too large now, having grown fat on the rising revenues generated by the credit bubble.  But do you see how when the QE genie is let out of the bottle, every special interest lines up to plead for the investment?  Bad enough that we have fiscal policy playing favorites for indebted homeowners at the expense of renters and those who own free and clear, but to make it a permanent part of monetary policy is foolish; it just creates a glut of homes, with marginal borrowers.

But consider Japan, which has not given up on QE, not because it works, but because they can’t think of an alternative.  It’s not as if there is a lot of demand for loans in Japan, but the Bank of Japan boosts a loan program anyway in the political season.

It makes me think that both Japan and the US have a comeuppance coming.  One cannot borrow forever without a bad result occurring, whether that be default, inflation, or high taxes.  But, in the short run, that game can go on with the politically connected disproportionately benefiting.  Though not on QE, this article from the Washington Post highlights the huge increase in Federal spending, and mentions in passing the huge benefits to DC, Virginia, and Maryland.  Yes, the benefits flow unequally, and it wasn’t as if the mid-Atlantic region was in bad shape.  Those near the capital benefit overmuch, and the hinterlands pay.

Summary

I stand by my thesis, which I hope to flesh out for stimulus spending in coming days.  QE does not benefit the US economy in the long run because it:

• Creates dependency on the Federal Reserve to continue the financing.
• Subsidizes governments and industries that need to shrink, and focus on core demand, not further expansion of mission.
• Drives up the costs of funding long-term liabilities
• Drives down the marginal efficiency of capital as the government and central bank does more of the investing, and invests in low ROE, or even negative ROE ventures.
• Only looks at the present, and at politics, leading to decisions that benefit those connected
• Tempts investors to take non-economic risks, where they will lose more than if they had stayed in cash.
• Makes average people less certain about the future, which makes them more conservative in spending.
• Undermines confidence in the fairness of government, and the value of a central bank.
• It helps leave foolish men in charge of governments and bureaucracies that should have failed.

New Buys:

• 5/19/2010      Petrobras
• 7/9/2010        Goldman Sachs Group Inc
• 8/31/2010      American Electric Power
• 8/31/2010      Corn Products International
• 8/31/2010      Zhongpin
• 8/31/2010      PC Connection
• 8/31/2010      Stancorp Financial

New Sales:

• 8/31/2010      Goldman Sachs Group Inc
• 8/31/2010      Dominion Energy
• 8/31/2010      PPL Inc.
• 8/31/2010      Sempra Power
• 8/31/2010      Safeway Inc.

Rebalancing Buys:

• 5/19/2010      Ensco International Inc
• 6/1/2010        Noble Corporation
• 6/29/2010      Computer Sciences Corp
• 6/30/2010      Industrias Bachoco
• 6/30/2010      Northrop Grumman
• 6/8/2010        Safeway Inc
• 7/6/2010        National Presto
• 8/12/2010      Constellation Energy Group

Rebalancing Sales:

• 8/2/2010        Noble Corporation

Thoughts

1)  I try not to trade too much.  For those that are new to my writings, rebalancing buys and sells are meant to bring the positions back to target weight after they have moved 20% away from the target weight.  As it is, for three months, I have not made a lot of trades.

2) I reduced utility exposure, it seems to have gotten relatively expensive amid the yield craze.  I have added cheap, well-financed names in a number of areas.

3) Assurant and National Western are double weights.  The rest of the portfolio is equal-weighted aside from that.  Note that National Western is quite illiquid.  Do not place market orders to buy or sell.

4) I flipped my momentum factor from small negative to moderate positive.  I have concluded that in a touchy macro environment like this, it is wise to consider return momentum.

5) I still don’t trust the financial sector aside from insurers here.

6) I had some runners-up in my analyses: AXS EDS TRH DFG

7 ) Some thoughts on the 8/31 buys:

• PC Connection is a net-net, illiquid, but makes money.  Unusual to have a company that trades for less than its net assets, and makes money.  THIS IS ILLIQUID.  NO MARKET ORDERS.
• Stancorp Financial is a well-run insurer trading at a discount.  Issues: Commercial mortgage exposure high, and disability may prove problematic during recessionary conditions.
• American Electric Power was cheaper than the utilities it replaced.
• Zhongpin sells pork in China.  Seems cheap, and has a decent amount of growth potential.  The financials look clean, but I am still reviewing it.
• Corn Products seems cheap, and its products are needed globally.

8 ) I have roughly 11% in cash.  If I find a really good idea, I might bring that down to 8%.  At present, my stocks are nearer to the high end of their rebalancing bands, so I am more likely to be doing a little selling than buying of my existing stocks in the short-run.

9)  Here was the last update.  Comments welcome.

Full disclosure (here is the whole portfolio): COP SBS DIIBF IBA VLO NTE SAFT RGA ESV ALL PRE PEP GPC LNT AIZ ADM CVX NE ORCL NWLI CB CSC NOC NPK SCG TOT SENEA CEG PBR AEP HOGS PCCC SFG CPO

In my last post on this topic, I went over the orthodox and unorthodox monetary policy responses to the crisis in the US.  Here were the orthodox options:

• Lower the Fed funds rate into lower positive territory.
• Offer language that says that the Fed Funds rate will be low for a long time.
• Buy more long-dated Treasury bonds.

And the unorthodox options:

• Lend directly to classes of private borrowers.
• Create negative interest rates for Fed funds.
• Debase the currency by expiration dates, lotteries, etc.

On orthodox policy: I’m not sure there is that much difference between Fed funds at 0.25% and 0.10%, except that money market funds will find themselves in further trouble, as yields are too low to credit anything. That the Fed will be on hold for a long time seems to be the default view of the market already, so an explicit declaration would likely prove superfluous.  On buying long-dated Treasury bonds, that will benefit the US Government by pseudo-monetizing the debt, but won’t help the real economy much.

Yes, some high-quality corporate and mortgage bond rates will be pulled down with it, but so will discount rates for liabilities.  The same applies to spending rules for endowments, and how much retirees can get if they go to buy an annuity.  The effects of QE are mixed at best, and on balance, might be depressing, not stimulating.  But what practical proof, if any, do we have that QE has ever worked?

We need policymakers to understand the bankruptcy of the theories they are working with.  So many macroeconomic models work with one interest rate.  But in the real world there are many rates, and duration and quality of lending make a huge difference in what rate is charged.  I would urge that every person who would be on the FOMC work at a buyside firm managing bonds and money market instruments.  Let them see how the markets really work, and it might disabuse them of their false neoclassical views of how the lending markets work.  Better still, if their P&L is less than the cost of capital, revoke their appointment.  It’s time to kick out the academics, with their failed ideologies, and let those who have worked in the markets successfully manage the economy.

Direct Lending

But then there are the unorthodox methods.  When Social Security came into existence, they argued over where the money would be invested.  It was decided that the only fair investment was in government bonds, because it was neutral.  Investing in other assets, like the S&P 500 would be unfair, because they would be favoring a sector of the economy.

The same argument applies to direct lending by the Fed, because it would smack of favoritism.   Going back to my last article, favoritism undermines confidence in the system, and makes people less willing to invest unless the government gives them an edge — cash for clunkers, $8,000 tax credit, etc.  We are Americans, after all.  Why buy from the retailer now, when you know that there will be another sale coming soon?  Economic policymakers should not rely on people to behave “as usual” when policy becomes unpredictable and unfair to the average person.

So I don’t see direct lending by the Fed, or buying high yield bonds, or offering protection on baskets of bonds as wise moves.  It may temporarily goose an area for a time, and make an area of the economy QE-dependent, or stimulus-dependent, but at best it is helping a few, while discouraging the rest.

Negative Fed Funds

I’ve been thinking about negative rates for Fed funds, and I think that they will have the following effects:

• Banks will drop their excess reserves at the Fed to zero, and vault cash (or its short-term debt equivalents) will increase.
• Banks will try to borrow from the Fed at negative interest rates, if they allow it, and just sit on the cash, park it in T-bills, Top-top CP — it’s free money, after all.  Of course, some point free money may be construed as valueless money, but that is another thing.

Required reserves are not a large percentage of liabilities.  Unless Fed funds goes deeply negative, it’s not going to affect bank profitability that much.  Banks may just view it as a cost of doing business, and pass it on to customers.

Destructive Creative Currency Debasement

With apologies to Schumpeter, who popularized the concept of creative destruction, I’ll try to define a new concept that is the opposite — destructive creativity.  Destructive creativity is when bureaucrats or regulators get too clever, and in an attempt to solve a lesser problem, end up creating a bigger problem.

I’ve heard proposals for further debasement of the currency via placing expiration dates on currency, or randomly canceling currency through lotteries based on the serial numbers on the bills.  The idea is that people will change their behavior: save less and spend more.

I can’t say that I can see every unintended consequence with these proposals, but according to Keynes, Lenin said, “The best way to destroy the capitalist system is to debauch the currency.”  These creative means of debasing the currency might do it.

Who gets to be the one holding the Old Maid card as expiry draws near.  How much time would be wasted scanning currency at registers as money is handed over and change is handed out?  Is the money cancelled or expired?  Close to expiration?  Quick, put it into the pile to give as change to the next customer.  There may be legal tender laws, but I can tell you that there would be fights over things like this.  Would all of the dollar bills used as a shadow currency overseas come trotting home?

If the Fed wanted to write its own death warrant, it should implement schemes like these.  The Fed is already viewed with enough skepticism by average people, that it wouldn’t take much to tip the scale from “Audit the Fed,” to “End the Fed,” where it gets replaced with the currency board tied to a commodity standard.

This leaves aside ideas like expiring/canceling a certain amount of monies in savings or checking accounts.  After all, why stop with the paper money?  Move onto the blips that we transfer day after day, silently, quietly choking the economic well-being of people, making them feel less safe, less secure, more paranoid.  Would we set up checking/savings accounts in other currencies to avoid this trouble?  Would that even work, such that we would have to set them up in foreign countries, and access funds that way?  What’s that you say?  Exchange controls?  Destructive creation indeed.  To “solve” a smaller problem, a dud economy, create a much larger problem…

Want to kill the economy/country?  Taxation is one thing, confiscation is another.  There are more than enough people who have question marks in their heads over what the government is doing with monetary policy and stimulus.  Aggressive actions to debase the currency can turn those question marks in to exclamation points.

This has gone longer than I thought.  Time to hit publish, and I will finish this tonight.

I haven’t written about my portfolio management methods in a while.  I’ll be writing on this a few more times over the next week or so.  The eighth rule of my investing is:

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

First I have to get new ideas.  I have two sources for that:

• My industry rank study.  Within those industries chosen, I run a screen that uses financial strength, valuation, and growth potential to highlight promising names.  Of the 34 current names in the portfolio, the screen chose 10 of them, out of 79 suggested names.
• Trolling around on the web and talking to friends.  When I hear a promising idea, I print it out or write it down, and put it in a pile to wait for the next reshaping.  This helps me to forget who suggested it and why, so that I am forced evaluate it independently.  If I don’t fully understand it, I will not know when to buy more or sell it.  That generated 40 additional names.

Anyway, here are the tickers for the replacement candidates:

ABFS ACM AEP AFL AMGN APA APC APOL ATPG AXS BCE BDX BHI BRY BT CAG CALM CAM CDI CL CLX CNQ CPO CVS DFG DLM DO EGN ENR ESLT FDP FISV FLIR FRX FST FTO GD GLRE GMXR HAL HOGS HRL HSII IP JBL KELYA KEX KFT KHDHF LLL LNC LPX MDT MDU MET MMM MOG/A MOT MRO MUR MWV NBR NEMNLC NOV NVDA OCR OII OSG PCCC PG PRU PXD PXP RAH RDS/A RE REP RIG RNR RTN SJM SPR SU SUN SXT TDW TDY TEG THS TK TLM TMK TMO TRH TRP TSO TTI UNM V VZ WAG WAT WMT WPP WY YUM

I will run my quantitative model on these companies versus the current companies in the portfolio, and kick out companies I now own that score poorly and buy some the score well.  This procedure is not absolute; there are often bits of data  that the quantitative factors ignore.  But when all is said and done, I buy companies that I think are better than those that I am selling.

This also forces me to review the whole portfolio, and be dispassionate about what gets sold.  It also forces me to take things slow, and not make hasty decisions.

What factors exist in my scoring model:

• Valuation – Earnings, Book, Sales
• Momentum
• Earnings Quality
• Sentiment indicators — neglect, volatility, etc.

I change the weights over time.  I ask myself, “What is working now?” and, “What has or hasn’t been working for too long?”  What working now should get extra weight, while leaning away from ideas that are too popular, and leaning toward those that are unfairly tarred as dead.

But this is only an aid and a guide.  If I put something into the portfolio, it has to pass my qualitative reasoning tests, which admittedly are subjective, but encompass my reasoning as a businessman.

In short, that is what I do.  I hope to give you an update in a few days to explain how this practically worked out in this reshaping.  If you have other tickers that you think I should consider please let me know in the comments, and I will toss them into the mix.  Thanks.

I have a post on the futility of fiscal policy coming, but the hubbub over Jackson Hole has made me alter my publishing schedule.  I want to give one more shot on the idea that the Fed is out of ammunition, and that unorthodox moves are more likely to scare the public than result in increased real GDP.

I am better off than all of my friends, I think.  A common occurrence for me is a friend coming to me and saying, “How can the government borrow so much?  It doesn’t make sense.  Why do they spend money on this and not on me?”  I understand the paradox of thrift, but I don’t agree with it.  One reason is that because it is a paradox, ordinary people will react badly to actions of the government that they can’t do themselves.  Second, when the government or central bank does it, it seems like a form of theft, because no one should get something for nothing, and it degrades the ordinary person’s view of the honesty of the Government or Central Bank.  Third, what the money gets used for is viewed as a waste by some.

This consideration of the basic sense of fairness among average people should not be discounted by policymakers, nor the fear engendered when policymakers take such actions.  It is how average people think.  If you remember my review of the book Priceless, you might realize that people often act out of a sense of fairness, not out of economic interest.  When you think about the Paradox of Thrift through that prism, it is plain why government action doesn’t work — many people do nothing different when the government/central bank is making bold moves, because they are less certain about the future because the powers that be are dishonest in their view.

That said, the main reason I don’t agree with the solution to the paradox of thrift is that the government generally misspends money on cronies or projects of cronies.  It does not build the productive capacity of the economy, but only current consumption.  It does not aid growth.

Monetary Policy Now

Looking over a variety of articles on the options the Federal Reserve has, I would say that they are out of ammo that can do good.  They have plenty of ammo to destroy the economy, but little to build it.  What options does the Fed have left?

• Lower the Fed funds rate into lower positive territory.
• Offer language that says that the Fed Funds rate will be low for a long time.
• Buy more long-dated Treasury bonds.

And the unorthodox options:

• Lend directly to classes of private borrowers.
• Create negative interest rates for Fed funds.
• Debase the currency by expiration dates, lotteries, etc.

I will pick up on this tomorrow, and explain why the options that the Fed has are limited.

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I still like energy names here, some utilities, and reinsurers, particularly those that are strongly capitalized.  I’m not concerned about hurricanes for the strongly capitalized (it’s not likely to be a strong season anyway; if it hasn’t been strong yet, it likely will not be); they will be around to benefit from the increase in pricing power after any set of hurricanes.

I’m looking for undervalued and stable industries.  Human resources — sure, more part time workers.  Healthcare information?  A growing field, even with the new “health bill.”  Same for Biotech.

Even in a double dip, toiletries will still be purchased.  Phone calls will still be made, and the internet will still be accessed.  Perhaps life insurers are worth a look here; after all, the Bush tax cuts are expiring, and there will be more demand for tax avoidance.

I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is more highly cyclical than I have seen in quite a while.  I will be very happy hanging out in dull stocks for a while.

11) I was surprised to read that there is not a perfect market in interest rate swaps.  They are so vanilla, but counterparty risk interferes.

12) There is always a skunk at the party, and who better than Baruch to dis bonds?  I half agree with him.  Half, because the momentum can’t be ignored entirely.  Half, because profit margins are wide.  But rates are low, and unless we are heading into the second great depression, stocks look cheap.  That’s the risk though.  Is this the second Great Depression? (Or the Not-so-great Depression that I have called it earlier.)

13) Housing is a mess.  The US government has been engaged in a delaying action on defaults, while calling it a rescue effort.  The sag in housing prices may lead to a recession.  The FHA is raising the costs of mortgages because their past loans have had too many losses.

14) Commercial Real Estate continues to do badly while some CMBS performs — no surprise that what is more secured does well.

15) The Fed gets whacked on its lack of transparency.  This could be a trend for the future.

16) In the current difficulties in the Eurozone, the ECB is beginning to suck in more bonds, presumably from peripheral Eurozone countries that are seeing their financing rates rise.  As central banks get creative, a simple question for currency holders becomes what backs the money?  It would seem to be governments, which will absorb losses if central banks generate them, and cover it with additional taxes or borrowing (some of which could eventually be monetized).  What a mess.

17) Bruce Krasting is almost always worth a read, and he digs up something that I had forgotten about how interest is credited on the Social Security Trust Funds.  It’s calculated this way:

The average market yield on marketable interest-bearing securities of the Federal government that are not due or callable until after 4 years from the last business day of the prior month (the day when the rate is determined). The average yield must then be rounded to the nearest eighth of 1 percent.

Krasting thinks that’s too high.  I think that is too low, given the true tradeoff that is going on here.  Think about it: when the government borrows from the SSTFs in a given year, a slice of the benefits incurred over that year don’t get “funded.”  The debt claim to back that should match the maturity profile of those future claims.  Medicare would have some short claims, Disability and Supplemental Security slightly longer, but Old Age Security develops most of the assets, and is a long claim.  Say the average person paying in is 40, and they will retire on average at 65.  That is a 25-year deferred claim that will last for maybe 20 years on average, with inflation adjustment.  The US offers no debt that is that long to back such a liability, so I would argue that the proper rate to use would be that of the longest noncallable debt offered by the Treasury.

But here would have been my second twist on this: they should have absorbed the longest marketable securities from the debt markets, and bought and held them.  That would have looked really ugly as the rates looked piddling against current interest costs.  But today, it would reflect the true costs of the borrowing from the SSTFs, and that cost would likely be greater than what was paid to the trust funds.  My guess is that the interest rate paid on the trust funds today would be higher than 5%, maybe higher than 6%, if a fair method had been used.

If there is enough interest, I could try to run the numbers, but the point is academic.  It would not change the total claims against the government plus SSTFs as a whole, but it might have changed the behavior of the government if it had tried to borrow on a long duration basis, competing for funds with private industry.  It would have revealed the true tradeoff earlier, and shown what a trouble we were heading for.

18) On retained asset accounts, this Bloomberg piece makes me say, “Yes, this is a big enough issue to deal with.”  For MetLife particularly, which has its own bank, it would be simple enough to set up a genuine bank account with all of the statutory protections involved.  If there are risks from forgery, that is big.  Even the risks of not being covered by the state guaranty funds is big enough.

My view is this: full cash payment should be the default, and a genuine bank account an option.  If you have one of these checkbooks now, and you want to minimize your risks, do this: write one check for the balance so that it is deposited in your bank account.  Simple enough.  You can protect yourself with ease here, even without legal change.

19) The yen will continue to rally until the Japanese economy screams.  Currency moves tend to last longer than we anticipate, and secular moves force needed economic changes on countries.

20) Consider what I wrote last week on long Treasuries:

I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.  And some think that I am only a fundamentalist value investor.  With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.  Better to miss the first 10% of a move, than miss it altogether.

Now, I never expect to be right so fast, but with rates gapping lower on economic weakness — the 10-year below 2.5%, and the 30-year below 3.6%, I would simply say this: don’t fight it.  Let the momentum run.  Wait until you see a significant pullback in prices, and then short.  Don’t be a macho fool fighting forces much larger than yourself.  The markets can remain crazy for longer than you remain solvent.

1) Start with the big one from yesterday.  On of my favorite monetary heretics, Raghuram Rajan, whose excellent book I reviewed, Fault Lines, pointed out how he had gotten it right prior to the crisis, versus many at the Fed who blew it badly.  Rajan suggests that Fed Funds should be at 2-2.25%, which to me would be a neutral level for Fed Funds.  That’s a reasonable level.  The economy needs to work its way out of this crisis, even if it mean failures of enterprises relying on a low short rate.  Entities that can’t survive low positive rates that give savers something to chew on should die.  Mercilessly.  Monetary policy at present is a glorified form of stealing from savers, who deserve more for their sacrifice.

2) Peter Eavis, an old friend, echoes my points on QE, in his piece Government Clouds Value of Investments.  When the government is actively trying to destroy the willingness to hold short-term assets, and engages in QE, it makes all rational calculations on investments a farce.

3) I agree with John Hussman in a limited way.  QE artificially lowers interest rates, which lowers the forward value of the US Dollar.  That doesn’t mean it will generate a collapse; I don’t think it could do that unless the Fed began to do astounding things, like monetize a large fraction of all debt claims.

4) The US Government is so dysfunctional that the baseline budget has increased 4.4 Trillion over the next 10 years.  This is the beginning of the end of the supercycle, and the reduction of America to the influence level of Brazil.  Earnings levels will converge as well, but more slowly.

5) While we are thinking soggy, think of Japan.  Years of fiscal and monetary stimulus have availed little.  Overly low interest rates have fostered an economy satisfied  with low ROEs.  Low interest rates coddle laziness, and encourage stagnation.

6) There are limits to stimulus, whether monetary or fiscal.  There is no magic way to produce prosperity by government fiat.  Stimulus, by its nature, will run into constraints of default or inflation, if taken far enough.  If not, why doesn’t the Fed buy up all debt?  (leaving aside laws) Isn’t QE a free lunch?

7) Deflation is tough; it weighs upon cities, states and other municipalities, who hide their true obligations.

8 ) Hoisington, the best unknown bond manager.  Where do they think long rates are going?  2% or so on the 30-year.  Makes the current buyers of bond funds look like pikers.  That’s over a 35% gain from here.  If they are right, their fame will be legendary.  Now, that could explain the willingness to fund ultra-long duration debt, because the gains will be bigger still.  What a great confusing time to be a bond investor, until something fails.

9) Or consider the Norfolk Southern 100-year bond deal yesterday.  Quoting the WSJ:

In what bankers hope will be the first in a new round of 100-year bond sales, Norfolk Southern Corp. raised $250 million Monday by selling debt that it won’t have to repay until the next century.

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Investor interest was strong enough that the company increased the size of the new sale from $100 million. Market participants said investors had expressed an interest in buying at least $75 million of the debt before the company decided to announce the $100 million deal.

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The interest rate on Norfolk Southern’s new debt is 6% for a yield of 5.95%, about 0.90 percentage points more than where the company’s outstanding 30 year debt was trading Monday. It was the lowest yield for 100-year debt bankers could recall, breaking through the 6% yield on the company’s 100-year issue in 2005.

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“There is no question, obviously, that you are giving up a bit of liquidity, but you’re getting a pickup of 90 basis points to move out of the 30-year,” said Jeff Coil, senior portfolio manager at Legal & General Investment Management America. “But you’re getting good income on a stable cash credit in a sector where there are only a handful of rails left.”

Mr. Coil said the firm had a “sizeable” order in the deal. There were approximately 20 investors overall.

Moody’s Investors Service rated the new senior fixed-rate bonds Baa1, and both Standard & Poor’s and Fitch Ratings rated them BBB+.

Is 0.90%/year enough to compensate from going from 30 to 100 years?  I think so. The difference in interest rate sensitivity of a 30 versus a 100 are small at a yield of 5-6%, and if you have a liability structure that can handle it, as a life insurer might, it makes a lot of sense.  After all, a life insurer can’t economically invest in equities because of capital restrictions. You could compare it to investing in long dated preferred stock or junior debt, but then if there is a default, the losses are more severe than with a senior unsecured bond.

10) I’ve never found the yield curve model for recession/recovery compelling.  Limited data set, not covering the Great Depression, etc.

More to come.

Illiquidity is an underrated risk.  Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.  Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

• Banks — too numerous to mention, though FDIC insurance restrains it now.
• Life insurers, particularly those that write a lot of deferred annuities.
• AIG and the GSEs — abominations all.
• Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
• Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
• No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.  Some were forced to raise liquidity in costly ways.  Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.  Most alternative asset classes involve additional illiquidity.  That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.  That factor is strategy capacity.  Alternative investments do best when they are new.  Here is my version of the phases that they go through:

• New — few know about it except some business-minded investors.  Only the best deals get done.
• Growing — a modest number know about it, and a tiny number of consultants.  Only very good deals get done.
• Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.  Good deals get done.
• Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.  All reasonable deals get done.
• Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
• Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.  Later adopters abandon the market, and take losses.  Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?  First determine how much of your funding base will never leave over the next 10 years.  When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.  Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.  Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.  Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.  There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.  The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.  The forecast is the least important item, because it is the toughest to get right.  (An aside: who has been right on bond yields consistently for the last 20+ years?  Hoisington, my favorite deflationists.  Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.  Divide your liabilities in two.  What obligations do you know cannot be changed, except at your discretion?  That group of liabilities can have illiquid assets to fund them.  Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.  You can try to buy assets that change along with the liabilities, but in practice that is hard to do.  (That said, there are no end of clever derivative instruments available to solve the problem in theory.  Caveat emptor.)  The assets have to be liquid for this portfolio.  Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.  A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

• Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?  As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”  (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
• Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?  Hard to say.  There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.  It also depends on where you are in the speculation cycle.
• Liquid public equities to private equity or hedge funds with lockups?  Tough question.  Try to figure out what the unlevered returns are for comparative purposes.  Analyze long-term competitive advantage.  Look at current deal quality and valuation metrics.  For hedge funds, look at how credit spreads moved over their performance horizon.  Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?  Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.  Safety first.  (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.  Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.  Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.