There was an interesting post on Bloomberg regarding asset class correlations, and a lot of blogs wrote about it, including Abnormal Returns, which did a nice summary, and expanded the argument to university endowments.  Part of the issue here is that under conditions of stress, assets separate into two simple categories — safe and risky.  To what degree can an asset be turned into cash at anything near its fair value under stressed conditions?

I ran into something similar back in 2006, so I wrote this CC post:

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples.

In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

Hmm… in early 2006, we were considerably in advance of the peak that would come in late 2007, but considerably above where we are now.  In my opinion, given my longer timeframe, a good call.

But maybe correlations might rise during times when everyone is anxious to buy risky assets, not just when the want to throw them away.  Do asset correlations rise near peaks for risky assets?

My model on correlations relies on the major industry sectors of the S&P 500:

• Consumer Discretionary
• Consumer Staples
• Energy
• Financials
• Health Care
• Industrials
• Information Tech
• Materials
• Telecom Services
• Utilities

If lots of money is getting thrown at stocks, won’t the correlations between sectors rise?  And if so, won’t future returns be low or negative?

Here is a graph showing the price return on the S&P 500 over the next 60 days as a function of the average sector correlation over the last 60 days:

Not much of a relationship, huh?  1% R-squared.  And it goes the wrong way — high correlations very weakly favor higher returns.

But what if we do a regression where future S&P 500 returns are regressed on past S&P 500 returns and average sector correlations?

Wow, we get a 2% R-squared! It also shows that momentum persists, and higher average sector correlation has a similar effect to the above model, still positive on future returns.

Here is a heat map where the average 60-day past return is on the horizontal axis, and average sector correlation is on the vertical axis, and the variable displayed is frequency of occurrence.

Looks pretty average, with the two effects being fairly separate, with an odd southwestern quadrant.

Here is a heat map where the average 60-day past return is on the horizontal axis, and average sector correlation is on the vertical axis, and the variable displayed is average future 60-day returns.

Here are my tentative findings:

• Price momentum persists.  60 days of weakness/strength tends to beget 60 more days of weakness/strength.
• Extremely high or low average sector correlations seem to go along with low returns.  Middling average sector correlations seem to go along with higher returns.
• Low average sector correlations and lousy past price performance seems to beget excellent future performance.
• High average sector correlations and lousy past price performance seems to beget lousy future performance.
• When past price momentum is high, average sector correlation doesn’t seem to matter as much.
• If past trends continue, average returns over the the next 60 days are around 2.5% with a very wide error band.  Current average sector correlation is 50%, and past 60 days returns are 90%.

One final graph:

Do you see a pattern here where high average sector correlations come before market peaks?  I don’t.

All that said…

I know the earlier articles dealt with asset class correlations, rather than correlations with stock market sectors.  I would have expected the same result.  Maybe there is aonther way to do this analysis separating out safe sectors from risky sectors.

But what are safe sectors?  Utilities? Consider 2001-2003.  Telephone services? Also 2000-2003.  Financials? 2007-?  Perhaps Consumer Staples is the only truly safe sector… or maybe it should be energy? Consider the early ’90s.

This is one article where I end scratching my head, but publish anyway, because:

1) My readers may help me.

2) It is valuable to know where research dead ends exist.

After all this, I don’t see average sector correlations as a valuable variable in investing.  Maybe that is not true of asset classes.  If anyone has the proper data to send to me on that, I will reproduce an analysis like this, and tell you what I find.

Just a brief post here.  The Economist features a simple symmetric model to try to explain cycles in the financial markets.  Cute model, but it can’t explain booms and busts.  The key missing feature is credit that can default.  Defaults are asymmetric.  With bonds you can make a little with high certainty, or lose a lot with low certainty.  This is true of all lending, leaving aside convertibles.

In a true bust, defaults are rampant, as badly capitalized firms fail amid weakening demand.  During booms, some  firms magnify the results by levering up (borrowing more).  This is the behavior that created booms and busts, together with the momentum effects that Brad DeLong’s model demonstrates.

Modeling in default behavior and leverage should complete the model.

Apologies to readers.  I have been gone last week at my denomination’s annual meeting.  As I often say at this time of year, I never work harder than at that time, so please forgive my lack of posts.  As it is now, I am worn out, but at least I am home.  Home is my favorite place.

I am presently reading a book by Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.  So far, a good book.  He has a recent blog post that impressed me as well: Dumbing Down Regulation.

Should regulation be dumb?  In one sense yes, in others, no.  It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among marketers and risk managers.  As those two increase, regulation can be smart.  “Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.”

But when either of those two aren’t true, dumb regulation may be in order:

• Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
• Disallowing risky types of lending, regardless of capital level.
• Disallowing liabilities that can run easily.
• Disallowing products that commonly deceive buyers.
• Disallowing certain types of contracts that fuddle accounting.

If everyone were smart, things could be different.  Deceiving people would not take place, and managements would not take undue risks.  Limits could be more loose, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.  Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.  Along with that, some bank will not fit the rules and go insolvent, though it does not register so on the solvency tests.

My poster child for relatively good dumb regulation is the insurance industry in the US.  The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.  There is room for improvement, though:

• Make risk based capital charges countercyclical.  Perhaps tinkering with the Asset Valuation Reserve would do that.
• Have some sort of rigorous testing for capital relief from reinsurance treaties.
• Ban surplus notes in related party transactions.
• Ban all forms of capital stacking, especially where the transactions go both ways.  I.e., subsidiaries can’t own securities of any companies  in their corporate family.  All subsidiaries must be owned by the holding company.
• More rigorous testing for deferred tax assets.
• Assets as risky as equities, including limited partnerships, should be a deduction from capital.
• Securitized bonds that are not “last loss” should have higher RBC charges than comparable rated corporates.
• A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

• Insurance companies list all of their assets.  Banks should as well.
• Intangible assets should be written to zero for regulatory capital purposes.
• Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
• Some sorts of lending to consumers should be banned.  I am talking about complex agreements, that individuals with IQs less than 120 can’t understand.  Insurance policies have to be Flesch-tested.  Bank lending agreements should be the same.  If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.  Credit is for the upper-middle-class and rich.  Poor people should not go into debt.
• Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.  Financial products must be made more simple for consumers to understand.  More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.  So be it.  Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.  Unfortunately, when financial firms fail, there are often larger repercussions.  It is better to limit regulated financial companies to businesses where the risks are well-understood.  Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

Quick Hits:

• The FOMC is following trends in the financial markets. The stock market is higher, and credit spreads are tighter, but what of tomorrow?
• They view much of the weakness as being an inventory correction that will end soon.
• They trust that slack capacity will keep inflation low, despite rising commodity prices. They are less worried bout deflation. Stagflation is not a word in their vocabulary.
• They are trying to lengthen the view of the market on how long the FOMC is able to maintain a low fed funds rate.
• They are projecting calm to all who will listen, but will inflation and the dollar cooperate?  Will economic weakness not deepen from here?  The jury is out.

One thing that I watch closely is the health of the finances of the states.  Because they don’t have a printing press, and most of them have to balance their budgets, they are a better read on the health of the economy than national statistics.

As it is, states are cutting their budgets drastically because their tax collection is down dramatically.  California is a leading example here.  Will it refuse to pay, and what of its municipalities?  How many will file for Chapter 9, like Vallejo?  My guess is that many municipalities will file Chapter 9, but that California will avoid nonpayment.

There is one more issue worth pursuing here.  Though states have to run balanced budgets (largely on a cash basis), that says nothing about pensions and other long-dated promises.  I find it fascinating that some states are still trying the gambit of pushing retiree expenses out into the future.  To me, that is a sign of desperation slightly smaller than making significant budget cuts.  It’s just playing for time at a time where delay has few advantages.

That’s one reason among many that I do not see “green shoots” at present.  During a period of debt deflation, many troubles fight prosperity as the financing bubble deflates.  If the states aren’t prospering the nation is not either, regardless of what statistics the national government might dream up.

Often when we talk about the Fed, we talk about a dual mandate — low inflation, and low labor unemployment.  But as I suggested at RealMoney many times, there is a hidden third mandate: protect the integrity of the banking system.

Often,  a tightening cycle would end with a bang, with some credit starved entity (Residential Housing, Nasdaq, LTCM, Lesser-developed Asia, Mexico, etc.) dying.  The Federal Reserve would then spring into action and say, “We must fight the threat of unemployment.”  Would they?  No, they would invoke protecting the financial system, which protects the banks.  After all, monetary policy does not work when banks are compromised, as they are today.  No wonder there is Credit Easing.

So when I hear the Fed proposed to be the systemic risk regulator, I have two thoughts:

1) You did a bad job with monetary policy and bank supervision, but you are nice guys, because you do for the US Government all of the things the Treasury Department can’t Constitutionally do.  Now let’s see if you can do better with controlling systemic risk, even though we haven’t granted you control over all the levers necessary to do so.

2)  Maybe this will make them better with monetary policy; it makes the triple mandate explicit.

My view is that the Fed is one of the major creators of systemic risk in our economy through the use of monetary policy to stimulate our way out of bad times.  The temptation that Greenspan succumbed to was to throw liquidity at problems too early, which avoided liquidation of marginal debts, and the debt levels built up.

If the  Fed has to minimize systemic risk in the economy, maybe it becomes less willing to loosen policy profligately.  I would hope it would work that way.

That said, given the lack of success for the Fed on its goals, I suspect that if it were given the task of reining in systemic risk, it would fall prey to political pressure, and fail at that as well.

I go back to my earlier proposal — the Fed would have to keep the US economy under a limit of private debts being less than 2x GDP.  But can you imagine the Fed tightening during a boom to avoid systemic risk, or raising margin requirements?  I can’t, so even though ideally the Fed would be the right player to manage systemic risk, in practice, systemic risk is unmanageable, because there are too many interests that benefit from boom times.  That’s why I don’t expect much from the proposals to manage systemic risk, regardless of who gets the power to do so.

When people look at this crisis, they look for simple answers — they want to find one or two parties to blame, not many, a la my Blame Game series.  The economic system is an interconnected web, and it is not easy to change one part without affecting many others.  Intelligent ideas for change consider second order effects at minimum.  This piece, and any that follow under the same title, will attempt to point at things that are not easily done away with.  Some of these will be controversial, others not.

1) Derivatives.  What is a derivative?  A derivative is a contract where two parties agree to exchange cash flows according to some indexes or formulas.  There are some suggesting today that all derivatives must be standardized, and/or traded on exchanges.  That might make sense for common derivatives where there are large volumes, but many derivatives are “out in the tail.”  Not common, and standardization of what is not common is a fool’s errand.

To regulate derivatives fully is to say that certain types of contracts between private parties may not exist without the consent of the government.  Thinking about it that way, what becomes of free enterprise?  Granted, there are some contracts that cannot be considered enforcable, like that of a hit man, arson for hire, etc.  Those are matters that any healthy government would oppose.

What makes more sense is to bring the derivatives “on balance sheet.”  Let the effects of the notional value play out, showing owners what is happening, rather than hiding it.

2) Rating agencies — Moody’s, S&P, and Fitch deserve some blame for what happened, but the regulators needed the rating agencies.  They still do.  The rating agencies make imperfect estimates of relative credit quality for a wide munber of instruments, which then feed into the risk-based capital formulas of the regulators.  To rate such a wide number of instruments means that the issuers must pay for the rating, because there is no general interest for most ratings.

Yes, let more rating agencies compete, but they will find that the “issuer pays” model is more compelling than the “”buyer pays” model.  The concentrated interests of issuers in a rating trumps the diffuse interests of buyers.  Bond buyers need to learn to live with this, and employ buy-side analysts that don’t take the opinion of the rating agencies blindly.  What the analysts at the rating agencies write is often more valuable than the rating itself, though it doesn’t change capital charges.

Rating agencies make the most errors with new asset classes.  Better that the regulators do their jobs and prohibit immature  asset classes where the loss experience is ill-understood.

I don’t think that rating agencies are going away any time soon.  I do think that the government and regulators contemplated this, but concluded that the changes to the system would be too drastic. (Contrary opinions: one, two)

3) Yield-seeking — the desire to seek yield is near-universal.  As a bond manager, I found it rare that a manager would do a “reduce yield, improve quality or certainty” trade.  The pattern is even more pronounced with retail accounts.  They underestimate the value of the options that they are selling, and take a modicum of yield in exchage for lower certainty of return.

Can this be banned, as some are proposing with reverse convertibles?  I don’t think so, there are too many variables to nail down, and too many people in search for a yield higher than is reasonable.  Yield-hogging is an institutional sport, not only one for retail fans to grab.  As one of my old bosses used to say, “Yield can be added to any portfolio.”  How?

• Offer protection on CDS
• Lower the quality of your portfolio.
• Buy all of the dirty credits that trade cheap to rating.
• Buy securities from securitizations — they almost always trade cheap to rating.  (Ooh! CDOs!)
• Sell a call option on the securities you hold.
• Buy mortgage securities with a lot of prepayment or extension risk.
• Accept the return in a higher inflation currency, assuming that their central bank will tighten.
• Do a currency carry trade.
• Lever up.
• Extend the length of your portfolio.
• Underwrite catastrophe risk through cat bonds.

Adding yield is easy.  The transparency of that addition of yield is another matter.  Reverse convertibles have been the hot issue recently since this article.  Here is a small sample of the articles that followed: (one, two, three).  Reverse convertibles, and other instruments like them give bond-like performance if things go average-to-well, and stock-like performance if things go badly.  The inducement for this is a high yield on the bond in the average-to-good scenario.

What to do?

I have three bits of advice for readers.  First, don’t buy any financial instruments tht you don’t understand well. This especially applies when the party selling them to you has options that they can exercise against you.  Wall Street excels at products that give with the right hand and take with the left, so beware structured products sold to retail investors.

Second, don’t buy any financial product that someone appears out of the blue and says, “Have I got a deal for you!”  Stop.  Take your time, ask for literature, maybe, but say that you need a month or more to think about it.  Haste is the enemy of good financial decision-making.  Instead, do your own research, and buy what you conclude that you need.  Consult trusted advisors in either case.

Third, don’t be a yield hog.  Yield is rarely free.  There are times to take risk and accept higher yields, but those are typically scary times.  At other times, make sure you understand the portfolio of risks that you accept, and that you are being adequately paid for those risks.  Better to have a ladder of high quality noncallable debt, and take some risk with equities than to take risk in a series of yieldy and illiquid bonds that you don’t understand so well.  At least you will be able to know what risks you have, and that is an aid to asset management.

Final Question

This article began as a discussion of things that are very hard to change in the current environment.  I thought of several here:

• The continuing need for derivatives, and the impossibility of full standardization
• The continuing need for rating agencies
• Human nature makes us yield hogs.
• Wall Street builds traps for investors off of that weakness.

What other things are very hard to change in the current environment?

I have learned a lot from the late Peter Bernstein. I remember a piece of his entitled (something like), “What is Liquidity?” where he described liquidity as the ability to change your mind or request a do-over. Bright guy, and one who focused on the big issues, not minutiae.

I met Peter Bernstein in 2002 when he delivered a timely talk to the Baltimore Security Analysts Society called (something like), “The Continuing Relevance of Dividends.” I asked a question during the Q&A, and then was able to talk with him for ten minutes afterward, because few wanted to embrace such a boring topic. He was very gracious to me, and encouraged me in my research pursuits.

There were many who offered their praises of Peter Bernstein and I offer the links here:

• THANK YOU, PETER
• Peter L. Bernstein, inspiring guy
• The continuing relevance of Peter Bernstein
• Peter L. Bernstein, Explainer of Stock Risks, Dies
• Peter Bernstein, Consultant, ‘Capital Ideas’ Author, Dies at 90

As for his books, I offer the links here:

• Against the Gods: The Remarkable Story of Risk
• Peter L. Bernstein Classics Boxed Set : Capital Ideas, Against the Gods, The Power of Gold
• Capital Ideas
• Capital Ideas Evolving
• Wedding of the Waters: The Erie Canal and the Making of a Great Nation
• A Primer on Money, Banking, and Gold
• The Power of Gold: The History of an Obsession
• Economist on Wall Street: Notes on the Sanctity of Gold, the Value of Money, the Security of Investments, and Other Delusions
• The Price of Prosperity: A Realistic Appraisal of the Future of Our National Economy
• Streetwise
• Investment Management

There may be more than this, but it was what I was able to find.  Peter Bernstein aimed for large targets, and gave broad and convincing evidence of how markets worked.  He only erred in letting Modern Portfolio Theory and Keynesianism affect him.

With that, I hail Peter Bernstein, regretting his demise.  He will be missed, as few of us had such global vision of markets as he had.

Full disclosure: if you buy anything from Amazon after entering here, I get a small commission, but your prices don’t go up.

John Reese and I share something in common: we both once wrote for RealMoney.com.  Occasionally I would question him in  the CC about what he wrote, but I never got an answer back.  He was probably a busy man.

Well, now I get to review his book, and I have to say that I like it.  It won’t be one of my favorite investment books, but it embeds many good ideas that will be useful to average investors.  Here are some of the main advantages:

1) It points people toward strategies that are valuation-conscious.  Whether investing for growth or value, the best investors pay attention to valuation.

2) Valuation is not everything.  Earnings growth and price momentum also are valuable to follow.

3)  Quality of the balance sheet matters.

One of the things that I like to say to investors is find something that fits your character, your free time, and your time horizon.   This book simplifies the strategies of ten clever investors.  Some require more time and effort, some less.  With ten good strategies to choose from, perhaps one will fit your situation well.

For the ten gurus, it describes them, their strategies, and how to implement them in a simplified way.  I knew a little about all of the gurus before reading the book, but I learned a little bit new about each one, except Buffett.  They made life choices that led them to their investment theories, and the book makes that connection.

Sell Discipline

The sell disciplines in the book are similar to mine — rebalancing, and adding stocks that the model likes better, and removing those that rank lower.  For fundamental investors, that’s a reasonable way of limiting risk, assuming that you review your thesis before adding new money.

Quibbles

1)  Earnings quality: leaving aside Piotorski, the rest of the gurus spend little time on earnings quality.  Particularly for value investors this component is critical for avoiding mistakes.

2)  What Reese puts forth is a simplified version of what most of these great investors do.  The actual process is more complex, and requires business judgment.  That said, his simplifed versions have done better than the market, in general.

3)  Performance calculations cut off in July 2008.  Now, he had to cut off somewhere, or he couldn’t publish.  Still, it would be interesting to know how the strategies did July 2008 through February 2009 — how did they do at risk control?

4) To be able to use this book effectively, you would need to have access to some reasonably sophisticated stock screening software.  The cheapest one that I know of would come from AAII, but you would also have to be an AAII member to buy it.  (If anyone knows a better one at a cheaper price, let me know.)

Who Would Benefit From this Book

This book would work best for people who want to follow valuation-conscious strategies, and not spend a ton of time at it, if they are willing to put in some time at the beginning setting up stock screens.

Summary

If after you have read this, you want to buy the book, you can buy it here — The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies.

Full disclosure: I get a small commission from Amazon on anything that gets bought after entering Amazon through my site.  Your price doesn’t go up, and Amazon is always happy to have additional sales, even at a lower gross margin.

This post should end the series, at least for now.  Tonight I want to talk about the limits to compounding growth.  Drawing from an old article of mine freely available at TSCM, I quote  the following regarding talking to management teams:

What single constraint on the profitable growth of your enterprise would you eliminate if you could?

Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:

• insufficient demand at current prices
• insufficient talent for some critical labor resource at current prices
• insufficient supply from some critical resource supplier at current prices (the “commodity” in question could be iron ore, unionized labor contracts, etc.)
• insufficient fixed capital (e.g., “We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we’re just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.”)
• insufficient financial capital (e.g., “We’re opening new stores as fast as we can, but we don’t feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.”)

There are more, but you get the idea.

Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.

As with biological processes, when there are unlimited resources, and no predators, growth of populations is exponential.  But there are limits to business and investment profits because of competition for customers or suppliers, and good untried ideas are scarce.  Once a company has saturated its markets, it needs a new highly successful product to keep the growth up. Perhaps international expansion will work, or maybe not?  Are there new marketing channels, alternative uses, etc?

Trying to maintain a consistently high return on equity [ROE] over a long period of time is a fools bargain and I’ll use an anecdote from a company I know well, AIG.  I was pricing a new annuity product for AIG, and I noticed the pattern for the ROE of the product was not linear — it fell through the surrender charge period, and then jumped to a high level after the surrender charge period was over.

I scratched my head, and said “How can I make a decision off of that?”  I decided to create a new measure called constant return on equity [CROE], where I adjusted for capital employed, and calculated the internal rate of return of the free cash flows.  I.e., what were we earning on capital, on average over the life of the product.

I took it to my higher-ups, hoping they would be pleased, and one said, “You don’t get it!  You don’t argue with Moses!  The commandment around here is a 15% return on average equity after-tax!  I don’t care about your new measure!  Does it give us a 15% return on average equity or not?!”

This person did not care for nuances, but I tried to explain the ROE pattern, and how this measure averaged it out.  It did not fly.  As many have commented, AIG was not a place that prized actuaries, particularly ones with principles.

As it was AIG found ways to keep its ROE high:

• Exotic markets.
• Be in every country.
• Be in every market in the US.
• Play sharp with reinsurers.
• Increase leverage
• Press the accounting hard, including finite reinsurance and other distortions of accounting.
• Treat credit default swap premiums as “found money.”
• Take on additional credit risk, like subprime lending inside the life companies through securities lending.

In the end, it was a mess, and destroyed what could have been a really good company.  Now, it won’t pay back the government in full, much less provide anything to its shareholders, common and preferred.

Even a company that is clever about acquisitions, like Assurant, where they do little tuck-in acquisitions and grow them organically, will eventually fall prey to the limits of their own growth.  That won’t happen for a while there, but for any company, it is something to watch.  Consistently high growth requires consistently increasing innovation, and that is really hard to do as the assets grow.

If True of Companies, More True of Governments

This is not only true of companies, but even nations.  After a long boom period, state and federal governments stopped treating growth in asset values as a birthright, granting them a seemingly unlimited stream of taxes from capital gains, property, and transfer taxes.  They took it a step further, borrowing in the present because they knew they would have more taxes later.  The states, most of which had to run a balanced budget, cheated in a different way — they didn’t lay aside enough cash for their pension and retiree healthcare promises.  The Federal government did both — borrowing and underfunding, because tomorrow will always be better than today.

Over a long enough period of time, things will be better in the future, absent plague, famine, rampant socialism, or war on your home soil.  But when a government makes long-dated promises, the future has to be better by a certain amount, and if not, there will be trouble. That’s why an economic downturn is so costly now, the dogs are behind the rabbit already, running backwards while the rabbit moves forwards makes it that much harder to catch up.

I’ve often said that observed economic relationships stop working when people start relying on them, or, start borrowing against them.  The system shifts in order to eliminate the “free lunch” that many thought was available.

A Final Note

Hedge funds and other aggressive investment vehicles should take note.  Just as it is impossible for corporations to compound their high profits for many decades, it is impossible to do the same as an investor.  Size catches up with you.  It’s a lot easier to manage a smaller amount — there are only so many opportunities and inefficiencies, and even fewer when you have to do so in size, like Mr. Buffett has to do.

“No tree grows to the sky.”  Wise words worth taking to heart.  Investment, Corporate, and Economic systems have limits in the intermediate-term.  Wise investors respect those limits, and look for growth in medium-sized and smaller institutions, not the growth heroes of the past, which are behemoths now.

As for governments, be skeptical of the ability of governments to “do it all,” being a savior for every problem.  Their resources are more limited than most would think. Also, look at the retreat in housing prices, because the retreat there is a display of what is happening  to tax revenues… the dearth will last as long.

Full disclosure: long AIZ