Sorry I haven’t written much recently.  The recent snowstorms have tossed me around, as I care for my family, and those around me.  It is amusing in a backwards way, to see Washington, DC frozen at a time when there is so much volatility in global finance.  Yo, Treasury, make sure the skeleton crew on international finance gets in, regardless.

The incentives are perverse in every way in Europe.  If Germany, France, and the Netherlands don’t bail out Greece, then what will become of Portugal and Spain?  And later, Italy and Ireland?  In aggregate, this is big.

But, if Germany, France, and the Netherlands do bail out Greece, then will Portugal and Spain be next in line?  And later, Italy and Ireland?  In aggregate, this is big.

Perverse, indeed, and I criticize my own thoughts on the Euro that I thought would die from inflation.  No such thing.  The Euro is strong –  So strong that marginal nations were able to borrow at rates lower than they ever dreamed imaginable.  The debts built up like mad, ignoring the day when the inevitable weakening in aggregate demand would come, and debts of marginal, overindebted nations would prove weak.  The EU is validating the idea that currency union requires political union.  We learned that in the US 200 years ago, but the youngsters in the EU have to learn that lesson the hard way.

This is an ugly situation, as ugly as China forcing exports into the rest of the world, or the US Government continuing to borrow with abandon.  What seems to have no limit may find the limit more rapidly than one anticipates.

Just be aware that sovereign volatility has negative impacts on asset prices.

The place that got the most snow during the recent storm was Howard County, Maryland.  Elkridge had 38″, Columbia 34″, and at Aleph Blog Global HQ we got a measly 30″.  Here are some photos:

looking out the front of the house

back deck from the inside…

and the back deck from the outside…

looking up the street…

icicles hanging from our house — eight feet long

some of my kids starting to shovel before the storm is over… and…

360 degrees after two feet

That should be an AVI file.  There were six inches to go after that.

Well, we have been busy bees, and we may be getting busier.  There is another storm coming.  Another 10-20 inches.  Wow.

Economic commentary on this?  It’s good to have boys — we have been helping out people where we can.  Neighborhood relationships have tightened as people have made efforts to help the elderly and infirm.

Maryland can’t afford storms like these — major roads are only half to 2/3rds plowed.  This may generate a political crisis here, but I am only surmising.  Even well-off Howard County can’t keep up.

All for now, gotta buy some more snow shovels and salt, if I can find them.

When I look at the present economic environment, I am not encouraged.  But if you really want me to be discouraged, talk to me about politics.

For the last 40-80 years we have been borrowing, whether implicitly (pensions, retiree healthcare) or explicitly, deferring problems into the future, where they will be compounded with interest and survivorship (lifespans have lengthened, Kaiser, and sadly for those who pay, they want a high quality of life in their dotage).

So, at present, legislators are more partisan, whether in the states or at the federal level.  Why?  There is less slack.  Let’s start at the state level, because most of them have to balance their budgets, and can’t print money to help out.

Many states are screaming in pain.  As such, they tell their legislators in the Federal Congress to send back money.  But that toughens the debate on the Federal level.

With almost all state budgets fighting against a deficit, and some in deep trouble, it makes for interesting and ugly politics.  Much of this was created by optimistic assumptions of what could be earned from equities over the long run, much of which is now being slowly repudiated, as markets fail to live up to expectations.

The Federal budget is hopelessly out-of-whack, with 4-5% of GDP deficits out as far as the eye can see.  So, what do we do about it?

1) Raise Taxes.  I don’t like this idea, because the US Government has entered many areas where it should not be.  I would rather see the discretionary government shrink considerably.  Also, remember, Social Security and Medicare are not guaranteed.  Congress could wipe out all benefits tomorrow, and face a political firestorm.  But remember, in the Great Depression, that is just what they did.  This is why I don’t insist that rates must head higher.  It depends on society as a whole.

Raising taxes has the perverse result of slowing economic growth, which affects future taxes.

2) Inflate the currency.  Ugh.  Oppress the elderly, who cannot work to make up the difference?  Create a new inflation mindset that has all of us focusing on the short-term.  Inflationary economies by their nature become more and more short term.

3) Default on obligations.  There are several forms of this:

a) Total default: anyone with a Treasury Note is a sucker.  Global depression ensues.

b) External default: we do not honor external obligations, but honor internal ones.  Global depression ensues, but the US does relatively well.

c) Internal default: what, are you joking?  Why do we pay off the losers who lent to us?

As we look at Greece, Spain, and Portugal, we chuckle over the foolishness of the EU thinking that they could have monetary union without full political union.  It didn’t work under the Confederation, why should it work elsewhere?

But we should not chuckle.  After all, we have California, Illinois, and New York, and more waiting in the wings.  There is no bankruptcy code for the states.  I am not sure what happens if one state does not pay, aside from being shut out of the municipal bond market.

So, my point remains — what are we going to do?  Raise taxes, inflate the currency, or default?  Perhaps in a real crisis, we would slim down the government.  We might also decrease Social Security and Medicare benefits.  We might also amend ERISA, to allow for reductions in pension payments.  In a real crisis, nothing is fixed.

Or, we might tax a lot more — the depression was an example of that.  That is a reason that I am not a total bear on Treasuries.

The government has choices to make.  What should they do?  Offer your answers as best you can.

When I was a corporate bond manager, I often dealt in less liquid bonds.  Why?  They had more yield, I only bought those that my credit analysts liked, and I had a balance sheet that could hold them.  I had the option of holding those bonds, but not the obligation of holding those bonds.  As credit conditions improved in early 2003, to leave my successor with a simpler portfolio, I decided to lighten my holdings of bonds issued by a private bank.  I held 35% of the issue, and bought most of it near the height of the panic.

I told my secretary, “The phone will start ringing off the hook in 30 seconds.”  She gave me that usual sweet smile and said, “Okay, David.”  I offered a chunk of the bonds 0.2% below the last trade in spread terms, without guaranteeing the level.  To my surprise, I got a lot of bids rapidly, to the point where I said “whoa! there are too many that want these bonds.”  I recalibrated my levels and offered a “supply curve” of bonds, where I offered more the higher the price went.  I ended up selling 2/3rds of my holdings, and made significant gains for my client.  The final trade was 1/2% tighter than my initial proposed trade.

Having traded small and microcap stocks, and traded illiquid bonds, I am less afraid of illiquidity than many are.  Illiquidity is something that one can absorb, if he has a strong balance sheet and a patient disposition.

The great Peter Lynch would buy small cap stocks for Magellan, with strict orders on price.  Then he would let them sit, while they gained in value on average.  Marty Whitman buys in “safe and cheap” small cap stocks that are illiquid and holds them until their value is recognized.

If you have a strong balance sheet or patient investors, take advantage of it, and buy investments that are less liquid, where value may take a while to obtain.

But liquidity is not natural to all assets.  Most things in an average person’s life will not be liquid.  Your house and car are not liquid.  It will take a lot of effort to sell them and buy a different house and car.  So why should futures on property values be liquid, or residential mortgage-backed securities?

Well, debts that are very certain will always be liquid.  Debts that are less certain will be liquid during boom-phases, and illiquid during bust-phases.  In general, that is why AAA-rated asset-backed securities, which are usually “last loss” securities are fairly liquid, while lesser-rated securities trade rarely.

My point is that you can’t take illiquid assets and make them liquid.  Assets are liquid because they are short term, where one knows the cash flow to be received soon.

Are public stocks, like Exxon Mobil, liquid?  In one sense, yes.  During the day, when trading is in session, and there is
no news hitting the wire, then yes, quite liquid — one can get in and out of a position easily with little difference between the bid and ask.  But, when news hits, or from the closing price to the next day’s open, the price can move considerably.

Over a long period of time, the shares of two companies in identical businesses, one publicly traded, and one privately held, could deliver the same value over a long period of time.  The public company would have the ability to adjust its capital structure to buy in shares when they are cheap, and sell when they are dear, unlikely as that behavior is.  The public company would adjust its debt levels more frequently, while the private company would likely keep debt high and equity low, to keep taxes low.  The private company could act quietly and think longer term, subject to the constraints of their loan agreements.  The public company would have more bumps to its seeming value from news events, including earnings releases.

For the holder of shares in the public company, though liquidity is available, the value of the shares will vary.  For the public and private companies alike, liquidity for any large amount of the shares would be an event.  And, aside from successful maturity dates, the same would be true of large amounts of debt — there might be a public market available for small amounts of it, but just try to buy or sell a big amount, and pricing conditions are rarely favorable.  My example at the start of the post, where I sold 20% of the total issued amount for a favorable price, only happened because the willingness of investors to take risk increased dramatically since the last trade.  Yield greed had set in.

But that brings up the other definition of liquidity — what does it cost to enter/exit fixed commitments?  Tight credit spreads mean that corporations can (borrow) enter fixed commitments cheaply, and lenders, dearly.  The same applies to Fed policy — a wide Treasury curve means that it is expensive to borrow long, and cheap to borrow short — but borrowers want more security than to have a short maturity leash.

But when lenders are scared, they gravitate to short loans and high quality — cash equivalents lent to the Treasury.  If enough do that, short term yields get really low.  They can even go negative.

I remember arguing with a visiting professor at Wharton back in 1990 that negative interest rates were possible.  He told me I was nuts, people would sit on cash.  I replied, “what if you can’t keep the cash safe?”  Maybe I should have said, “What if it is inconvenient to transfer and guard several billion dollars in cash?  There are costs to that as well.”

In a liquidity trap like we are in, short-term money managers that must have US Treasury collateral must bid for it, no matter what.  They can’t move to cash.  Cash to them is very short-term debts of the most creditworthy entity that they know — their Government, the one that controls the Fed, sorta.

But the volume of lending, particularly to smaller business borrowers is light.  Is there really a lot of liquidity out there?  Or, is it being used primarily by the US Government and its affiliates while the economy is weak?  I think that is the case.

Liquidity is not magic; it can’t be created or destroyed — it just travels where it is needed.  During booms, liquidity appears abundant because of loose monetary policy and high willingness to take credit risk.  It seemingly disappears in the bust, as the marginal fixed income investor attempts to eliminate credit risk — liquidity then flows to the highest quality assets.

Liquidity is always around; it is only a question of where the marginal credit buyer has migrated.  In the current environment, it is short high-quality obligations that are still king, and lower-quality longer obligations that trail, though not as badly as last winter.

I am sure that I will write more on this topic, should I live so long.  My contentions are:

• Securitization does not create liquidity, it only redirects it.
• The Fed does not create liquidity, it only redirects it.
• The Treasury does not create liquidity, it only redirects it.

Liquidity is a function of human action.  We all have to work and trade to survive.  Liquidity is where people are transacting at any given moment toward that end.  Structural changes in the economy, whether by the government or through private channels will shift where liquidity goes, but it will not change the amount of liquidity, unless the changes are so severe that the economy itself becomes much less productive.

I have been thinking about the the forces distorting the global economy.  In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.  Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.  The biggest distortionary force in the world now is China.  They encourage banks to loan to enterprises in order to force growth.  They keep their currency undervalued to favor exports over imports.  What was phrased to me as a grad student in development economics as a good thing is now malevolent.  The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.  Well, this era is different.  Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.  I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.  I expected inflation to be the problem, and the real problem is deflation.  Will there be bailouts?  Will the troubled nations leave?  Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.  The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.  Residential delinquencies are at all-time highs.  Strategic default is rising.  The shadow inventory of homes that will come onto the market is large.  I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.  There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.  The state economies are weak at present.  Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.  Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.  Thus the low short-term interest rates.  Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.  The low short term interest rates touched off a competition to bid for risky debt.  The only question is when it will reverse.  Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.  Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest  pressures, but it is hidden.  Many of the European nations and Japan face shrinking populations.  China will be there also, in a decade.  Nations that shrink are less capable of carrying their debt loads.  In that sense, the US is in good shape, because we don’t discourage immigration.

I think earnings quality is one of the great neglected concepts of investing.  Why do many growth investors blow up on seemingly promising companies?  The answer is often that the investors did not review earnings quality.  Why do value investors fall into value traps?  The answer is often that the investors did not review earnings quality.

I have reviewed a number of books, and written many articles about earnings quality  Because so much of the investment world is blind here, the idea still has punch.

Thornton O’Glove hits at the subject in a traditional way — accrual accounting entries are always more suspect than cash entries.  He focuses on:

• Being skeptical — don’t trust management, analysts, auditors.
• Look for inconsistencies in disclosure.  Who tells a happy story broadly, bet is serious in regulatory filings?
• Who plays games with one-time events?  What companies push the limits in determining what is a one-time event?
• How do companies play with their accruals in order to report income?
• Is taxable income significantly out of whack with GAAP income?

The book was written in the Mid-1980s, before it was easy to review SEC filings.  That has changed, but few really review filings today, even though it is easy to do so.

This is a good book, and you can learn a lot from it, but many of the references are dated, as in the classic version of “The Intelligent Investor.”  I mean, I recognize most of the examples, but many readers will say, “Huh, I’ve never heard of that company!”

Do you want to improve your investing?  Look to earnings quality.

Who could benefit from the book?  Any investor could benefit from the book, particularly those that analyze fundamentals.

If you want to buy the book, you can buy it here: Quality of Earnings

Full disclosure:  I bought this book.  I review books old and new.  This old book still has value, and I recommend it.  It will require more effort than most investors are willing to put forth, but I believe it will yield value to those who work with it.  This is simple stuff, but it is work, and there is always a barrier to entry around work.

Also, anyone entering Amazon through my site and buying anything — I get a small commission, but you don’t pay anything more.  I love it when both my readers and I win.

I ordinarily like the writings of Jason Zweig, so this post is not meant as a criticism of him.  He wrote an interesting article suggesting that US investors may suffer reduced performance because they invest too much in US stocks.  Ideally, shouldn’t investors seek out the stocks that are likely to perform the best, regardless of where they are located in our world?

Ideally, yes.  Practically, there are difficulties.  I write this as one who has always allocated more than the average to international stocks.  Investing internationally assumes several significant things:

• There will be no war that changes the amount or terms of commerce.
• There will be no legal changes that affect property rights abroad.  This includes exchange controls.
• I will get the same flow of news that an investor in the target country will get.
• I understand the differences in the accounting rules, and will not get tripped up if they are more liberal than in the US.
• I understand that regulations are different in foreign countries as well.
• Transacting in non-ADR foreign stocks from the US can be expensive for retail accounts.  Buying mutual funds that invest in foreign stocks carries expensive management fees.
• Economic policy will remain rational in the target country, or at least, better than that of the US.
• I understand the trading nuances of the target country.

Home bias is normal, around the globe.  We understand the business dynamics of our own countries far better than foreign countries, together with our understandings of accounting, regulation, exchange controls, information disclosure, legal systems, economic policy, etc.

Even within the US, there is home bias among investors to the extent that we tend to invest more in companies that are near to us — perhaps it is a greater flow of informal information.

I would encourage all of my readers to invest abroad but to do it selectively.  Does the country allow for relatively free capital flows?  Do they honor the rule of law?  Is their accounting as good as that in the US?  Are there war risks?

There are risks in investing abroad that do not exist locally.  Make sure you minimize those risks if you invest abroad.

Ordinarily, I don’t think much of video on the web.  Writing is usually a more concise way to get a view across.  But video can be more effective if it gets past the genre of “talking heads,” in which case, one is usually better off reading a transcript.  Consider the State of the Union message as an example: regardless of who is president, would you rather spend an hour on it, of five minutes?  And, it would be five minutes where you are not distracted by the crowd, and can dissect things rationally.  I pick reading.

There are places where video can be useful, but it has to be well thought out.  I first saw the above video over at “The Big Picture,” which has enough readership to kick up a video’s viewings.  I thought it was clever, representing the economist’s views in a short catchy way, and capturing their philosophies  as well.  The next day, I showed it to three of my boys — they thought it was interesting, and mentioned it the next night at dinner.  My wife, incredulous at the idea of an economics rap video, then watched it the next night with all of the kids, while I cleaned up the dinner dishes.

Then the surprise happened.  “Dad, what are animal spirits?”  “Are animal spirits the bull and the bear?”

Interesting.  The video prompted questions from the children for me to answer.  I’ve written on Animal Spirits before, at least twice.  Animal spirits attributes irrational risk taking and avoidance to businessmen, as if they are irrational animals.

I told my children that businessmen are generally rational, and they make their decisions off of their own balance sheets, and the general willingness of the market to spend, which is related to balance sheets in aggregate.

The contrasts of the video are considerable:

• Keynes is known, Hayek is unknown.  Desk clerk immediately knows Keynes.
• The two men are hybrid in what they portray.  To some degree they represent the schools of thought that each was a leader of, and to degree the men themselves.
• Hayek reaches into the hotel room drawer, and rather than finding the Bible, finds the General Theory. Similarly, Keynes says, “I am the agenda.”  This is a statement of the dominance of Keynesian thought in modern macroeconomics.  Keynes was important, but not as dominant while he lived.
• Hayek assumes they will go via the subway.  Keynes hires a limo.  Keynes is worldly wise, having a great time, and Hayek is uncomfortable.  Keynes has alcohol; if Hayek is having alcohol, he is sipping it through a thin straw.
• Alcohol is an allusion through the whole piece.  Stimulus is just more of “the hair of the dog that bit you.”  The boom is a good time where we drink freely, and the bust is where we deal with our hangover.  It was no surprise to see that the Bartenders were named “Ben” and “Tim” and that they were serving up alcohol for as long as the patrons would survive.  Even the pyramiding of the glasses had meaning — building up to a stuporous, unsustainable level.
• Keynes holds money as he begins his rap, and throws it midway through.  It is an aspect of how incentives from the government or central bank can lead behavior for a time.
• Keynes ends his rap with “We’re all Keynesians now.”  Keynes himself did not live to hear that comment uttered by Friedman in the ’70s.
• Keynes and Hayek had different views on spending and savings.  On spending, Keynes didn’t think what money was spent on mattered, only that it was spent.  Hayek felt that intelligent spending would grow the economy more.  On savings, Keynes was negative, whereas Hayek said that moderate savings were valuable, and would facilitate future investment.
• As for animal spirits, businessmen only get bold when they have sufficient free capital to act.  When interest rates are artificially low some businessmen invest, trusting that good times will continue.  Alas, those good times never last; avoid long commitments when times are good.
• There are liquidity traps, but they occur when banking systems are broken due to misregulation.
• “In the long run we are all dead.”  Well, Keynes, way to care for our progeny.  You had no kids, for a variety of reasons, but some of us care for how our children, and the nation that we love will do after we have died.

The video portrays a Goliath and David situation.  Keynes is dominant, and totally assured of his position in the world.  Hayek is less certain of himself, but certain in his message.

My wife and my kids have a better understanding of the current economic situation now than they did before the video came out.  I am grateful that the video was made.

I once wrote a post on university endowment investing that I thought was one of my better ones, but drew little attention.  It helped to inform another piece I wrote that was better received, The Forever Fund.  Okay, two more if you are a glutton for this kind of stuff: Liquidity Management is the First Priority of Risk Management, and The First Priority of Risk Control. (Note: university endowments had a lousy year ending in June of 2009.  Things may be looking better now, but with interest rates so low, university endowments are even more reliant on outperformance of equities and other risky assets.)

The key idea is this: understand what you are trying to fund before you begin investing.  When will the money be needed?  How much?  How realistic is the implied rate of return?  What if everyone with needs like yours tried to do this?  Would it work then?  Is the demand for investments that are optimal for entities with your liability structure greater than the available investments to be had?  Do you have some sustainable competitive advantage that few others have?

When I look at ideas like pension plans employing leverage (also here), I think they don’t know what they are doing.  Anybody remember how New Jersey decided to sell pension bonds and lever up their pension investments in risky assets?

• How the Garden State Dug a Hole
• Strapped Governments Revive Pension Bonds
• Christie Crosses N.J. Party Line Amid $34 Billion Pension Gap

That last article is timely, published today.  What began as borrowing $2.7 billion to plug a gap became a $34 billion gap.  Risky assets, particularly equities, did not perform.  Not only did they not earn enough to earn the actuarial rate needed to fund the defined benefit plan, they also had to pay interest on the pension bonds.

Trying to fill a funding gap via a more aggressive strategy is usually foolish.  If that were the best strategy, you should have been employing it already.

But consider the leverage angle more closely.  A defined benefit plan is by its nature a plan to pay out a stream of benefits over time to beneficiaries.   Typically they invest some of their assets in bonds that are shorter than the length of the stream of benefits they will have to pay.  Those bonds typically don’t earn enough to cover the actuarial funding rate, so they invest the rest in risky assets that they think that blended with the return on the bonds, will earn the actuarial funding rate or better.

There are at least three problems here:

• It would be ideal to invest entirely in super-safe debt instruments that match the expected liability cash flows, but that would require too much in taxes from the citizenry.
• But the moment that you move to funding some of the assets into stocks you open up two risks: 1) funding risk — what if the risky assets don’t perform to the degree needed? and, 2) Interest rate risk — the moment you are not matched there are risks if interest rates move against you.  This is usually a risk if rates move down.  It is rare for a defined benefit plan to buy enough long debt such that the value of bonds rises as much or more than the present value of the liabilities rise when interest rates fall.
• Pension bonds, or any sort of investments with internal leverage have the potential to increase funding risk, and they increase interest rate risk as well.  Pension bonds add another fixed claim to the existing semi-fixed claim of the benefit stream.

Are we the double-down society as far as investing goes?  It sure seems like it, and if many entities do this as a group the failure of the idea will be spectacular.  Risk premiums are not high now; take a look at Jeremy Grantham’s forecasts on page 4 of this PDF (which has many other useful bits that you can learn from).  Borrowing money to invest when risk premiums are small is playing the exact same game as we were doing with CDOs from 2005 to 2007.  If the spreads are thin, pile on more leverage!  That will get us to our earnings target.

It’s sad to see this phenomenon reappearing.  Don’t we ever learn?

Comments

• Hoenig’s dissent is interesting, but not significant.  The regional bank presidents have lost a lot of effective authority since unconventional lending came into existence.
• As has the Fed funds rate – so long as the Fed is buying long dated paper such as agency MBS, the Fed funds rate is not the pinnacle of monetary policy.
• Watch capacity utilization, unemployment, inflation trends, and inflation expectations.
• The FOMC shades up its certainty level on almost everything except real estate, where they seem to express more doubt.
• They think the recovery has begun, and they are definite about it.