The Aleph Blog » 2007 » March

Archive for March, 2007

Update on Indicators

Saturday, March 31st, 2007

Usually I look at my indicators at the beginning of a month. If I look at them more frequently, the changes are too small, and I don’t get the signal. In no particular order, here are my thoughts, both Bullish and Bearish:

Bullish

  1. Contrary to what the bear in Barron’s said this weekend, the chart for the Merger Fund is bullish. They paid a dividend at year end, and the current chart shows that arbs are making money, which is bullish.
  2. ECRI’s indicators are forecasting growth up, and inflation down.
  3. Both emerging market stocks an bonds have bounced back well.
  4. Earnings yields are still high relative to Treasuries, though if profit margins mean-revert, this argument is hooey.
  5. ISI Group’s broadline retailer’s survey is showing some life.
  6. Securitization of subprime loans, and CDOs containing tranches of subprime deals rated less than AA, are not getting done. These assets are getting sold to financial intermediaries that have adequate balance sheets to fund them.

Bearish

  1. From Alan Abelson’s column in Barron’s this weekend, Henry Kauffman uses a concept akin to my “bicycle stability versus table stability” to discuss liquidity. The former is access to credit, while the latter is excess high quality assets that are readily salable.
  2. Imposing tariffs on China is a real dumbkopf move. Eventually that will bite into the capital flow that keeps our interest rates so low, in addition to decreasing the benefits from the global division of labor.
  3. M3 is falling, and significantly. The banks are pulling back from landing, and credit availability is shrinking. My M3 proxy is the total liabilities of the banking system. Works very well.
  4. Fed funds continues to miss on the high side, since the FOMC meeting. The monetary base has gone flat, and there has been only one permanent open market operation this year, on 2/26.
  5. Financial stocks are lagging the market.
  6. The yield curve is still flat.
  7. Equity REITs don’t yield enough relative to Treasuries.
  8. Housing prices are falling nationwide.
  9. Asset price changes are increasingly in two camps: safe and risky. Correlations within the two camps are high and positive. Correlations of the two camps are very negative.
  10. Inflation remains high over the Fed’s comfort zone.

Neutral, or You Call It

  1. Implied volatilities have bounced up, but are still low.
  2. Corporate bond spreads have bounced up, but are still low.
  3. Implied 5 year inflation, five years forward, has been in a channel between 2.2% and 2.8% for the last four years.
  4. TED spreads are higher, but still low.
  5. The swap curve gained slope after the recent mini-crisis.
  6. The FOMC tightened less this time relative to prior times, if the measure is inflation versus the Fed funds rate.

That’s all for now. The two biggest bits of news are the tariffs on Chinese goods, and the decline in my M3 proxy. Bearish items both.

Current Industry Model

Saturday, March 31st, 2007

My current industry models can be found here. No commentary, just a service for readers. If you use it in value mode, pick from the green zone. If in momentum mode, the red zone.

A Good Quarter

Saturday, March 31st, 2007

I’m still looking for a way to document my performance to readers, but let me simply say that the broad market portfolio beat the S&P by a few percent. What worked?

  • Fresh Del Monte
  • Grupo Casa Saba
  • Valero Energy
  • Helmerich & Payne
  • ABN Amro (sold too soon) ;)
  • Dorel Industries (wish they hadn’t delisted)
  • Lyondell Chemicals
  • Dow Chemicals, and
  • SPX Corp

You see any commonalities there? Energy, especially refining. Chemicals. Aside from that, I don’t see anything really correlated.

What didn’t work?

  • St. Joe
  • Barclays plc
  • Japan Smaller Capitalization Fund
  • Nam Tai Electronics
  • Cemex
  • Lithia Motors
  • Conoco Phillips
  • Magna International
  • Jones Apparel
  • Deerfield Triarc, and
  • Allstate (ouch)

Commonalities? Autos, maybe? Away from that, it seems eclectic to me.

In my balanced mandates, my foreign bonds and floating rate securities worked. High quality paid off as volatility rose. Really didn’t have any problems with my bonds.

Now I just have to do as well next quarter. :)

Full disclosure: long  FDP SAB VLO HP ABN DIIB LYO DOW SPW JOE BCS NTE CX LAD COP MGA JNY DFR ALL

Getting Your Portfolio in Better Shape

Thursday, March 29th, 2007

I had a two-part series that was published at RealMoney, and at the free site, TheStreet.com, that further explains a series of posts that I did here on my recent portfolio reshaping. Here are the links:

Getting Your Portfolio in Better Shape

Getting Your Portfolio in Better Shape, Part 2

It’s relatively unusual for my articles to be out on the free site, so enjoy the boon from The Street.com.

Around the Web, and then Some

Wednesday, March 28th, 2007
  1. There were two articles on reinsurers this morning suggesting that there should be a lot of consolidation via M&A. I’m not so sure. First, most players there want to acquire, not be acquired. Second, most of them don’t trust the underwriting and reserving of their competitors to the degree that they trust their own. To the extent that current players want to diversify, it is cheaper to do it organically than by acquisition. With the high degree of ease of entry into the market, the franchise value of a reinsurer is low. Now, maybe the property-centric reinsurers want to diversify (a smart idea, but they are stubborn), or the new reinsurers want to buy in a reverse merger one of the class of 2001 to eliminate the capital haircut from the ratings agencies (but they don’t have the cash for it). Those ideas make sense, but scale isn’t that much of a virtue here, and with P&C reinsurers the reserving is opaque as mud. I can see a deal or two getting done, but not a lot of them.
  2. With all the hand-wringing in the Wall Street Journal this morning on free trade, just watch, we impose some series of tariffs or restrictions that reduce the current account deficit, only to see the capital account surplus shrink also, leading to higher interest rates and a lower dollar, breaking the current cycle giving the US cheap imported goods in exchange for dollar denominated bonds.
  3. Throw a rock, hit a commentator who says that the Bank of China (or other major central bank with large dollar holdings) would never sell their positions because it would work against their interests, driving the value of the dollar down. That’s a half truth at best. Here’s why: the central bank will eventually focus on the future, realizing that sunk costs are sunk. Just because you have a big dollar position, does that mean you have to add to it to preserve its current value. Ignore the past, and let the dollar denominated securities mature. Use fresh cash and maturity proceeds to buy assets in the currencies that you like. It won’t cause a panic, but the dollar will still adjust down. Recognize from the start that the dollar assets are worth less than current exchange rates, and maximize value from there. (Large holders of any asset under pressure have to think this way to maximize value.)
  4. Buyer Beware. Or maybe, it should be borrower beware. People are generally less competent at making rational choices when they are borrowing rather than paying cash. So it is no surprise that when Beazer finances homes that they sold, buyers might have gotten less than an optimal deal. This is true with many financial transactions. In general, the more moving parts in a transaction, the worse off the average person is in evaluating a deal. Better to line up your financing separate from the decision to purchase an asset, or you could end up up with a bop on your beezer, figuratively speaking.
  5. So FASB might have a tighter leash on its neck from the SEC? Not sure whether that is good or bad. Neither organization gets high marks in my book. FASB desperately needs a more coherent overarching approach to accounting, rather than the piecemeal addjustments that they are doing. The SEC, if anything, is more beholden to political pressure, and the idiocy that that brings into accounting.
  6. Then there’s Texas, basically invalidating the GASB on reporting the liability for long term government employee benefits. You might remember my piece at RealMoney, Pensions: Things Can Always Be Worse. Well, this is an example of that, and it is not limited to Texas. Though the Texas argument may have merits, governments all over the country are finding that they have to finally recognize the present value of the pension promises that they have made, and disclose it to the citizenry. It will be a mess, because a large amount of these promises are totally unfunded, much like Social Security, Medicare, and most other programs of our Federal Government.
  7. It takes a week, but finally the market comes around to my view of the FOMC, though it takes Bernanke before Congress to correct the view of the markets. Inflation is not on hold, but the FOMC is, for now.

Bicycle Stability Versus Table Stability

Tuesday, March 27th, 2007

A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

I developed this analogy back when I was a corporate bond manager, because there were some companies that would only stay afloat if they kept moving, i.e., if operating cash flow continued at its projected pace. That is bicycle stability; they have to keep pedaling. There were other companies that could survive a setback in earnings, and even lose money for a time, and the debt would still be good. That is table stability.

Need I mention that in a crisis, the equity of companies with table stability typically fall less than those with bicycle stability?

I think that it is incumbent on every portfolio manager to look over his portfolio, and ask what companies that they own would not be able to survive if they were not able to raise capital for two years.

My current main economic concern is that inflation in the developing world, particularly China and India, will lead to their central banks to overshoot on policy, and cause a drop in global aggregate demand. Inflation is accelerating, and money supply is not slowing. The excess liquidity is not finding its way into goods prices as much as into asset prices.

This portfolio review will not protect you from loss, but it will protect you in relative terms in a crisis. You won’t be hurt as much.

Around the Web

Monday, March 26th, 2007
  1. There was an article in Forbes interviewing Jeremy Grantham that made me think. He suggests that value investing might be heading for a period where it will underperform. I.e., value stocks are not as relatively undervalued as they normally are. If he is correct, what should I do? I could shut off the value discipline, and run my industry models in GARP [growth at a reasonable price] or even momentum mode. That cuts against my grain; perhaps what I would do is give a little more weight to the industry models as I make my selections. That would tilt me away from hard value measures. My methods are eclectic, so I have to adapt to what the market is likely to reward 2-4 years from now.
  2. “Minsky moment.” Ah, cute phrase. Well, I loved Edward Chancellor’s, “Devil Take the Hindmost,” and he has an interesting article at Institutional Investor. The themes he talks about are dear to me. My only quibble is that we aren’t yet there for a collapse. There is enough cash available to mop up problems at present. Whether that will continue to be true is another question.
  3. My biggest concern is the dollar, and the carry trade. If the dollar dips below 112 yen, I suspect that there will be a self-reinforcing panic as short yen positions get covered. The Economist had a piece on this recently that made a lot of sense. Eventually we will have an unwind here, but it will come with a lot of kicking and screaming in Asia.
  4. For wonks only, First American Corelogic posted a report called Mortgage Payment Reset 2007: The Issue and the Impact. Very informative on the effects of the loan reset features on hybrid loans, and what might happen to the real estate markets.

The Kelly Criterion

Monday, March 26th, 2007

In an upcoming article at RealMoney, I will be writing an article on optimal position sizing. To do that, I use the Kelly Criterion, which says that a position size should be equal to (edge/odds). There is added complexity in applying this to stocks, because in gambling, each game is uncorrelated with the last one. In investing, if you have a number of investments going at the same time, they are to some degree correlated with one another, particularly for me, because I concentrate sectors.

The Kelly criterion applied to stock investing would recommend a fixed weight portfolio. Optimally, you would rebalance daily to those fixed weights, but there are two factors that interfere: first, there are costs to trading, and second, momentum tends to persist in the short-run. To me that implies that one has fixed weights, but that you set a band around those fixed weights for rebalancing. I use a 20% band, but the more I think about it, the band should be smaller, like maybe 10%. My portfolio has gotten bigger over the past few years, and trading costs are a smaller percentage cost factor. I’ll stick with 20% for now. It has served me well, but I will re-evaluate this.

I firmly believe that my eight rules tilt the odds in my favor. How much are each of the rules worth? Well, that I will describe in the article at RealMoney, and that hopefully will explain why holding 35 or so positions is proper for me in running my strategy.

One more thing, I appreciate the work done at the CASTrader Blog on the Kelly criterion. We manage money very differently, but we both appreciate the value of the Kelly Criterion.

PS — As an aside, I get ribbed by some at RealMoney, whether contributors or readers about holding 35 positions as hyperdiversified. In general I agree with portfolio concentration, but given that I concentrate sectors and industies, that makes 35 a lot more like 20 in terms of total volatility. On the other hand, compared to most mutual fund managers, 35 names would be a tighter ship than 95% of them run.

SFAS 159

Saturday, March 24th, 2007

I’m not an accountant.  I have never taken an accounting course in my life.  Yet as an actuary and a financial analyst, I have had to use accounting rules to understand financial statements, both in the production of them, and the interpretation of them.  (I even remember writing a paper explaining the effect of the then-current FAS 52 on foreign exchange when I was a grad student.)

There are a number of Statements of Financial Accounting Standards that I think have been mistakes.  We are between paradigms.  The central question is this: how often do we want to re-estimate the value of balance sheet items, and if they change, how should they be reflected in the income statement?

There are two consistent ways to do this.  Other methods are a kludge in my opinion.  Method one is amortized cost on both sides of the balance sheet.  Method two is the estimation of fair market value on both sides of the balance sheet.

But SFAS 159 allows companies to elect which assets and liabilities (with some restrictions, and subject to SFAS 115) they can value at amortized cost or at fair market value, together with disclosure on how the assets/liabilities are valued.

Now, I know that the FASB is trying to create standards that will be more consistent with international accounting standards, but what they are doing here will make accounting less comparable across US companies, particularly given that adherence to SFAS 159 is optional.

For companies with no long term agreements, SFAS 159 will not have any major impacts, but as for me, given that I follow the insurance industry, this will make my life more complex, without any equivalent increase in understanding.

As I said once to a panel of the IASB and FASB, create two consistent financial statements, one amortized cost, and one fair market value.  This would mean two income  statements and two balance sheets, and one cash flow statement.  They though that was too much work, but I disagree; companies are doing that work now, but they are not reporting it.  Better they should disclose what they know.

Survival of the ABX.HE Indexes

Saturday, March 24th, 2007

When Wall Street comes up with a good idea, they overdo it until the system chokes on the product they created. After the market failure, the system becomes more sophisticated and risks are priced better.

The ABX.HE indexes were created to have a uniform way of trading tranched subprime mortgage credit on a consistent basis. This would allow parties to go long or short, and in greater volume than the underlying cash market would support. They started with the 06-1 deal, which reflected subprime mortgage deals from 20 different originators from the second half of 2005.  They have gotten as far as the 07-1 deal,which reflected subprime mortgage deals from the same 20 originators from the second half of 2006.

Well, now what?  Many of those originators are gone, and most of the rest have scaled back massively. Will there be an 07-2 deal?  In some ways, I wonder if the existence of the ABX.HE deals didn’t help to create part of the problem, in that the 20 originators had to come out with at least one deal of a certain size every six months.  Being in the index would mean cheaper funding, so an originator would want to do that if possible.

I don’t see how the ABX.HE 07-2 gets done, and honestly, the system might be better off if it doesn’t get done.  The existence of subprime mortgages encourages some people to take on onerous debt that they would be better off not incurring.  Anything that encourages more subprime lending (and other high interest forms of debt) is in my opinion, a bad thing.  Let people learn to defer their gratification, put more money down, and on the whole, they and the whole nation will be better off.

Disclaimer


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


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


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

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin