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Archive for May, 2007

Going Through the Research Stack

Thursday, May 31st, 2007

Once every two months or so, I go through my “research stack” and look at the broad themes that have been affecting the markets. Here is what I found over vacation:

Inflation

  1. Commodity prices are still hot, as are Baltic freight rates, though they have come off a bit recently. Lumber is declining in the US due to housing, but metals are still hot due to global demand. Agriculture prices are rising as well, partly due to increased demand, and partly due to the diversion of some of the corn supply into ethanol.
  2. While the ISM seemingly does better, a great deal of the increase comes from price increases. On another note, the Implicit Price Deflator from the GDP report continues to rise slowly.
  3. Interest rates are low everywhere, at a time when goods price inflation is rising. Is it possible that we are getting close to a global demographic tipping point where excess cash finally moves from savings/investment to consumption?
  4. At present, broad money is outpacing narrow money globally. The difference between the two is credit (loosely speaking), and that credit is at present heading into the asset markets. Three risks: first, if the credit ignites more inflation in the goods markets which may be happening in developing markets now, and second, a credit crisis, where lenders have to pull back to protect themselves. Third, we have a large number of novice central banks with a lot of influence, like China. What errors might they make?
  5. The increase in Owners Equivalent Rent seems to have topped out.

International

  1. Global economy strong, US is not shrinking , but is muddling along. US should do better in the second half of the year.
  2. The US is diminishing in importance in the global economy. The emerging markets are now 29% of the global economy, while the US is only 25%.
  3. Every dollar reserve held by foreigners is a debt of the US in our own currency. Wait till they learn the meaning of sovereign risk.
  4. Europe has many of the problems that the US does, but its debts are self-funded.
  5. The Japanese recovery is still problematic, and the carry trade continues.
  6. Few central banks are loosening at present. Most are tightening or holding.
  7. There is pressure on many Asian currencies to appreciate against the dollar rather than buy more dollar denominated debt, which expands their monetary bases, and helps fuel inflation. India, Thailand, and China are examples here.

Economic Strength/Weakness

  1. We have not reached the end of mortgage equity withdrawal yet, but the force is diminishing.
  2. State tax receipts are still rising; borrowing at the states is down for now, but defined benefit pension promises may come back to bite on that issue.
  3. Autos and housing are providing no help at present.

Speculation, Etc.

  1. When are we going to get some big IPOs to sop up some of this liquidity?
  2. Private bond issuers are rated one notch lower in 2007 vs 2000. Private borrowers in 2007 are rated two notches lower than public borrowers, on average. Second lien debt is making up a larger portion of the borrowing base.
  3. Because of the LBOs and buybacks, we remain in a value market for now.
  4. Volatility remains low – haven’t had a 2% gain in the DJIA in two years.
  5. Hedge funds are running at high gross and net exposures at present.
  6. Slowing earnings growth often leads to P/E multiple expansion, because bond rates offer less competition.
  7. Sell-side analysts are more bearish now in terms of average rating than the ever have been.
  8. There are many “securities” in the structured securities markets that are mispriced and mis-rated. There are not enough transactions to truly validate the proper price levels for many mezzanine and subordinate securities.

Comments to this? Ask below, and I’ll see if I can’t flesh out answers.

The Premature Return of Equity REITs?

Thursday, May 31st, 2007

Ugh. After the purchase of EOP, I felt that equity REITs had reached valuation levels that not only discounted the lifetime of my children, but eternity as well. With the purchases of Archstone Smith and the Pennsylvania REIT, we are at valuation levels near those at the EOP purchase. My metric is equity REIT dividend yields versus the 10-year treasury yield. When one has to give up 1.2% in yield to move from safe Treasuries to risky REIT equity, there is something amiss. The valuation levels embed significant assumptions for growth in rents, which is particularly dangerous when the bull cycle in commercial real estate is so extended.


As a side note, before the purchases were announced, REITs looked the worst from a technical standpoint in the financial space. Now they are the best. So much for the utility of technical analysis.

Alt-A Loan Performance Statistics Getting Worse

Wednesday, May 30th, 2007

Look at this press release from Fitch. Though it is only dealing with one set of securitizations, Residential Accredit Loan, Inc., or RALI, it is interesting to see how many 2005 and 2006 deals are experiencing poor performance, and as a result, the lowest classes in those deals are being downgraded.

Just a reminder that the stress in lending is not limited to only subprime lending. All non-prime lending is affected. This is just a straw blowing in the wind… but I would lighten up on financial stocks with significant commitments to Alt-A lending relative to their overall book of business.

When Will the Goat Reach the End of the Snake?

Tuesday, May 29th, 2007

Speculation.  Rampant speculation.  This run in the market has to end soon, right?  Right?!

Look, I’m not so sure.  I have a lot to write on this topic, but not so much time.  Market trends have a nasty tendency to persist longer than fundamentally-based market observers would expect.  Let me give you the four things that could derail the markets, and tomorrow I can detail what I have seen in the markets concerning the four potential trouble spots (and more).

  1. The recycling of US dollar claims from the trade deficit ends because the US dollar falls enough to make imports dear and US exports cheap.  US interest rates rise as a result, stopping the substitution of debt for equity, and in some cases, leading to the raising of new equity capital.  We have seen upward adjustments in many foreign currencies so far, but not enough to change the basic terms of trade.
  2. Defaults in the bond and loan markets lead to a closing of the synthetic CDO market, which in turn leads to underperformance of many hedge fund-of-funds.    Bond spread widen as risk returns to lending, and the substitution of debt for equity slows to a halt.
  3. New supply comes to the equity market, overwhelming cash available.  This could come from private equity seeking to liquefy marginal asses at favorable prices.  Alternatively, this could come from private equity investments that are unable to pay their debt coupons.  It is less well known outside of fixed income investing that most insolvencies occur because companies can’t make a coupon payment, not that they can’t refinance a principal payment.
  4. Rising inflation in countries providing capital to the US forces them to revalue their currencies higher, and not keep sucking in US dollar claims, which don’t provide any goods to their people who want to buy goods to support their lives.

Interest rates need to be around 1.5% higher to shut off the speculation with near-certainty (did not work in 1987… rates got much higher.).  Until then, the party can go on.  I have an article being developed on this topic, but I fear it is a “next week” item.

Bottom Left Hand Drawer Issues

Tuesday, May 29th, 2007

Back in the saddle.  I have a lot to write about, but not so much time.  The insights developed over vacation will be spread out over the next week or so.

Just a quick one to get started.  In general, I think insurance companies with more than $100 million in assets should have their own investment departments, and not outsource the management of assets.  (Note: to any insurance CEOs reading this — would you like a chief investment officer with experience in all major fixed income classes, equity, and derivatives, and a knowledge of the actuarial side of investing as well?  E-mail me, and we can talk.)

I only know one insurance asset outsourcing larger than this, but Safeco has outsourced their asset management to Blackrock.  I think that it is a mistake.  Why?

  1. Insurance companies excel at creating tailored liabilities, taking individual risks away, and pooling them.  The same should be done with assets.  Anyone can hire Blackrock (a very good firm), but an intelligent management will take the time and effort to develop in-house expertise, which is usually cheaper than most third party solutions.  It gives up what should be a profit center for the enterprise as a whole.
  2. Third-party arrangements miss what I call “The Bottom Left Hand Drawer” issues.  I worked in insurance for 17 years, and I grew to love the competent but uncelebrated people in the company that did excellent work, but management thought were expendable.  Third-party relationships lack the freedom for customization that in-house management allows for.  Often because accounting systems don’t get it quite right, human intervention is needed.  Someone makes an adjustment off of a schedule that they keep in their bottom left hand drawer once a year, and that keeps the system running right.  In a third party solution, those issues can get lost; I have personally seen it fail.
  3. Penny wise, pound foolish.  The explicit expense savings are easy to see, but the implicit losses from not having someone managing the investments that is totally on your side is hard to measure.  Though I can’t prove it, the soft costs are large.

If I served an insurance company again as an asset manager, I would want to serve that company only, and not run a third-party asset management shop.  The work of an insurance company is important enough that it deserves the undivided attention of professionals on staff.

Away for the Next Week

Saturday, May 19th, 2007

2007 is the transition year at the Merkel household.  Our two oldest children go off to college in the fall, and our youngest starts home schooling at the same time.  As such, this is the last time that we can rely on that we will be able to take all of our children on a trip.  In the late summer of 2006, we went to visit my wife’s parents in San Diego; next week, we visit my parents in Milwaukee.

Now, I have no idea what internet access I might have while there.  If I have good access, I will post in the late evenings.  If not, well, you’ll hear from me next on the 29th.  With that, I sign off.  I have a lot of other things to write about, but little time to do so.  Traveling with eight children is quite a feat, and it will take a lot of my energy to accomplish that.

On Inflation

Saturday, May 19th, 2007

Inflation is a vague concept, because the term stretches to do duty in multiple areas: wage inflation, consumer price inflation, asset inflation, and monetary inflation, to name a few.  I agree with what Milton Friedman said that inflation is always and everywhere a monetary phenomenon, but where I differ is that monetary inflation may express itself in terms of inflation in the prices of goods and services, or in asset inflation.  Where inflation chooses to manifest itself depends on the balance of savers vs. spenders in a country.  Monetary inflation plus saving equals asset price inflation.  Monetary inflation plus spending equals goods and services price inflation.

As for the last week, I have a few articles to bring to your attention on inflation:

  1. Baby Boomers need to think about purchasing power risk in their old age.  This doesn’t mean overdosing on stocks, but it does mean considering investment classes that are correlated with inflation, like TIPS, floating rate bonds, selected commodities, and stocks of companies that produce them.
  2. I’m on record that I don’t like the way that the US government calculates goods price inflation.  From the way that they deal with owners equivalent rent, to the substitution effect, to hedonics (correct in principle, but they don’t do it right), to plain mismeasurement of the proper basket of goods, and the concept of core inflation, they mess things up.
  3. Barry Ritholtz and I agree on many things.  Inflation is one of them.  These two articles express much of what I think about what is wrong with the measurement of inflation.  Far better to use a median (Cleveland Fed) or trimmed mean (Dallas Fed) to eliminate volatility than to exclude food and energy.  Food and energy are crucial to our lives, and they have been running at higher rates of inflation.

Inflation is growing in many areas of the world, including those that finance our current account deficit.  Buying our bonds rather than letting their currencies rise, encourages inflation in their countries, while suppressing it in the US.  There will come a day when they float their currencies, and then inflation will return to the US with a vengeance.  When that happens, call Chuck Schumer to thank him for his vigilance on the Chinese exchange rate, not.

Insurance Earnings So Far 1Q07 — XII (Final)

Thursday, May 17th, 2007

Only three more companies to mention since my last post, here goes:

Primary Commercial

Employers Holdings beats estimates, but on falling premium volume. North Pointe misses earnings on falling premium volume, a higher loss ratio, and expansion expenses that can’t be deferred. Their acquisition looks interesting though; should be accretive to earnings.

Personal Lines

Affirmative Holdings misses estimates badly. More premiums, but higher loss and expense ratios.

Quarter End Summary

Here are the themes of the quarter. I would expect them to persist into the next quarter, which is what normally happens, but when themes don’t persist, the adjustment to prices can be severe.

  1. Though the sell side has gotten into greater agreement with the idea that the top line doesn’t matter much (an idea that I support), the buy side did not agree this quarter. In general, companies that grew their premiums were rewarded, and vice-versa for those who shrank or stood still.
  2. What worked: Primary Commercial, The Bermudans, Financial Guarantors and Life Companies. With Life companies, in general, the larger companies, and the ones with greater exposure to asset management did better. With Primary Commercial insurers and the Bermudans, in general the less conservative did better.
  3. What sort of worked: Personal lines and Conglomerates.
  4. Indeterminate: Title Insurers.
  5. What didn’t work: Brokers, Mortgage Insurers and Specialty Credit players. Credit trends were poor in the first quarter, and brokers faced shrinking revenue from shrinking premium rates.

That was the quarter as I saw it. Did you find this series valuable? If so, e-mail me at the address listed at the Aleph Blog. I have a few ideas on how to make it better, but perhaps this is too superficial to be of use. If so, tell me, and I’ll focus on other things.

Full Disclosure: long NPTE

Back From Bermuda

Wednesday, May 16th, 2007

My blog isn’t meant to be mostly about insurance, but I’ve been writing about it a lot lately.  After this, I should have one more wrap-up post about first quarter earnings, and that should be it.

My Bermuda trip went well.  Here’s what I learned:

  1. On net, pricing is actually improving at present.  Property rates have been improving, with 6/1 and 7/1 renewals at the same level as last year.  Casualty rates continue to deteriorate across almost all lines with aviation and D&O possibly having the most overcapacity.  Florida rates have been improving, because insurers are buying coverage above the Florida Hurricane Catastrophe Fund, and second event coverage as well.  Demand is high.  (And Florida is not charging anywhere near enough for reinsurance in their fund… a disaster waiting to happen.)
  2. Everyone wants to expand their specialty businesses, whether through tuck-in acquisitions, or lift-outs of underwriting teams.  At the same time, more of the business is being written standard by admitted writers.
  3. Because capacity with the highly rated carriers is adequate, the class of 2005 is having a hard time gaining enough business.  This is exacerbated by the insureds generally taking higher deductibles, and insurers retaining more and ceding less.  Also, sidecars are less needed in such an environment; many are maturing, and disappearing.
  4. “Revenge of the Nerds” could have been the theme of the meetings.  Only two of the 10 companies is growing their business.  Most are doing buybacks, and rest, minus Axis, are considering it.  All of them are following roughly the same investment models (excluding Max Capital), and all of them are following roughly the same risk control strategy, though a few are limiting their writings at absolute limits, rather than probability based limits, which have been known to overexpose companies when rare bad events hit.
  5. Conservatism is generally a good, but over-conservatism is a bad.  Platinum Underwriters is too conservative, and is losing vitality by not writing business unless they are almost certain they will make a 10% ROE.  They are shrinking now.
  6. Finally, reserves are the biggest area of disagreement.  Everyone says their own reserves are conservative, but few are willing to prove it, like PartnerRe and ACE.  XL may be going that way as well, disclosing reserve triangles.  In general it seems that if there are problems, it should be located in the portfolios of the heavier Casualty writers, like ACGL.

I came away relatively happy with our positions.  I like Allied World, Endurance, and PartnerRe roughly equally well.  I was impressed with Flagstone, and think that it could be a good buy during a wind crisis.  Arch and Max Capital presented well; there are reserving questions with Arch though.  XL did well, but I still wonder if they have control over their lines the way PartnerRe does.  Platinum is too conservative, and Axis smacked of braggadocio, somewhat touchy and defensive.  Answers were among the least clear given.

Final note, on people: The Arch meeting was a hoot.  They spoke their minds and dished on everyone, though not by name (clever analysts know, though).  XL’s CEO expressed contempt for MR Greenberg (“glad he’s gone”), and AWH’s CEO talked about his friendship with Greenberg, and how it is bringing AWH business.  Going with Harry Fong was a plus — his 30 years of experience is unmatched, and he has a quirky way of teasing the answers out.

Full disclosure: long AWH ENH

Still Another Boon from RealMoney.com

Saturday, May 12th, 2007

There are a number of articles that I wrote for RealMoney that fell into the “labor of love” category. So it was with my “If you get to Talk to Management” series. RM has republished the series at their TheStreet.com University. Enjoy it if you haven’t read it already.

Much as would like to post more, while I am in Bermuda it is unlikely that I will post much; look for me to be back on Wednesday.

Disclaimer


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


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


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

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