28 July 2007 – The Aleph Blog

Speculation Away From Subprime, Part 2

Posted on 28 July 200729 July 2007 by David Merkel

What a week, huh? Even with all of my cash on hand, I did a little worse than the S&P 500. One house keeping note before I get started, the file problem from my last insurance post is fixed. On to speculation:

When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can’t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don’t), volatility is reduced, and panics are more slow to occur.
Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here’s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
Shhhhh. I’m not sure I should say this, but maybe the investment banks are cheap here. I’ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.

We’re going to have to end it here. Part 3 will come Monday evening.

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Book Review ? An American Hedge Fund by Timothy Sykes

Posted on 28 July 20075 September 2007 by David Merkel

An old boss of mine once said that in the investing world, it paid to do favors for people, because you can never tell what good will come from it. I have read an advance copy of Timothy Sykes? forthcoming book, An American Hedge Fund.

Aside from our common love of investing, it is hard to find similarities between Mr. Sykes and me. He trades rapidly and aggressively; I trade infrequently. He relies on momentum; I resist momentum. He became a professional investor early in life, and has always worked for himself; I became a professional investor later in life (38), and have always worked for others. Loss control for Mr. Sykes is a fast hand on the sell button (or the buy button if he is short); for me it is diversification, margin of safety, etc.

I have always maintained that there is something to be learned from analyzing those that do not invest like I do, particularly if they are successful by means that strike me as unlikely. I learned seven lessons from the book:

1) One thing that I share with Mr. Sykes is understanding where my edge is. Early on, Timothy Sykes figured out that he had an advantage in analyzing the technicals in micro-cap stocks. He pressed that advantage assiduously, and did exceptionally well, though with significant pullbacks.

2) Another thing that I share with him is that I don?t give up easily. He persevered through some drawdowns that would make most people give up.

3) The book helps reinforce the lesson of sticking to your edge. If you?re a momentum guy, don?t try to be a fundamental investor, and vice-versa. Once you know your edge, stick to it. If you don?t, your results will likely suffer.

4) Another lesson that the book holds is the psychological differences in running other people?s money. It ain?t easy; risks that you are comfortable taking for yourself, you might not be comfortable taking for others.

5) As a professional, one must investigate the carrying capacity of the edge that you employ. How much money can you run before your strategy stops working?

6) Is a great investment strategy and track record enough to start an investment firm? Early money is hard to come by. There are many who contribute only when a firm is obviously successful, and few that will contribute to a fledgling firm. Also, good fund marketers are hard to come by at a reasonable price, if they exist at all. So far in my life, I haven?t met one.

7) The last lesson: do what you are good at; do what you love, but recognize realities. There are times when opportunity knocks, and times when it doesn?t. Pursue the advantage you see in front of you, until a better advantage presents itself.

In summary, I enjoyed An American Hedge Fund. Through the lens of Timothy Sykes, I got to see the creation of an investment process, a hedge fund, and all the difficulties that go along with it.? The book is available for purchase at Amazon.com.

Insurance Earnings So Far 2Q07 ? Part V

Posted on 28 July 200728 July 2007 by David Merkel

We’re not even midway through earnings season for insurance, and I have a dirty secret to share: Insurance stocks are down on the year on average. 🙁 What a scandal, particularly for an industry with little ties to the sectors in the market with the most credit stress.

Here’s the most recent file on insurance stock performance at earnings. Here are the main lessons, so far:

Beating earnings by 10% leads to beating the price performance of the index by about 1%.
Brokers and Commercial Lines are doing the best so far.
Positive price performance is associated with growing revenues, and rising guidance.
With the credit furor going on, it is no surprise that financial insurers are doing the worst of all of the subgroups.
Asset sensitive life insurers are faring badly in the face of good earnings, because with the fall in the equity markets, insurers might have lower asset based fees coming.