Before I get started on tonight’s piece, I thought I might apologize for a wrong prediction, lest I be confused with a famous guy that I sometimes get associated with.  I was wrong that ABX.HE 07-2 would not get created.  A number of the tranches priced significantly above a 500 bp yield, and so those lower rated tranches got sold at a dsicount to the par value of the securities.  In the unlikely event that those securities get paid off at par, the buyers will be most happy indeed.

But onto tonight’s topic.  Regarding credit default swaps, and their new cousins, ABX, CDX, LCDX, CMBX, etc… there are often more swaps trading than there are underlying cash obligations.  What this implies is that most of the activity going on is not hedging and speculation facilitating hedging, but merely speculation/betting.

What this means is that in the short run, until the cash obligations underlying the default swap mature, there is little to keep the cash and derivative markets together.  The swap spread could be a lot higher than the cash market spread, indicating fear, and a lot of players being willing to bet on partial or total default occurring.  That’s where we are now.  So, when I hear new lows on ABX.HE indexes, and some authoritative voice says that means many defaults are occurring in subprime mortgages, I take a breath and remind myself that it means that more players are betting on increased defaults and loss severity on subprime mortgages.

The opposite can happen too.  Back in 2002, when I was a corporate bond manager, and default swaps were pretty new, I would not buy bonds where the cash spread was smaller then the swap spread, because that indicated a lot of players betting against the bonds in question. If someone holding a bond would sell and replace it with offering protection on a default swap, they would improve their yield, so when the swap spread was wider, it would often lead the bond spread wider as well.  I would wait until the swap spread fell beneath the cash bond spread, and then I would pile in.  Worked really well, and my brokers at the time thought I had this great sense of timing.  Well, maybe I did, but it was analytical, not intuitive.

My main point for my readers: take the prices and yields from swap markets with a grain of salt, particularly on anything they imply to the real economy.  For that, look at the spreads in the cash bond markets.  Limited arbitrage aside, those spreads are more free from raw speculative frenzy.

One last note: almost all users of the bundled credit default swaps are speculators.  They never hold the exact exposure as the swaps, and so the best of them cross-hedges his positions.  So why did these get created?  Wall Street saw a need to allow speculators to express bets that correspond to larger liquid composites in the cash bond markets.  Individual tranches in structured bond deals below AAA are all very thin, and the ability to put a lot of money to work rapidly is limited as a result.  But what if you could pair up additional shorts and longs to take on opposing risks, without them directly investing in the cash bonds?  You would then have a swap market, and the spreads there would differ from the cash market depending on which side of the trade was more motivated: the side needing yield, or the side betting on default.  It’s a big side bet, and hopefully both sides are well-capitalized, but who can really tell?

What an ugly day for insurance stocks, falling more than the market as a whole, and for no good reason.  No good reason?  Well, I can think of two things: First, insurance gets tossed out with financials, even though aside from the financial insurers, they don’t typically share in the subprime mortgage or systemic risk concerns.  Second, listen to the first seven or so minutes of the Brown and Brown earnings call.  Pricing is falling apart almost everywhere in P&C insurance, with primary commercial weakening the most, and personal lines and reinsurance lagging.

Here’s the earnings summary file.  I added a field for movement in the main insurance index, to help point out movements in stock prices relative to the industry.  What are the trends?

  • Personal lines are doing badly, both bottom and top lines, aside from specialty areas.
  • Commercial lines are still winning, even with premium rates weakening.  When do premiums finally get below technical pricing levels?
  • Mortgage and financial insurers are weak, but how much can they really get whacked when they are so near book value?  (Perhaps down to 80% of book?)
  • Life lines are doing adequately.
  • Expectations have caught up with reality with the Bermudans.  Property looks weak;  maybe  Tony Taylor can seek advice from Michael Price on how to shrink a company profitably and conservatively…  (just kidding  🙂  , but good job, PTP.)

Liquidity, that ephemeral beast.  Much talked about, but little understood.  There are five pillars of liquidity in the present environment.  I used to talk about three of them, but I excluded two ordinary ones.  Here they are:

  1. The bid for debt from CDO equity.
  2. The Private Equity bid for cheap-ish assets with steady earnings streams.
  3. The recycling of the US current account deficit.
  4. The arbitrage of investment grade corporations buying back their own stock, or the stock of other corporations, because with investment grade yields so low, it makes sense to do it, at least in the short run.
  5. The need of Baby Boomers globally to juice returns in the short run so that their retirements will be adequate.  With equities, higher returns; with bonds, more yield.  Make that money sweat, even if we have to outsource the labor that our children provide, because they are too expensive.

Numbers one and two are broken at present.  The only place in CDO-land that has some life is in investment grade assets.  We must lever up everything until it breaks.  But anything touched by subprime is damaged, and high yield, even high yield loans are damaged for now.

With private equity, it may just  be a matter of waiting a while for the banks to realize that they need yield, but i don’t think so.  Existing troubled deals will have to give up some of the profits to the lenders, or perhaps not get done.

Number three is the heavy hitter.  The current account deficit has to balance.  We have to send more goods, assets, or promises to pay more later.  The latter is what is favored at present, keeping our interest rates low, and making equity attractive relative to investment grade debt.  Until the majority of nations buying US debt revalue their currencies upward, this will continue; it doesn’t matter how much they raise their central bank’s target rate, if they don’t cool off their export sectors, they will continue to stimulate the US, and build up a bigger adjustment for later.

With private equity impaired, investment grade corporations can be rational buyers of assets, whether their own stock, or that of other corporations that fit their operating profiles. Until investment grade yields rise 1-2%, this will still be a factor in the markets, and more so for foreign corporations that have access to cheap US dollar financing (because of current account deficit claims that have to be recycled).

The last one is the one that can’t go away, at least not for another seven years as far as equities go, and maybe twenty years as far as debt goes.  There is incredible pressure to make the money do more than it should be able to under ordinary conditions, because the Baby Boomers and their intermediaries, pension plans and mutual funds, keep banging on the doors of companies asking for yet higher returns.  With debt, there is a voracious appetite for seemingly safe yet higher yielding debt.  The Boomers need it to live off of.

So where does that leave us, in terms of the equity and debt markets?  Investment grade corporates and munis should be fine on average; prime MBS at the Agency or AAA level should be fine.  Everything else is suspect.  As for equities, investment grade assets that are not likely acquirers look good.  The acquirers are less certain.  Even if acquisitions make sense in the short run, it is my guess that they won’t make sense in the long run. On net, the part of the equity markets with higher quality balance sheets should do well from here.  The rest of the equity markets… the less creditworthy their debt, the less well they should do.

I’ll give this one more quarter to see how well my readers like this, but here are the earnings in insurance so far this quarter.  As you can tell, I am doing it a little different this time, in providing a file, and less qualitative commentary.  It’s the same data that I provided last time, but now you can do your own slicing and dicing.

What affects insurance equity prices when earnings are released?  Three things: guidance changes (most powerful), earnings surprises (powerful), and revenue growth. (When the market can’t decide otherwise, they like to see top line growth.  I think that’s dumb, but give the market what it wants, then it will change what it wants on you…)

Trends so far:

  • Exposure to UK property with the floods is a negative.
  • Personal lines are doing badly, both bottom and top lines, aside from specialty areas.
  • Commercial lines are still winning.  When do premiums finally get below technical pricing levels?
  • I like Brown and Brown.  Wish I owned some.  Hope no one buys it tomorrow. 🙂
  • Mortgage insurers are weak, but how much can they really get whacked when they are so near book value?

Full disclosure: long ALL

Everything old is new again.  If we jumped into the “wayback machine” (“Where are we going Mr. Peabody?”) and turned the dial to 1957 (“1957. We are going to meet Elvis, Sherman.”) we would find that the few equity investors that are there are highly concerned about yield, and that the yield on stocks was threatening to dip below the yield on bonds.

This was the twilight for yield-based investing.  Through the next fifty years, there would be among value investors a few absolute yield investors that prospered for a time, then died when interest rates rose, and a few relative yield investors who would die when credit spreads blew out. (Note: an absolute yield manager will only buy stocks with more than a given yield, like 4%; a relative yield manager will only buy stocks that yield more than a benchmark, like the yield on the S&P 500.)

As an example, when I was with Provident Mutual in the mid-1990s, I created a series of multiple manager funds.  One was a value fund that we were creating to replace an absolute yield manager who had done exceptionally well over the past 19 years, but cruddy over the last four.  Assets had really built up in that fund, and our clients were getting jumpy.

A large part of the problem was that interest rates had fallen from 1980 through 1993, but had risen since.  Buying steady cash generating low-growth companies while interest rates were falling was a thing of genius.  As interest rates fell, the dividend stream was worth more and more.  When interest rates rose, that pattern reversed, and 1994 was particularly ugly.  We sacked the absolute yield manager as a one trick pony.  A wise move in hindsight.

Now we have enhanced indexers basing whole strategies off of yield, because their backtests show that yield is an effective variable for allocating portfolio weights.  Given that the last 25 years or so have had falling interest rates, this should be no surprise.  Yield will always be an effective variable when rates fall; but what if rates rise?

Also, what happens when Congress does not renew the reduction of the tax on dividends?  Don’t get me wrong, I like dividends; my portfolios yield much more than the markets.  But I don’t go looking for dividends.  I look for companies that generate cash earnings.  What they do with the cash earnings is important; I don’t want management reinvesting the cash foolishly, but if they have good investment prospects, then please don’t send me dividends.

Roger Nusbaum ably pointed out how demographics favors an increasing amount of dividends being paid to retiring Baby Boomers.  That is true.  We have ETNs being set up to do that (beware of Bear Stearns default risk), and hedge fund-of-funds crowding into strategies that synthetically create yield.  Beyond that, we have Wall Street creating funky yield vehicles that gyp facilitate the yield needs of buyers (while handing them capital losses).

My main point is this.  Approach yield the way a businessman would.  If you see an above average yield, say 4% or higher, ask what conditions could lead them to lower the yield. History is replete with situations where companies paid handsome dividends for longer than was advisable.

Back in 2002, I heard Peter Bernstein give an excellent talk on the value of dividends to the Baltimore Security Analysts Society.  At the end, privately, many scoffed, but I thought he was on the right track.  I still like dividends, but I like businesses that grow in value yet more.  Aim for good returns in cash generating businesses, and the dividends will follow.  Stretching for dividends is as bad as stretching for yield on bonds.  That extra bit of yield can be poisonous, leading to capital losses far greater than the incremental yield obtained.

With all of the concern in the present environment, it is good to be reminded of the actions one should take in order to reduce risk in the present, should the investment environment turn hostile in the future.

  1. Diversify by industry, country, currency, inflation-sensitivity, yield, growth-sensitivity and market capitalization
  2. Diversify by asset class. Make sure you have liquid safe assets to complement risky assets. This is true whether you are young (tactical reasons) or old (strategic reasons).
  3. Diversify by advisors; don’t get all of your ideas from one source (and that includes me). In a multitude of counselors, there is wisdom, which is something to commend RealMoney for — there is no “house view.”
  4. Diversify into enough companies: better to have smaller positions in 15-20 companies, than 5 larger ones. When I began investing in single stocks 15 years ago, I started with 15 positions of $2,000 each. That made each $15 commission bite, but the added safety was worth it.
  5. Avoid explicit leverage; don’t use margin.
  6. Avoid shorting as well, unless you’ve got a profound edge; few are constitutionally capable of doing it well. Are you the exception?
  7. Avoid implicit leverage. How much does the company in question rely on the kindness of the financing markets in order to continue its operations? Highly indebted companies tend to underperform.
  8. Avoid balance sheet complexity; it can be a cover for accounting chicanery.
  9. Analyze cash flow relative to earnings; be wary of companies that produce earnings, but not cash flow from operations, or free cash flow.
  10. Avoid owning popular companies; they tend to underperform.
  11. Avoid serial acquirers; they tend to underperform. Instead, look at companies that do little in-fill acquisitions that they grow organically.
  12. Analyze revenue recognition policies; they are the most common way that companies fuddle accounting.
  13. Focus on industries that are out of favor, and look for strong players that can withstand market stress.
  14. Focus on companies with valuations that are cheap relative to present fundamentals, particularly if there are low barriers against competition.
  15. Take something off the table when the markets run, and edge back in when they fall.
  16. Analyze how any new investment affects your total portfolio.
  17. Don’t use any investment strategy that you don’t fully understand.
  18. Understand where you have made errors in the past, so that you can understand your weaknesses, and avoid acting out of weakness.
  19. Buy only the investments that you want to buy, and not what others want to sell you. Use only investment strategies with which you are fully comfortable.
  20. Find ways to take the emotion out of buy and sell decisions; treat investing as a business.
  21. Match your assets to the horizon over which you will need the proceeds. Risky assets should not get a heavy weight when the proceeds will be needed within five years.
  22. When you get a new idea, and it seems like a “slam dunk,” sit on it for a month before acting on it. More often than not, if it is a good idea, you will still have time to act on it, but if it is a bad idea, you have a better chance of discovering that through waiting.
  23. Prune your portfolio a few times a year. Are there new companies to swap into that are better than a few of your current holdings?
  24. Size positions inversely to risk levels.
  25. Finally, think about risk before you need to; make it a positive component of your strategies.

Remember, risk preparation begins today. That way, you will be capable to invest in the bargains that a real bear market will produce, and not leave the investment game disgusted at yourself for losing so much money.

If I had a dollar for every person that I knew who ignored risk in the late 90s, and dropped out of investing in 2002, just in time for the market to turn, I could buy a nice dinner for you and me in DC, near where I work. So, analyze the riskiness of your portfolio today, and prepare now for the bad times that will eventually come, whether this year, or four years from now.

I have three portfolios that I help manage. They are listed over at The big one is insurance stocks, where I serve as the analyst, and have a lot of influence over what is selected, but don’t make the buy and sell decisions. The second is my broad market fund, over which I have full discretion. The last is my bond fund, which doesn’t have an independent existence, but fills the fixed income role for the two balanced mandates that I run, in which the broad market fund serves as the equity component. I’m going to run through each portfolio, and hit the high points of what I think about my holdings. Here we go:
Bond PortfolioI sold our last corporate loan fund in early June. We made a lot of money off these over the past two years as LIBOR rose, and the discounts to NAV turned into premiums. New issuance of corporate loans has been more poorly underwritten. I’m not coming back to the corporate loan funds until I see high single digit discounts to NAV, and signs that credit quality is flattening from its recent decline.

The portfolio is clearly geared toward preservation of purchasing power. We have TIPS and funds that invest in inflation-sensitive bonds [TIP, IMF]. We have foreign bonds [FXC, FXF, FXY, FAX, FCO]. The Yen and Swiss Franc investments are there as systemic risk hedges. The Canadian bonds and the two Aberdeen funds are there for income generation. If energy stays up, Canada might never need to borrow in the future. I also have a short-term bond fund [GFY] trading at a hefty discount, and cash. Finally, I have a speculative deflation in long Treasuries. [TLT]

This is a very eclectic portfolio that has done very well over the last 24 months. This portfolio will underperform if any of the following happen:

  • Inflation falls
  • The dollar strengthens
  • The yield curve steepens amid the Fed loosening
  • Credit spreads tighten

The Broad Market Portfolio

There are four things that give me pause about RealMoney. First, there is a real bias toward sexy stocks, and commonly known stocks. That bias isn’t unusual; it plagues all amateur investors. Two, few players talk about bonds, and how to make money from them, as well as reducing risk. Three, almost everyone trades more than me. Finally, there is a “home turf” bias, where everyone sticks to their niche, whether it is in favor or not.

I try to be adaptive in my methods through careful attention to valuation and industry rotation. Underlying all of it, though, is a focus on cheap valuations. There are seven summary categories here at present, and then everything else. Here are the categories:

  1. Energy — Integrated, Refining, E&P, Services, Synfuels. I am still a bull here.
  2. Light Cyclicals — Cement, Trucking, Chemicals, Shipping, Auto Parts
  3. Odd financials — European banks, an odd mortgage REIT [DFR], and Allstate [ALL].
  4. Latin America — SBS, IBA, GMK. All are plays on the growing buying power in Latin America.
  5. Turnarounds — SPW, SLE, JNY. Give them time; Rome wasn’t burnt in a day.
  6. Technology — NTE, VSH. Stuff that is not easily obsoleted.
  7. Auto Retail — LAD, GPI.

So far this overall strategy has been a winner for the past seven years. No guarantees on the future, though. In the near term, rebalancing trades could include purchases of JNY and sales of DIIB and SPW. Beyond that, I am waiting for a week or so to sell my Lyondell. It is possible that another bid might materialize. Allstate is also on the sell block, though, I might just trim a little. What makesme more willing to sell the whole position is the disclosure of an above average position in subprime loans.


There is one easy play going into earnings season, and one moderate play. Beyond that, there is dabbling in the misunderstood.

Easy: buy asset sensitive life insurers, ones with large variable annuity, life and pension businesses. Who? LNC, NFS, SLF, MFC, PNX, PRU, MET, HIG, and PFG. Why? Average fees from domestic equities are up 5% over the first quarter, and the third quarter looks even better for now. Guidance could be raised. Away from that, the dollar fell by 2% on average over the quarter, so those with foreign operations (excluding Japan) should do well also, all other relevant things equal.
Moderate: no significant hurricanes so far. Given that there is some positive correlation between June-July, and the rest of the season, are you willing to hazard some money on a calm storm season? With global warming DESTROYING OUR PLANET!!!! (not, this is cyclical, not secular.) If you are willing to speculate, might I recommend FSL? They manage their business well, though they are new.

Beyond that, I would commend to you both Assurant (a truly great company that will survive the SEC), and Safety Insurance (investors don’t get the risks here, they are small, and management is smart).


Managing portfolios has its challenges. One has to balance risk and reward on varying investments. Sometimes the market goes against you, and you question your intelligence. But good fundamental managers persevere over time, and produce good returns for their investors. That’s what I aim to do.

Full Disclosure: all of my portfolios are listed here.

Late editorial note: where I wrote FSL above, I meant FSR.  Thanks to Albert for pointing the error out.

As I mentioned previously, I have a post coming on the relationship of the VIX to the S&P 500.  With apologies to Bill Luby, who handles VIX issues well, this should be a significant piece for those that are willing to bear with a little math.

One aspect of me that is weird, is that I love and hate mathematical finance.  When it is done well, it is a thing of beauty.  I tuck those articles away, and if I can, I implement them.  Most of it is not done well, though, particularly among practitioners, and academics that are slaves to modern portfolio theory.

I am done with all of the calculations, and probably all of the graphs for the article.  I am impressed with the results, which is not a common occurrence. I am my own worst critic on my efforts in mathematical finance.

After this, the next two posts should deal with commentary on my portfolios (tonight), and speculation in the markets, while ignoring subprime lending to the greatest extent possible (tomorrow?).

Not such a great day for me. Yes, Lyondell got bought out. Nice. But in my insurance portfolio, Aspen gets tarnished by IPCR’s earnings warning regarding floods in North England and in New South Wales, Australia. Aspen has exposure to the UK, but not necessarily Australia. I find it unlikely that it should have driven down the price 4% though.On another front after falling 8% over two weeks, Safety Insurance fell another 1.3% today over fears that liberalizing Massachusetts auto insurance markets will lead to decreased profitability in the future. A few notes: 1) the proposed liberalizations will not likely make it through the legislature. 2) the liberalizations are not thorough enough to attract meaningful competition to Massachusetts. 3) Safety management is ready for the liberalizations if they should happen. They have proven themselves to be worthy competitors over the years.

Were I able to buy Safety for myself (I can’t because of restrictions), I would do so here. Have a good night.

full disclosure: long LYO SAFT AHL

Bouncing off of Cramer’s lucid post regarding the Tribune deal (when Cramer is good, he is goooood), I wonder if it wouldn’t be better for all involved if the deal didn’t fail.  As I pointed out before, Zell doesn’t have a lot of skin in the game, and the workers get all of the downside and little of the upside.  Zell has a lot of upside, relative to his contribution, which means little downside.

Don’t get me wrong, the newspaper business is tough.  My view is that the ESOP should refuse to fund the deal, and let the equity price fall.  Someone will fund the deal at a lower price, and the remaining workers will get paid, if less than before.

One great lesson of all of this is that no matter what labor demands, it is impossible for labor to do well if the industry does not do well.