This post will be a little controversial. I believe that most investors over- or under-estimate the Fed. There are two ways to mis-estimate the Fed: power and wisdom. With respect to power, the most common errors are to overestimate the Fed in the short run, and underestimate them in the intermediate run. With respect to wisdom, the errors are to think that they are the wisest player in the market, or that they are less wise than the average market player.

My hypothesis is that the Fed is one of the brighter players in the market, top quartile, but not top decile, and that their power is quite great toward the end of the cycle, but modest until then.

My first contention stems from the lack of scalability of intelligence in a bureaucracy. You can gather large amounts of information, and have bright people interpret it, but the large numbers of Ph.D. economists insures that the result will tend toward consensus, and not be that much different from the consensus of economists outside the Fed, which means that the Fed will miss turning points. Also, in a bureaucracy, political pressures often dominate those near the apex of the organization, which twists the interpretation of the data, as well as what is deemed to be data. (M3 is no longer data worthy of being calculated.  A mistake in my book; the cost savings were minuscule, and the measure told us a lot about credit that M2 does not.)

Also, because of our political culture, there is a bias toward making it look like you are doing something, even when doing nothing is the optimal policy.  (We would likely all be better off by having Congress be a part-time legislature.  Okay, sorry, formally a part-time legislature… they have a lot of vacation already.  The same would apply to the Executive branch, but it would mean reducing the number of regulations enforced.)  So, even if the Federal Reserve is correct about the right long-term strategy, political pressure can force a different policy action, at least in the short run.

The Fed is a political creature, and it prizes its independence.  The funny thing is that it often preserves its independence by giving in to the political pressures that threaten its independence.  E.g. employment is slightly weak, but present policy is adequate to handle it if we wait 12 months?  No problem, we’ll loosen policy further.  (We can always take it back later, right?)

I would argue that no, you can’t take it back.  Yes, the Fed can reverse the cut later, but the effect is not the same as if they had not done the additional cut.  Here’s why, and this speaks to the power of the Federal Reserve: when the Fed lowers rates, more assets become financable at the lower short-term interest rates.  The lower rates go, even if for a time, the more economic players think that they can afford a given asset.  The effect is slow at first, because there’s a threshold to be met for psychology to change.  Changing the financing cost by 5% is dust on the scales; it’s not worth the fixed costs and effort.  Changing it 10, 20, or 30% is another manner, and cheap short-term capital will lead many to speculate and bid up asset prices, whether the assets are housing or businesses.  Economic activity accelerates accordingly.

It also takes a while for policy to bite when rates are rising.  Homeowners and businessmen make adjustments as rates rise, but it takes more of a rise to make their free cash flow go negative, forcing unpopular decisions that may have large fixed costs.  Asset prices normally decline in such an environment, slowing down economic activity.

My contention is that in order for Fed policy to have real impact it has to move the short rate significantly.  Time is not what does it, but the amount of the move.  Because the Fed moves slowly, the two effects become confused.

Back to my original questions.  How powerful is the Fed?  Very powerful when they move rates far enough, but weak before then. How wise is the Fed?  Pretty smart, but hamstrung by politics and bureaucracy, which keeps them from implementing the right strategy even if they have it.  They don’t always have the right strategy; they still miss turning points the same way that external economists do as a group, and often their actions add to economic volatility by being accidentally pro-cyclical.

The question that I have at this point in the cycle is how low the Fed will get before they get scared about inflation, and flatten out policy to see which effect is larger — deflation from overvalued housing assets purchased with debt, or inflation of goods and services prices.  They are separate phenomena, and can occur at the same time.  If they do occur simultaneously, what will the Fed do?  The US has almost always been debtor-friendly, so I would expect inflation, but that is just a weakly held opinion for now.

If you are looking for more of me to read, pick up a copy of the November 2007 MoneySense magazine for my article “Nerve Medicine.”  It describes five points on risk control for individual investors.  Thanks to MoneySense for publishing my article.  The magazine costs only C$5.50 at the newsstand.  That’s about $6.00 US, right? 😉

As an aside, to editors of publications that peruse my blog, I am available for other writing assignments.  I enjoyed writing a longer article for a retail audience, and would accept the challenge again.  E-mail me if you have interest.

Here’s my second video from on the Federal Reserve.  This one is on where to invest from an equity standpoint.  There are two areas to look at.  Companies that benefit from:

  • Lower borrowing rates
  • Higher inflation

In the first category are healthy financials, and companies with the flexibility to borrow short-tern and buy back stock.  I highlighted insurance companies in my video, but this could apply to other financials and yield-sensitive companies, so long as they don’t face any significant fallout from housing and housing finance.

In the second category are companies that are exporters, and companies where the global prices of their products will rise in dollar terms, while their inputs stay relatively fixed.  This would include energy and most commodities.

Bonds were not a topic of discussion, but I still favor foreign, high quality and short-to-intermediate bonds for now.

While in NYC, I did two videos on the Federal Reserve for  Here is the first of them.  The second one should be published soon.  Please pardon my inability as I express myself, but it’s a fair picture of what I look like, sound like, and how I think (or not) on my feet.

I got to see what a day at is like, from the video facilities, to how coverage changes as news breaks (Merrill Lynch being the example du jour).  I got to meet several people face-to-face who I had never met before: James Altucher, Kristin Bentz (indeed fair-haired and ingenious), George Moriarty, Gregg Greenberg, Simon Constable, Farnoosh Torabi (of course), Mark DeCambre, and many other members of the staff.  Especially fun was lunch with my editor Gretchen Lembach.  I saw a few others that I knew (including James Cramer, who was in a good mood, but busy, as you can imagine.  I don’t think he recognized me.), but they were busy.  It’s a low key, fun, and connected kind of place; I’ve never seen as many monitors showing CNBC in one place, aside from some of the bulge bracket trading floors.

After my time at The, I had an interview with a major insurance company in NYC.  Hopefully something will come of that, even if it is only a consulting relationship.  One impressive thing about the company that I visited: the offices of the senior management were the most modest that I have seen in the industry.  In any business, that’s a good sign; it shows that they are concerned about the shareholders.

It is also possible that my relationship with will expand as well.  I’ll be putting together a proposal for them, and we will see where it goes.  Oh, one more thing; if anyone reading this is short TSCM, do yourself a favor and cover.

Tickers mentioned: TSCM

Last night’s post got eaten by a loss of power.  It’s time to return to “FOMC mode” in anticipation of the meeting ending on the 31st. Let’s review the data as I see it:

  • Even with the recent loosening in FOMC policy, the Fed still hasn’t done a permanent injection of liquidity since May 3rd.  Growth in the monetary base since then has been anemic.
  • The narrow monetary aggregates have not been growing rapidly, even since the FOMC began its temporary liquidity injections back in August.  Even M2 has been flat.
  • My M3 proxy has not been flat, though it overstates matters somewhat.  Total bank liabilities have grown 4% since mid-August, which is close to a 20% annualized rate.  This has to be taken back a bit, because with the Treasury-Eurodollar [TED] spread around 110 basis points, liquidity from the unsecured Euro-dollar markets has diminished.  How much for US banks?  I’m not sure; I can’t find a data series for that yet.
  • The TED spread has retreated 65 basis points since the last meeting.  Things are better, but external dollar liquidity is still tight, which in my book means a TED spread above 60 basis points.
  • Off of Fed funds options, the odds of no change are 10%, odds of a 25 basis point cut are 70%, and the odds of a 50 basis point cut are 20%.
  • Since the last meeting, fed funds have averaged 3 basis points over the target.
  • The discount window moves aided PR efforts, but never amounted to much.
  • As measured by TIPS, five year forward five year inflation has fallen since the last meeting, but has been slowly rising over the past five years.

There’s my data, now for the analysis.  Credit conditions have loosened, but monetary conditions aren’t loose.  Banks have been willing to expand their balance sheets, I believe partly due to the Fed loosening capital requirements, e.g.,  lending to securities affiliates.  Also, with the bigger banks, the Federal Reserve is talking tough, but not playing tough in bank examinations, because they can’t allow credit to contract that much, or their loosening policy will have little impact.  The smaller banks, and banks where mortgage lending could have a big impact are undergoing sharper examinations.  Part of that looseness is canceled out by the tightness in the Euro-dollar markets; the big banks are less than fully willing to trust each other’s balance sheets.

My opinion: The FOMC will loosen 25 basis points on 10/31, and will continue to express worries over economic growth.  Though inflation is a growing threat, the FOMC will downplay that.  There will be a lot of trading noise around the news, but after the dust clears, stocks and bonds won’t have done much, and the yield curve will be a little wider.  TIPS should outperform inflation un-protected bonds.  The dollar will weaken to the degree that the FOMC hints that they aren’t done.

I make no pretense to being anything more than a value manager.  It’s what I’ve done for the past fifteen years, with pretty good results.  Granted, my new methods over the past seven years attempt to incorporate industry rotation in two ways:

  • Industries where pricing power is near there nadir, such that the only direction is up, given enough time.  Strong companies in weak industries survive weak pricing cycles, and do well when the cycle turns.
  • Industries where pricing power is underdiscounted, and it will pay just to wait for future earnings to validate a higher P/E.

But no, I don’t explicitly focus on earnings growth, though I do look at forecast earnings for next year, which embeds a future ROE forecast.  I ignore growth forecasts for several reasons:

  • Growth forecasts tend to mean-revert.  Low growth companies tend to surprise on the upside, and high growth on the downside.  With a little help from pricing power, I tend to get more good surprises.
  • ROEs also tend to mean-revert.  Competition enters spaces with high ROEs and exits spaces with low ROEs.
  • It’s rare for a high growth, high P/E company to grow into its multiple.
  • Low growth, low P/E companies can be treated like high-yield bonds.  A P/E of 10 implies an earnings yield of 10%; I may not capture all of that 10% in dividends and buybacks, but a modestly good management team will find ways to deploy excess cash into other organic growth opportunities which will grow earnings in the future.  With a little good management, I can see my company with a P/E of 10 grow its intrinsic value by more than 10% in a year.

As for momentum, my rule of thumb is that momentum persists in the short run, and mean-reverts in the intermediate term.  I have to size my trading to the rest of my strategies.  Value emerges over the intermediate term, not rapidly.  The same tends to be true of industry rotation; it works with a lag, but it works.  I have to become like Marty Whitman at that point and say that often the fundamentals and price action are lousy when I buy, and for me that’s fine, because:

  • I focus on balance sheet quality,
  • Accounting integrity, and
  • Cheapness.
  • I have my rebalancing discipline standing behind me, which often has me buy more before the turn occurs.
  • I also stay reasonably well-diversified.

The turns usually do occur.  I never make a ton of money on any trade, but typically 80% of my trades make money. And, my losses are typically small, so this method works well for me.

Anyway, that’s why I embrace negative momentum and don’t explicitly embrace growth.  It can place me in the “caricature” camp for value managers, because my valuation metrics are usually lower than most.  Given my longer holding period, I’m fine with that, because low valuations tend to produce their own catalysts for change, if one has done reasonable research on the shareholder-friendliness of the corporation, and the strength of its financials.  Besides, as intrinsic value grows with companies having low valuations, there is a strong tendency for the stock to rally.  Think of PartnerRe, which has never had a high valuation; as it puts up good earnings year after year, the price of the stock keeps running.  Just another example of an underdiscounted trend in the markets.

Full disclosure: long PRE

  1. Doug Kass over at RealMoney made the following comment: “The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.”  An interesting comment to be sure.  Unlike other insurers that benefit from state guarantee funds, the mortgage insurers do not so benefit.  That said, in a concentrated sub-industry that has only seven players (MTG, RDN, PMI, TGIC, GNW, ORI, and AIG), one advantage that poses is that failure of one company will not lead to assessments on the rest of the companies, leading to cascading failures.  So who would be affected?  Fannie and Freddie would get a lot of credit risk back, as would any private lender that used the mortgage insurers to reduce risks.  Even some of the mortgage originators with captive mortgage reinsurers would take some degree of a hit (most of the top originators had these).
  2. Some younger friends of mine asked me for advice recently, and the question came up, “Should I invest in the market, or pay down debt?”  Now, we weren’t talking about credit card debt, which they paid off in full every month.  They did have a home equity loan at 8.5% fixed.  My view was this: with 10-year Treasuries yielding 4.4%, and marginal investment grade corporate bonds yielding 6.0% or so, a reasonable return expectation for the equity markets as a whole would be in the 8-9% region.  Add 2-3% to the BBB-bond yield, and that should be a reasonable guess, given that I think the market is somewhere between lightly undervalued and fairly valued.  My advice to them was to pay down the home equity loan, and once it was paid off, invest in an index fund, or a diversified mutual fund.  Until then, better to earn 8.5% with certainty, than 8-9% with uncertainty.
  3. As can be seen from my recent reshaping, yes, I do buy sectors of the market that look ugly.  Shoe retailers and mortgage REITs have not done well of late.  Am I predicting no recession by buying the retailers?  No; so long as the shoe retailers aren’t too trendy, demand for shoes is relatively stable, and these stocks are already discounting a recession.  I chose two that had virtually no debt, so I am on the safer side of the trade, maybe.
  4. Does buying a mortgage REIT mean that I am betting on further FOMC loosening?  No.  The mortgage REITs that I hold embed a pretty nasty set of assumptions for the riskiness of the safest parts of the mortgage bond markets.  While a FOMC loosening would probably help, I’m not counting on that.
  5. My value investing is different than most value investors, because I spend more time on industries, either buying quality companies in beaten-up sectors, or companies with pricing power, where that power is underdiscounted by the market.
  6. If we are trying to estimate the central tendency of inflation and eliminate volatility, it is better to use a trimmed mean, or median, rather than toss out volatile components like food and energy, particularly when those components have led inflation for the last 5-10 years.  The unadjusted CPI is a better predictor of the unadjusted CPI than is the core CPI.
  7. Personally, I think the next ten years will be kinder to “long only” equity managers than hedged managers.  There is only so much room for shorting, which is an artificial overlay on the system.  We aren’t at the limits of shorting yet, but we are getting closer to those limits.  It would not surprise me to see ten years from now to find that balanced fund managers beat hedge fund managers on average (after correcting for survivor bias, which is more severe with hedge funds).  It’s much easier and more effective to do risk management in a long only mode, and I believe that the virtues of long only management, and balanced funds, will become more apparent over the next ten years.
  8. I’m thinking of doing a personal finance post on what insurance to buy.  Is that something that readers would like to read about?

The reshaping file can be found here. In order to stay in compliance with the Bloomberg data license, I only include numeric fields that I have calculated. My ranking method ranks the companies in my portfolio, and all replacement candidates by several variables:

  1. Relative Strength (lower is better, double weight)
  2. Trailing P/E
  3. This year’s P/E
  4. Next year’s P/E
  5. Price-to-book (double weight)
  6. Price-to-sales (double weight — financials are counted as average)
  7. Dividend Yield
  8. Net Operating Accruals (a measure of accounting integrity — double weight — financials are counted as average)

I rank the companies on all of the criteria, weight the ranks, and calculate a grand rank. I look for the company that I own that has the middle rank for all of my currently owned companies, and I sell a few companies that I own below that, and buy some new companies near the top of the list. Here are my actions:


  • Sara Lee
  • Dow Chemical
  • DTE Energy


  • Redwood Trust [RWT]
  • Gehl Corp [GEHL]
  • Shoe Carnival [SCVL]
  • Charlotte Russe Holding [CHIC]

Future Sale

One reinsurer — could be Flagstone, PartnerRe, or Aspen Holdings.


I have enough reinsurance names going into earnings. If you need more of an example of how well they will do this quarter, then look no further than PartnerRe’s solid earnings report this evening. On the other sales, DTE Energy and Dow Chemical were solely for valuation reasons. Sara Lee is another matter; my confidence that they can turn around the company is reduced, and valuation is not compelling.

As for purchases, on the shoe retailers, there were a bevy of cheap names, but Shoe Carnival and Charlotte Russe seemed to have the most consistent operations, and low debt. Gehl seems to be in a good industry, small agricultural machinery is in demand, and valuations are modest. Finally, Redwood Trust seems to be well-run as mortgage REITs go. Asset quality is good and leverage is moderate. Also, the debt is all from securitizations, so it is non-recourse to the company; the most that can happen is that the assets in the securitizations depreciate to the degree that their residual interests are worthless.

One other shift that is unintentional here, is that my portfolio becomes more small cap in nature. I am selling away larger companies, and buying smaller ones. That is an accident of the process, but occurring because there are some genuinely cheap companies to buy. Time will tell as to whether these are good purchases, but most of what I like in investments are lining up here.

Full disclosure: long PRE AHL FSR CHIC SCVL RWT GEHL

On Friday over at RealMoney, I posted the following:

David Merkel
1987 Memories
10/19/2007 5:20 PM EDT

I was a young actuary when the crash hit in 1987, one year and change into my career. I did not have any investments at that time, but I had just bought a house with my (then) new wife. Few today remember that the crash of 1987 was the culmination of three separate crashes. In late 1986, the US Dollar hit new lows, amid massive intervention by central banks. In February 2007, I came down with a bad cold that sidelined me for four days. Cuddled up with the WSJ while my wife was at work, I concluded that the bond market was about to fall apart, so we accelerated buying a small home. Two months after we completed the financing, mortgage yields rose by 2% during the bond market meltdown.

The stock market roared on, though. Through August, the market rose, and the earnings yield shrank. Bond yields remained stubbornly high; it was a great time to invest in high quality long bonds, particularly long zero coupon bonds.

The eventual crash in October is no surprise to me today. Equities could not stand the competition from bonds, so the market slumped from August to October, until the pressure of dynamic hedging took over starting on Friday the 16th, selling into a declining market in order to maintain the hedges, and spilling over in a self-reinforcing way on the 19th. For what it is worth, there was a humongous rally in long bonds as people sought safety.

Now, my Mom was buying the day after the crash. This is why she is more professional than most professionals I know. She bought solid companies that would survive bad times. I knew far more people who sold into the panic. As for me, I got a trial subscription to Value Line, and picked six stocks, which I sold too soon for a 20% gain, and didn’t return to direct investment in single equities until 1992. (I used mutual funds.)

Since then, I have been consistent in plying my advantage in picking cheap stocks where the fundamentals are under-discounted. It’s been a good niche for me, maybe it can be of value to you as well.

PS — no bounce today, kinda like October 16th, 1987.

Position: none

Now, should the crash have been bought? Yes, at least in the short run, even without knowing the verdict of history. The difference between stock and bond yields narrowed dramatically, and option implied volatility was making a bold effort to escape earth orbit. Beyond that, fast moves tend to mean revert; slow moves tend to persist.
Now, my knowledge of the markets was rather crude back in 1987, so I never would have caught those then; nor did most commentators at the time. People were too scared to be rational. Even the FOMC blinked, with a neophyte Greenspan, with no serious crisis imminent, thus beginning his career of throwing liquidity at small problems, and leaving the consequences for later.

Well, at least I bought the lows in 2002. That event was similar, but not nearly as short-run severe as 1987, though it had the “strength” of longer duration as a bear market.

Before I close for the evening, I would like to mention that I will have the portfolio reshaping complete on Monday, and watch for it here first. As an aside, there are a lot of cheap small cap shoe retailers, and a lot of cheap general and apparel retailers also. I don’t normally buy retailers, but this time things are too cheap. Expect to see me buy one.

Back after a hiatus of sorts.  I should have a piece on my portfolio reshaping coming on Monday or so.  Tentatively, what I find fascinating, is that I have so many shoe and retail names near the top of my list.  Oh, and a few mortgage REITs, if they make sense… 🙁

But on with this morning’s topic, which deals with global macroeconomic pressures.  A few of the articles are a month dated, most are current, but this is meant to illustrate the pressures that the economy is under.

  1. Let’s start with the good news, ECRI still doesn’t see a recession on the horizon.  They’re pretty accurate, so I give them room, and mute my own views.
  2. That doesn’t mean there aren’t significant pockets of weakness.  Mortgage equity withdrawal is a spent factor, so to speak, and it ripples through current consumption and housing price weakness.  The less equity available, the less to pad consumption, and the less buying power for homes.  Credit card default rates are worsening, which can’t be good for buying power either.  On the low end of the income spectrum, many Hispanic workers are finding it hard, and that affects Wal-Mart, among other retailers on the low end.  That said, I have read that the Hispanic immigrants are much less likely to default on their mortgage loans than non-immigrants with similar credit characteristics.
  3. CLSA predicts a record gold run, and so far, gold is cooperating.  That said, it will take a lot more to get gold to $3400/ounce.  We would need a real dollar collapse, and not this slow grinding selloff.  That said, the grinding selloffs tend to persist; more on that later in this post.
  4. Of course, we could look at the price of wheat, or even just the price of stuff.  If it deals with food or energy, two items that are core to almost everyone’s budget, prices are rising.  John Wasik repeats a number of my arguments for why core CPI does not represent the diminution of the average person’s buying power.  I’m honestly surprised that no one has made a campaign issue out of honesty in inflation statistics so far.  It helped Reagan versus Carter in 1980.
  5. That said, maybe we should be grateful that fuel grade ethanol is in surplus, at least temporarily, because we can’t distribute it to the end consumers efficiently.  Maybe not.  It’s no good for price to go down, if it only indicates lack of effective end-demand.
  6. Oil at $90/barrel?  It’s partly a US dollar phenomenon (new trade-weighted low today), but not just a US dollar phenomenon.  In Euros, as I measure it, it’s a new high there as well, just not by much.   Now, when a critical commodity becomes scarce, it tends to attract wars, kidnapping, sabotage, etc., because bargaining power goes up as the price of the commodity goes up.  (Think of “blood diamonds” for another example…)  So we see pipeline sabotage, graspy politicians wanting a bigger cut of the royalties (no, not Chavez this time), and tensions between the Turks and the Kurds.  This leaves aside issues in Nigeria, and other aspects of supply disruption.
  7. Now if that’s not enough, Western oil companies, which are often shut out of places where goverment monopoly oil companies tread, are finding less oil, and find that they have to buy back stock because of a limited number of places to invest in new fields.  Now, perhaps OPEC has the same problem, but it manifests differently.  They’re making a lot of money also, and don’t want to plow it into too many new projects, for fear of killing the price.  So what do they do with the free cash flow?  Their governments buy US Treasuries and other US debt claims, closing the money loop and financing the US current account deficit.
  8. Well, maybe not entirely, though.  We had a glitch in capital flows in August, and foreigners sold more US securities than they bought by a significant margin.  Can’t help but think that it led to more pressure on the US dollar.  That said, the books have to balance: foreign capital inflows must balance the current account deficit over the intermediate term.  That doesn’t mean that they have to balance at the same price, though, just that the nominal values must balance at some implied exchange rate.  On the other hand, some nations are adjusting their currency baskets, like Vietnam and Qatar to reflect the lower value of the US dollar.  Quite a statement about their relative faith in their own currencies versus the US dollar.
  9. The US has not had a strong dollar policy for some time, despite protests to the contrary.  We are happier to see export industries prosper, US tourism prosper, and consumer buying power from abroad suffer.  My question is when we will see foreign governments notably uncomfortable.  We’re not there yet, which makes me think that the path for the US dollar is lower still.
  10. One final factor that doesn’t help: the size of the US budget deficit on an accrual basis.  Much larger than the stated deficit because of extra inflows to social security, and debt that doesn’t get counted because other government programs buy it to fund future liabilities.  Add onto that the wars which largely off-budget, and you have a significant present and future cash flow hole to cover.  Here’s to our children and grandchildren, who will have to pay it one way or another.