Eight Notes on Insurance, Economics, and Value Investing

  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?


  • Steve Milos says:


    I would really appreciate a personal finance oriented post. The complexities and pricing of various types of insurance, with different options such as joint first to die, second to die, etc. are something that only an actuary (know any? LOL) can comprehend and truly explain.

  • Quints says:

    I would like to see a writeup on what insurance to buy.
    I appreciated your comment on whether to pay off the home equity or invest. I am in a similar situation, but paying 7.75%. I have decided to continue investing and take out half of what I earn to pay off the mortgage. Ultimately, I will deleverage. The deleveraging will be quicker when I am making big profits. I know it may be risky, but I think that approach is rational.

  • PhDmom says:

    I would also appreciate a personal finance oriented post….ditto Steve Milos
    Again, thank you for taking the time to write out your insights, thoughts and ideas and sharing them with us on your Blog. May your days be blessed.

  • Steve W says:

    Though the answer may still be the same I like to compare mtg. interest paid net of tax deductions against tax free bonds or quality mlps.

  • “The unadjusted CPI is a better predictor of the unadjusted CPI than is the core CPI.” Interesting that the Fed disagrees with you. It would be nice to see some longer-term regression analysis on the various price indices, with various time lags, to move from statements of opinion to explications of fact.

    “a home equity loan at 8.5% fixed” Was this a 2nd? 30-year fixed mortgages are running 1.5% APR below HEL rates, and 15-year fixed rates are 1.75% below, so refinancing (if it’s a 2nd) may be the better option. Then you’re talking 7.75% on a 15 year amort vs an extra point with some variability, plus the tax benefits if they itemize, plus the opportunity to refinance at lower rates in the future if rates fall. Another piece that has to be considered is the prospect of home price appreciation as compared to other investment. I do know that many folks have an anti-debt bias (Clark Howard, Dave Ramsey, et al) and I suppose that for them, any situation that is even close becomes a “pay off the debt first” situation.

  • Ooops, I should do this in Word and look at it before posting. “Then you’re talking 7.75% on a 15 year amort ” should be 6.75%, the 8.5% minus the 1.75% difference from HEL to 15-yr fixed.

  • Tomxp says:

    I’m ALWAYS interested to hear your thinking and this would certainly be a subject of interest.

  • Khyron says:

    I’d be interested in that personal finance post about insurance.

  • James Dailey says:


    Given your value bias I am really perplexed by your characterization of the market as being fairly to slightly undervalued. I know that you have argued that profit margins are likely to remain higher for longer but eventually mean revert. Let me put forth a basic mathematical exercise to challenge your assessment and your future return comment of 8-9%.

    Lets assume that nominal SPX profits grow at a 6% annualized rate over the next 10 years. Lets also assume that profit margins eventually do revert to post WWII average levels in year 10. Lets also assume that the P/E on those earnings revert to post WWII average in year 10. The average annual return for the SPX(including the current dividend yield) would be low single digits at termination of the 10 year period. Even assuming a historically high P/E of 18 would only generate mid single digit returns.

    Price to sales and price to book values are between 35%-45% above long term average levels. Adjusting the current P/E on the SPX using the long term profit margin average results in a P/E around 25 – which fits with the 35%-45% over valuation indicated by the P/S and P/B.

    Even if margins remain near record levels and persist for a long time, the upside is still high single digits. However, if any of these factors revert then returns would be much lower. In addition, reversion cycles rarely stop at average and returns would be terrible if things went to below average.

    I would really value your input on these items because I have racked my brain trying to “see” what the people arguing value are seeing that I am clearly not.

  • RB says:

    The Fed as a committee focuses on core PCE which could be misleading. The Fed as an organization will offer support for the notion that the unadjusted PCE (not CPI) is better than core PCE for predicting future PCE.

  • Misleading to whom? If you are trying to anticipate their movements, looking at different data from what they look at is misleading … to you.

    I linked to that article in one of my blog posts. Note the disclaimer at the bottom of the article: “Views expressed do not necessarily reflect official positions of the Federal Reserve System.”

    There are two separate questions: (1) what is the data to look at to anticipate Fed action? (2) what is the data that I (or YOU) would look at if someone died and made me (YOU) “King of the Central Banking System?”

    The answer to (1) is answered in the Fed’s official statements. It is not open to argument. If you look at anything else in order to anticipate Fed moves, you do yourself, and anyone who reads you, a great disservice.

    The answer to (2) is open for discussion. Assemble your data, run your regressions, report back with analysis. Just keep in mind the answer is MOOT, as far as (1) is concerned. What you or I think should be done, does not impact what the makers of policy think should be done.

  • RB says:

    Misleading as far as monetary policy is concerned and not in a deliberate way — the point is that while the FOMC is not convinced yet, they are keeping an eye on this debate and one cannot necessarily say that bloggers are wrong though they do not have a rigorous process. I have never disagreed that what matters is (1) as far as Fed action is concerned and in fact wrote so over here.

    Above, I also made a distinction above between the Fed as a committee and the Fed as an organization. But the Fed is keeping an open eye on this for the same reason as bloggers (persistent energy prices).

  • Non-deliberately misleading in terms of the Fed possibly misreacting to the data – is that your point? Am I expressing it correctly?

  • RB says:

    Misreacting doesn’t sound right as they don’t include the “relevant” data — they are errors of omission rather than commission in my armchair opinion. I also believe (based on what I’ve read) that there has been an inflection point for global energy sources due to which the floor on energy prices is probably closer to $30 than the $10 in 1998. While monetary policy can do nothing about global demand, I don’t believe energy prices are independent of monetary policy.