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).
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.
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.
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.
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.
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.
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.
I’m thinking of doing a personal finance post on what insurance to buy. Is that something that readers would like to read about?
David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →