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Archive for January, 2008

Seven Brief FOMC Notes

Thursday, January 31st, 2008

1) From an old post at RealMoney:


David Merkel
Nominate Fisher for the ‘FOMC Loose Cannon’ Award
6/1/05 4:05 PM ET

It was pretty tough to dislodge William Poole, but if anyone could win the coveted “FOMC Loose Cannon” award in a single day, it would be Richard Fisher, after suggesting that the FOMC was “clearly in the eighth inning of a tightening cycle, we’ve been doing 25 basis points per inning, it’s been very transparent, and very well projected by the Federal Open Market Committee under the leadership of Chairman Greenspan,” and, “We’re in the eighth inning. We have the ninth inning coming up at the end of June.” [quoted from the CNBC Web site] Why don’t they have media classes for rookie Fed governors and Treasury secretaries? Even if he’s got the FOMC position correct, typically the Fed governors come out with a consistent message, and then, they cloak and hedge opinions, in order not to jolt the markets.

Okay, so Fisher dissented.  So he hasn’t had a predictable tone since becoming a Fed Governor.  Big deal.  The Fed needs more disagreement, and more original thought generally, even if it is wrong original thought, just to challenge the prevailing orthodoxy, and force them to think through what are complex decisions that might have unpredictable second order effects.

2) I hate the phrase “ahead of (behind) the curve,” because there is nothing all that clear about where the curve is.

3) Watch the yield curve, and note the widening today.  That is a trend that should persist, regardless of FOMC policy.

4) Rate cutting begets more cutting, for now.  The current cuts will not solve systemic risk problems embedded in residential real estate, and CDOs, anytime soon.  They will help inflate China (via their crawling dollar peg), and healthy areas of the US economy.

5) Where is the logical bottom here?  How much below CPI inflation is the Fed willing to reduce rates before they have to stop, much less raise rates to reduce inflation?  My guess: they will err on lowering rates too far, and then will be dragged kicking and screaming to a rate rise, as inflation runs away from them.  The oversupply in residential housing will cause housing prices to lag behind the price rises in the remainder of the economy.

6) Eventually the FOMC will resist Fed funds futures, but for now, the Fed continues to obey the futures market.

7) The stock market loves FOMC cuts in the short run, but has not honored them in the intermediate-term.

Time to Begin Increasing Credit Risk Exposure

Thursday, January 31st, 2008

Ugh, today was a busy day.  My views of the FOMC were validated as to what they would do and say, though I was wrong on the stock market direction on a 50 bp cut.  The bond market direction I got right.

Look at this post from Bespoke.  Ignore the percentage increase, and just look at the raw spread levels.  Better, add an additional 3%+ (for the average Treasury yield) to the current 685 spread, for a roughly 10% yield.  When you get to 10% yields, the odds tip in your favor on high yield.  That said, today’s crop of high yield corporate debt is lower rated than in the past.  Don’t go hog wild here, but begin to take a little more risk.  I was pretty minimal in terms of credit risk exposure for the last three years, owning only a  few bank loan funds, the last of which I traded out of in June 2007.

With fixed income investing, if I have a broad mandate, I start by asking a few simple questions:

  • For which of the following risks am I being adequately rewarded?  Illiquidity, Credit/Equity, Negative Convexity (residential mortgages), Duration, Sovereign, Complexity, Taint, Foreign Exchange…
  • What are my client’s tax needs?
  • How much volatility is my client willing to tolerate?
  • How unconventional can I be without losing him as a client?
  • What optical risks does he face from regulators and rating agencies, if any?

One of my rules of thumb is that if none of the other risks are offering adequate reward, then it is time to increase foreign bond positions.  That is where I have been for the past three years, and now it is time to adjust that position.  With respect to the list of risks:

  • Illiquidity: indeterminate, depends on the situation
  • Credit/Equity: begin adding, but keep some powder dry
  • Negative Convexity: attractive to add to prime RMBS positions at present.
  • Duration: Avoid.  Yield curve will widen, and absent another Great Depression, long yields will not fall much from here.
  • Sovereign Risks: Avoid.  You’re not getting paid for it here.
  • Complexity/Taint:  Selectively add to bonds that you have done due diligence on, that others don’t understand well, even if mark-to-market may go against you in the short run.
  • FX: Neutral.  Maintain core positions in the Swiss Franc and the Yen for now.  Be prepared to switch to high-yield currencies when conditions favor risk-taking.

That’s where I stand now.  The biggest changes are on credit risk and FX.  That’s a big shift for me.  If you remember an early post of mine, Yield = Poison, you will know that I am willing to have controversial views.  Also, for those that have read me here and at RealMoney.com, you will know that I don’t change my views often.  I’m not trying to catch small moves.  Instead, I want to average into troughs before they hit bottom.  If you wait for the bottom, there will not be enough liquidity to implement the change in view.

With 401(k)s and Other Defined Contribution Plans, Watch Your Wallet

Wednesday, January 30th, 2008

When financial matters are opaque, there must be a large discount to prices representing clarity to interest people to buy.  Unfortunately, with 401(k)s and other defined contribution plans, it is sometimes akin to being limited to the “company store.”  I’ve written about these issues before, both here and at RealMoney.  Here’s a good example of one of them:


David Merkel
Pension Consultants: Watch Your 401(k) Expense Levels
9/27/2006 5:36 AM EDT

I want to point you to an article of John Wasik’s of Bloomberg. Having worked in the pension business while an actuary at a mutual life insurer, I had the experience of reviewing the pension services proposals of a number of competitors, and of complementary service providers. Most players were honest, but there were a number of players, while technically not breaking the law, would stretch ethics by finding ways to disguise fees by wending them into the change in unit value of the funds inside a deferred compensation plan. Why embed them in the unit value change? Slice up a fee over hundreds or thousands of participants, and over 365 days a year, and it is remarkable how little people notice it, because most people don’t bother to go and look at plan expenses as disclosed in the Form 5500. Even if everything were disclosed in detail there (some charges don’t get unbundled), an individual doesn’t see that the pro-rata expenses are coming out of his hide. Unless the plan sponsor goes the extra mile to try to minimize costs to participants, there is little that an individual can do.

We had a rule at our firm. We only take fees from one source, and we disclose them. We had a second rule: we only pay commissions once, and they can be disclosed to the ultimate client, or nondisclosed, but not both, but if nondisclosed, the ultimate client must know that.

Oe reason why we did not hire certain investment consultants was the potential for conflict of interest. We eventually hired a consultant to aid us in manager selection that took no fees from the managers, so we could get unbiased advice. There were other consultants that were less than scrupulous in that matter. Without naming names, we terminated our first investment manager consultant because we learned they would not recommend managers to us, unless they were receiving a fee from the manager. That fee would get built into the expenses would into the unit value, or, come out of my firms profit margins, which were for the good of the participating policyholders.

Now that was just my experience, so take that for what it’s worth, perhaps I’m just an investment actuary with a axe to grind. If you want a more general view of the problem, you can review this 2005 study of conflicts of interest done by the SEC. Now, as John Wasik notes, “The commission didn’t take any enforcement action after the report was issued, nor did it name any of the firms surveyed.” The problem is still there, and I’m afraid your only advocate is for you to appeal to your plan sponsor to watch out for the best interests of all participants, which is the duty of trustees under ERISA.

Position: none, but at the mutual life insurer, we had a saying, “We’re out to save the world for 25 basis points on assets, plus shipping and handling.” Beats a lot of other deals out there…

Now, here is another piece from Bloomberg: Fees on 401(k)s Rock Boomers Facing Flawed Disclosure.

The difficulty here is that fees on small plans are sometimes high, and defined contribution plans don’t allow for easy examination of the total fee structures.  How much are the investment managers taking?  The recordkeeper? The custodian/trustee?  The marketer?  It is not always clear.  What can be worse is the manager selection, which are usually random on average (before fees) in terms of any outperformance versus indexes.

Now, in fairness, anytime you have a large number of small accounts, the costs will be high as a percentage of assets.  But there are limits.  Disclosure needs to be improved, but until then, ask your plan sponsor for all of the Form 5500 documents.  There are two classes of expenses.  Explicit: what the fund pays for directly.  Implicit: what gets deducted from investment returns.  Add the two together, because that is the total load.  Insist on as full of an accounting as the plan sponsor will give you.

If you are paying more than 1% of assets per year, then something is wrong, unless the asset classes are esoteric, which should not be the case for DC plans.  Remember, you have to be your own guardian with defined contribution plans.  No one will do it for you.  And, if a few of your colleagues complain at the same time, you will be amazed at how quickly it will be taken seriously, because the administrative staff of the plan sponsor usually doesn’t get that much feedback.

Completion of the Reshaping

Wednesday, January 30th, 2008

I ended up doing more in the first quarter reshaping than I had originally intended. Here are the trades:

New Buys

  • Avnet
  • Ensco International
  • Alliance Data Systems

New Sales

  • Bronco Drilling

Rebalancing Sales

  • Valero Energy (that was fast)

The trades left me with 5% available in cash, and my normal 35 positions, with one being a double-weight (NAHC), and one being a 1.5x weight (JOF).

I didn’t want to go a lot heavier into financials, and particularly not insurance. Ensco ends up replacing Bronco; it’s time to move from the land to the sea in drilling, at these oil price levels. In addition, much as I admire Third Avenue and Curtis Jensen, I reckon their efforts to renegotiate the merger might end up with no merger, as likely as a better deal.

In technology, I tend to buy cheap simple building block companies rather than companies that face possible obsolescence from technological change. Avnet fits that bill.

As for Alliance Data Systems, they are cheaper than before the attempted acquisition, and still have decent growth prospects. This is not usually my style, but the free cash flow can support the current valuation. Yes, it is a financial, but very different from the other companies that I hold.

That’s all. Oh, what a snapback in Valero. When I bought more, I could feel the panic in the market. I bought it anyway; don’t give in to feelings of panic when you are dealing with well-capitalized companies that are leaders in their industries.


Full disclosure: long JOF NAHC AVT ADS ESV

Personal Finance, Part 12 — Longevity Risk

Tuesday, January 29th, 2008

When I started this irregular series on personal finance, I didn’t think it would live this long. Maybe it’s appropriate then that this piece deals with longevity risk. After all, my prior piece dealt the the concept of the PRIER [Personal Required Investment Earnings Rate].


One of the main ideas there is that you have to take enough risk so that you earn enough money to meet all of your goals. One of those goals would likely be having enough to live off of if you live to a ripe old age, like 100. 100 sounds old; after all, it serves our fascination with watching the odometer roll over. Old age mortality has been improving, though and the number of centenarians is growing rapidly. The same is true of those living into their 90s. Yet many people plan retirement as if they were only going to live to 85.


The destitute elderly definitely have it worse than those with resources. What if you could eliminate some of the risk of outliving your income? I have a product that could help you — the life-contingent immediate annuity. Life-contingent immediate annuities pay a stream of income for the life of the annuitant (or joint lives of two annuitants). They give an income that cannot be outlived. Today, a number of insurance companies do that one better, and offer inflation adjustments on the payments, with the trade-off being accepting a lower initial payment than the unadjusted annuity. The only remaining risk is insurance company solvency, but only buy from reputable firms. That said, remember that the state guarantee funds stand behind the companies, and the benefit payments they are least likely to cut off in an insolvency are death benefits, disability payments, and immediate annuity payments.


Immediate annuities are bought, not sold, unlike other life insurance products. Why? Because once they are bought, there are usually no ways to surrender the policy. You can only take payments over time. Agents don’t like selling immediate annuities, because they will never derive another commission from that money. They would rather sell a variable annuity with a living benefit rider, because it will be possible to roll the policy at a later date to a “better” policy (surrender charges are low), and earn another commission.


Though I am not crazy about variable annuities with living benefit riders, if you own one, be careful before you surrender it. You may have a valuable option to have the company pay a fixed amount for a long time that is worth more than your surrender value rolling into a new policy. In general, be careful in buying any deferred annuities, because the fees are stiff. Be most careful if the agent comes to you when the surrender charge is gone, and encourages you to “roll” to a new product. His interests are different than your interests. You are likely better off staying in your existing deferred annuity.


Are there any other solutions to longevity risk? There are a few. First, cultivate younger friends and family who will be advocates for you in your dotage. They are necessary for kind treatment on the part of the staff of any old age home that you might enter. Those that have no advocates don’t fare well. (For those who are really young, marry, and have more than two kids! Love them, and they will love you.) Second, have an investment policy that reflects the longer-term, realizing you might live longer than average for those that have attained your age. This means more risk assets (stocks) on average than what is commonly recommended, but I would temper this with two caveats:


1) Remember that the Baby Boomers are graying, and will need to liquidate assets to support their old age.


2) Sometimes the markets are overvalued, and it is time to preserve capital, not go for capital gains. Tweak you asset allocation to reflect asset valuations.


A long life is a blessing, and even more so when you have friends, family, good health, and peace with God. Plan now to live longer than you expect. Save more, invest wisely, and buy some longevity insurance.


PS — Don’t go “hog wild” with any single pecuniary strategy for your old age. This is another area where diversification pays, so don’t put all of your eggs in one basket.


PPS — Some of the larger insurers (Pru, Met, Hartford) allow you to buy future income streams should you be alive to receive them. They are an inexpensive way for younger people to put money away for retirement, though there are risks of early death, company insolvency and inflation.


Full disclosure: long HIG

Could Investors Manipulate the Fed?

Tuesday, January 29th, 2008

When I began my career as an actuarial trainee in 1986, I didn’t know much. When I began working in fixed income as an actuary back in 1992, I didn’t know much. When I entered my first investment department and bought my first bond (institutionally CMAT 1999-1 A4) in 1998-99, I didn’t know much. When I was made a corporate bond manager in 2001, I didn’t know much. When I went to work for a hedge fund in 2003, I didn’t know much. It is probably still true today, because “the markets always find a new way to make a fool out of you.” I’ve made my share of mistakes, and then some. But for the most part, I have been a fast learner.

So, what I write in this post is a little speculative. I don’t know as much as I would like to. About seven years ago, I had a conversation with a more experienced colleague about Fed funds futures. It went something like this:

David: Fed funds futures do a really good job predicting Fed moves.

Colleague: Yes, they do.

D: What if Fed is using Fed funds futures to set policy?

C: Huh? You mean let the view of market participants set policy? They would never do that.

D: They certainly could never let it be known that they do that, if they did. There would be too much money chasing the Fed funds futures markets in order to influence policy.

C: The Fed would never do that. Why would they give up their discretion?

D: Perhaps Greenspan might do it in a misguided free-market attempt to let the markets dictate monetary policy, rather than removing the punchbowl, as was said in the ’60s.

C: I think you are wrong here. The Fed is a complex institution and can’t be boiled down to a simple futures market. They take a lot of different things into account before making their decisions. The Fed funds futures market is just very good at sensing the various forces that affect the Fed, and the collective wisdom of the market is very good at predicting the Fed. After all, there is a lot of money on the line.

D: Okay, you’re probably right. One last thing. How much would it be worth if you knew that the Fed followed the Fed funds futures markets, and no one else did?

C: If you had enough money to manipulate the Fed funds futures market, that would be worth a lot. But the Fed sets its own policy, and does not want to be manipulated, so that’s not happening.

D: Thanks. I think I get it.

C: You’re welcome.

I’ve talked before about the Fed outsourcing monetary policy before to the markets. I consider it a possibility that the FOMC uses Fed funds futures to set policy. After all, even with the TAF, the Fed uses Fed funds futures to set a reservation yield for the auction. Even if it is not true that the Fed uses Fed funds futures to set policy, the futures work really well when one tries to predict what the Fed will do.

Now, perhaps this is a bad argument for a different reason: the Fed funds futures market trades alongside all of the short-term debt markets — eurodollars, CP, T-bills, etc. In order to truly move Fed funds, you would have to move much more, and it is unlikely that any single player could do that. The market as a whole could do it, though, because it is bigger than the Fed. But if that were true, no one would be manipulating. The FOMC would simply follow the judgment of the marginal short-term fixed income investor, which wouldn’t make the policy correct, because markets a a whole make forecasting errors.

Back to the Present

I will say it now, the FOMC will cut 50 basis points today, the stock market will rally, and the yield curve will steepen. The explanatory language will make the requisite bows to both sets of risks, but will say that current weakness justifies the cuts. Now, I don’t like this forecast for a few reasons:

  • The yield curve has enough slope already. 138 basis points between 2-year and 10-year Treasuries should be enough to allow the banks to make money over the intermediate-term.
  • The NY Fed has left Fed funds on average 6 basis points higher than the target since the emergency cut. Why the incremental tightness?
  • Total bank liabilities and MZM have been growing at 10%+ rates over the last year. That level of credit growth should be adequate for our level ofnominal GDP growth.
  • The Fed hasn’t done a permanent injection of liquidity since 5/3/07, and was sparing with them early in 2007. The behavior there is unusual to say the least. Why not be be more conventional if you are loosening monetary policy?
  • Economic weakness is noticeable, but isn’t severe once one gets outside housing and related industries.

At some point, the Fed has to break with the futures market, and deliver a surprise to the markets as a whole, whether positive or negative. Even breaking out of the 1/4% steps would break some of the models used to analyze the FOMC. How about a 3.1% Fed funds rate? This is a digital era where stocks trade in penny increments. The FOMC can move into that digital world as well.

I was taught in economics class (way back when) that policy moves that were anticipated had no effect. Well, eventually the Fed either needs to take back its mandate that it delegated to the markets, or inform the markets that their best estimate of their policy is wrong, and deliver a surprise. A little confusion, a little lack of transparency would benefit the markets over the long haul, and help to reinstate a sense of risk that has been lost among many market participants.

Eventually this will happen, and it might happen tomorrow, but the money on the line says “Cut 50 bps,” and so I don’t argue.  Compared to the market, I don’t know much.

Personal Finance, Part 11 — Your Personal Required Investment Earnings Rate

Saturday, January 26th, 2008

Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.  Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.  Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.  Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.  There’s a reason for this, and I’ll get to that later.  Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.  (Today that would be higher than 9%.)  That means you are not likely to make your goals.   You can either:

  • Save more, or,
  • Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.  Now, I left out a common choice that is more commonly chosen: invest more aggressively.  This is more commonly done because it is “free.”  In order to get more return, one must take more risk, so take more risk and you will get more return, right?  Right?!

Sadly, no.  Go back to Defined Benefit programs for a moment.  Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.  What have they earned?  On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.  The overshoot of the ’90s has been replaced by the undershoot of the 2000s.  Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

While the ’80s and ’90s were roaring, DB plan sponsors made minimal contributions, and did not build up a buffer for the soggy 2000s.  Part of that was due to stupid tax law that the government put in because they didn’t want pension plans to shelter income from taxes for plan sponsors.  (As an aside, public plans did less than corporations, even though they did not face any tax consequences.)

But the same thing was true of individuals.  When the markets were good, they did not save.  Now when the markets are not good, the habit of not saving is entrenched, and now being older, saving might be more difficult because of kids in college, interest on a mortgage for a house larger than was needed, etc.

Now, absent additional saving, when investment earnings lag behind the PRIER, that makes the future PRIER rise, to try to make up for lost time.  Perhaps I need to apply the five stages of grieving here as well… trying to earn more to make up for lost time is a form of bargaining.  It rarely works, and sometimes blows up, leaving a person worse off than before.  Most aggressive asset allocation strategies only work over a long period of time, and only if a player is willing to buy-rebalance-hold, which only a few people are constitutionally capable of doing.  Most people get scared at the bottoms, and get euphoric near tops.  Few follow Buffett’s dictum, “Be greedy when others are fearful, and fearful when others are greedy.”  Personally, I expect the willingness to take investment risk over the next five years to rise, but over the next ten years, I don’t think it will be rewarded.

Now, as time progresses, and the Baby Boomers gray, unless the equity markets are returning the low teens in terms of returns, there will be a tendency for the average PRIER to rise, absent people realizing that they have to save more than planned, or reduce their goals.  This problem will be faced in the ’10s, bigtime.  The pensions crisis will be front page news, and I’m not talking about Social Security and Medicare, though those will be there also.  The demographics will be playing out.  After all, what drives the funding of retirement at a DB plan, but aging, where the promised expected payments get closer each day.

Well, same thing for individuals.  Every day that passes brings a slow weakening of our bodies and minds.  Dollars not saved today, or bad investment returns mean the PRIER rises, making the probability of attaining goals less achievable.

Now, is there nothing that can be done aside from increasing savings and reducing future plans?  In aggregate, no.  You will have to be someone special to beat the pack, because few do that.  Better you should take the simple solution, which is a humble one: save more, expect less.  For those that do have the talent, you will have to take the risks that few do, and be unconventional.  Note: for every four persons that think they can do this, at best one will succeed.  My own methods are always leaning against what is popular in the markets, and I think that I am one of those few, but it takes work and emotional discipline to do it.

Then again, I have done it, as far as my PRIER is concerned — it is below the rate on 10-year Treasuries.  Most of that is that my goals are modest, aside from putting my eight kids through college, and I am not planning on retiring.

With that, I leave to consider a post I wrote at RealMoney two years ago.  It’s kind of a classic, and Barry Ritholtz e-mailed me to say that he loved it.  Given what we are experiencing lately, it seems prescient.  Here it is:


David Merkel
Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

My Best Relative Value Week in a Long Time

Saturday, January 26th, 2008

I’ve worked for years to take the emotions out of my investment processes, with some success.  Where it gets tough is when I am in an absolute and relative drawdown, as I was for most of the second half of 2007.  Nonetheless, I stuck with my disciplines.  This week, a lot of things went right:

  • Retail
  • Insurance
  • Trucking
  • Energy
  • Small cap value was the best style

Will this persist?  Who can tell…  I was ahead of the Russell 2000 Value index this week, even though my portfolio is more midcap value in nature.  I’m still wrestling with where to deploy incremental funds.  I’m 2-3 positions light at present, and I know I am already insurance-heavy, with many of my best candidates being insurers, and the rest Irish Banks.  I don’t want to get too heavy in financials… I’m overweight there now.  Ideas are welcome.  Oh, at the end of the day I did make a small purchase:


David Merkel
Rebalancing Buy
1/25/2008 4:02 PM EST

Bought some Gruma, SA into the close. Tortillas and other Mexican foods are not going out of style, even if the Mexican stock markets are having difficulty of late. I’ve had a good week. Hope you did too.

Position: long GMK

The market always has a new way to make a fool out of you, so I am not relying on a change in the financial weather here.  I just keep doing what I do best.

Full disclosure: long GMK

Miscellaneous Musings on Our Manic Markets

Friday, January 25th, 2008

1) I had another good day today, but my body is telling me otherwise.  As I wrote at RealMoney:


David Merkel
Two Positive Surprises; Two Things I Don’t Do
1/24/2008 3:11 PM EST

Two more news bits. I don’t buy for takeovers, but today Bronco Drilling got bought out by Allis-Chalmers Energy. (Now I have three open slots in the portfolio.) I also don’t buy to bet on earnings. But I will ignore earnings if I feel it is time to buy a cheap stock. With yesterday’s purchase of RGA, I did not even know that earnings were coming today. What I did know was that they are the best at life reinsurance, and that it is a constricted field with one big (in coverage written) damaged competitor, Scottish Re. So, today’s good earnings are a surprise, but the quality of RGA is not.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Scottish Re to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long RGA BRNC

2)  There’s a lot of commentary going around on the Financial Guarantors and bailouts, whether to profit-seeking individuals like Wilbur Ross, or a consortium of investment banks who will not do so well without them.  For a good summary of what will make a consortium bailout of the industry as a whole tough, read this piece at Naked Capitalism.  I will say that Sean Egan’s estimate of $200 billion is too high (maybe he is talking his book).  Just on a back of the envelope basis, the whole FG industry earned about $2 billion per year.  If they needed $200 billion more capital to be solvent, their pricing would have to expand about 5-10 times to allow them to earn an acceptable ROE.  No one would pay that.  So, if the $200 billion is right, it is just another way of saying that the FG industry should not exist.  (Well, the Bible warns us of the dangers of being a third-party guarantor…)

Then again, there are many risks that Wall Street takes on where the probability of ruin is high enough to happen at least once in a lifetime, but adequate capital is not held because protecting against the meltdown scenario would make the return on equity unacceptable.  The risk managers bow to pressure so that the businesses can make money, and hope that the markets will stay stable.

3) There’s been even more musing about the Fed 75 basis point cut, with a hint of more to come.  No surprise that I agree with Caroline Baum that the Greenspan Put is alive and well, or with Tony Crescenzi that we could call it the Bernanke Pacifier.  But Bill Gross leaves me cold here.  He and Paul McCulley consistently argued against raising rates during the recent up cycle, and in the prior down cycle cheered the lowering of the Fed funds rate down to 1%.  These policies, which overstimulated housing, helped lead to the situation that Mr. Gross now laments.

I also think that David Wessel and many others let the Fed off too easily on their misforecasting.   Who has more Ph.D. economists than they do?  I’m not saying that the Fed should read my writings, but there is a significant body of opinion in the financial blogosphere that saw this coming.  Also, they basked in their aura of invincibility when it suited them, particularly in the Greenspan era.

As I commented last night, Bernanke is a bright guy who will not let his name go down in the history books as the guy who allowed Great Depression #2 to emerge.  So as  the bubble bursts, the Fed eases aggressively.  Even Paul Krugman points to the writings of Bernanke on the topic.

One last note on the Fed: Eddy Elfenbein points out the basic mandate of the Fed.  I’m not sure why he cites this, but it is not a full statement of the Fed mandate, unless one interprets it to mean that the Fed has to promote the continuing growth of the credit markets (I hate that thought).  Since the Fed is a regulator of banking solvency, and must be, because money and credit are similar, the Fed also has a mandate to preserve the banking system under its purview.  That’s difficult to do without overseeing the capital markets, post Glass-Steagall.  Unfortunately, that is what creates at least the appearance of the “Greenspan Put.”  And now the market relies on its existence.

4)  But maybe the Fed overreacted to equity markets getting slammed by SocGen exiting a bunch of rogue trades.  Perhaps it’s not all that much different than 2002, when the European banks and insurers put in the bottom of the US equity markets but being forced to sell by their regulators. If so, maybe the current lift in the markets will persist.
As for SocGen, leaving aside their chaotic conference call, I would simply point out that it is a pretty colossal failure of risk control to allow anyone that much power inside their firm.  Risk control begins with personnel control, starting with separating the profit and accounting functions.  Second, the larger the amounts of money in play, the greater the scrutiny should be from internal audit, external audit, and management.  I have experienced these audits in my life, and it is a normal part of good business.

Because of that, I fault SocGen management most of all.  For something that large, if they didn’t put the controls in place, then the CEO, CFO, division head, etc. should resign.  There is no excuse for not having proper controls in place for an error that large.

That’s all for the evening.  I am way behind on my e-mail, so if you are waiting on me, I have not given up on responding to you.

Full disclosure: long RGA BRNC

Living in the Shadow of the Great Depression

Thursday, January 24th, 2008

Don’t we wipe the slate clean after two generations or so?  Or, as my old boss used to say, and he is looking smarter by the day, “We don’t repeat the mistakes of our parents; we repeat the mistakes of our grandparents.”  Our monetary policy is being guided by fear of repeating the Great Depression.  We may avoid that, and end  up with two lost decades, like Japan.  (it would fit the demographic trends…)  Or, maybe, the FOMC will ignore (or suppress the knowledge of) inflation, and bring us back to an era reminiscent of the 1970s.  Either way, we may face stagnation, but defaults are fewer in a 1970s scenario, though those on fixed incomes get hurt worse.

Don’t get me wrong.  I’m not blaming Bernanke and the current FOMC much; the blame really rests with Greenspan, and the political culture that can’t take recessions, so monetary policy must bail us out.  Consistently followed, it eventually leads us into a liquidity trap, or an inflationary era, or both.

Recessions are good for the economy; they clear away past imbalances.  We should have been accepting them to a greater degree over the past 25 years.  But now things are tougher, and most policy actions will lead to suboptimal results.  Personally, if the FOMC could resist the political pressure, leaving Fed funds on hold at 3.0-3.5% would produce an adequate result 2 years out, with some increase in inflation, but allowing the banks to reconcile their bad loans.

The fear is that the FOMC will drop rates to Japan-like levels in order to avoid a Great Depression-style scenario, and create the Japan scenario as a result.  My guess is that we would get more inflation than Japan, and not be able to do that.  We are a debtor nation, versus Japan as a creditor nation; that makes a difference.

Patience is a virtue, individually and corporately.  We are better off waiting and allowing monetary policy to work, rather than overdoing it, and setting up our next crisis.

As For A Financial Guarantor Bailout

The last time financial guarantors went broke in a major way was during the Great Depression.  The financial guarantor stocks have rallied massively in the last few days, and I think those rallies are mistaken.  There is much hope for a bailout of the insurers.

The insurers may indeed get bailed out, if the NY Commissioner can convince those that would get hurt to pony up equity, much as many of them are already hurting at present, but that equity would significantly dilute existing shareholders of the holding companies of the guarantors.  I would not be a buyer of the guarantors here; I would sell.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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