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Archive for November 4th, 2008

The Biggest, Baddest Bubble of Them All

Tuesday, November 4th, 2008

It’s election day, and I may as well try to fuse economics and politics for a moment.  Personally on an economic basis, I don’t think this election means that much.  Consider this post at RealMoney from earlier this year:


David Merkel
Cultures are Bigger than Economies, Which are Bigger than Governments
1/7/2008 1:19 PM EST

To start this off, I don’t fit neatly on the political spectrum. I am an economic libertarian, socially a conservative, but utterly against the recent wars that we have pursued. I also think that we need to find a way to dismantle the two party system, but that will never happen. So now you have enough to disregard me if you like.

I don’t think the primaries make any difference at all. The three leading Democrats are all very alike. It doesn’t matter which one wins the primary. The Democrats would have their best chance with Obama, because general elections tend to be won on (sadly) which candidate is more likeable.

As for the Republicans, there are differences, but not to any great degree on likely economic policy. I say “likely economic policy” because none of their differential policies are likely to survive if one of them wins the general election. Any Republican win is unlikely to have that much of a mandate.

There are differences between the Republicans and Democrats on economic policy, but this is where my headline comes into play: “Cultures are Bigger than Economies, Which are Bigger than Governments.” Given the mismanagement of our government, particularly with respect to entitlement programs, though also costly wars, future governments will have less wiggle room. Raise spending, cut taxes? Go ahead and try. No surprise that the US Dollar continues to fall. Outsiders will eventually tire of funding US deficits in US currency.

The Republicans will leave the micro-economy more free than the Democrats, but aside from that, I don’t think the election matters much, at least as far as economics goes. There may be other reasons to vote for one side or the other, but pocketbook issues rank low for me, and in this election, the payoff from the differences will not be big.

Now, cultural change, in the unlikely event that it would occur, is another matter. But American history has been replete with big shifts before, and the economy and politics get dragged along. Perhaps the question to ask is what will be the next big shift in American culture? I don’t have any read on that now, but then, when it happens, it is often fast.

Position: none

Our biggest bubble, which is still inflating, are the debts of the US Government, both explicit and those not accrued for.  We are going to have a difficult time borrowing in the present for all of these new bailout/stimulus/pork programs.  Our debts are getting deeper, not shallower.

Consider this graph from this article at Clusterstock:

We may have a slight breather from the increase in total debt recently (2006-7), but it is going up in the near term.  My view is that we need delevering, and that will be a big theme in coming years once the government tires of the new policy of shifting private debts onto the public balance sheet.

Now, I’m still dubious that the bailout policy will work.  Reasons:

When a foreign holder of Treasuries is willing to give up 40 basis points of yield on a 10-year T-note yielding 3.80%, so that they can get paid off in Euros if there is a repudiation of US Treasury obligations, there is significant uncertainty over the creditworthiness of the US Government.  (That’s just an example, there are other reasons to enter into such a CDS.)

Now, the debt-to-GDP graph above doesn’t take into account pension and entitlement underfunding/non-funding.  From another comment at RealMoney:


David Merkel
Digging a Hole to China (So We Can Borrow Some More)
10/28/03 08:26 AM ET
With a gracious assist from one of our readers at Economy.com, here is the link I promised yesterday. The report does not break out one final number — one has to look at the “balance sheet” on page 58, and the “Statements of Social Insurance” on page 65, which they count as an off balance sheet liability, and add them up. It looks like this (in USD):

  • Net Liability: $6.8 trillion
  • Soc Sec, Pen & Dis: $4.6 trillion
  • Medicare, part A: $5.1 trillion
  • Medicare, part B: $8.1 trillion
  • Total: $24.6 trillion
  • This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

    np

    That $24.6 trillion figure was from September 2002. As of September 2007, it would now be around $50 trillion. ( Here’s the link to the 2007 figures.  New figures out in two months.)  By the way, thanks Mr. Bush, for being such a reformer of Social Security and Medicare. You added on another $10 trillion of unfunded liabilities that future generations will have to fight over bear in your prescription drug program.  You have been the most damaging president on economics since Nixon.  (Sorry, I lost my cool. :( )

    That $50 trillion does not count in state and corporate underfunding of pensions and benefits.  Oh, and with the fall in the markets, they want a bailout also.

    Who doesn’t want a bailout?  The US Government can just borrow some more to aid us on our way to prosperity.  Those debts and unfunded promises will have to be paid someday, either through taxes, inflation, or repudiation (total or external).  The economic mess at that point will be far worse than it is today for all those who rely on the US Dollar.

    Our problems in the US are larger than our politics.  It goes down to our very culture, borrowing from the future to take care of the present.  It is true for our Government, and many corporations and individuals.  The pain will come, the only question now is what form it will take.

    Time to Ditch the Style Box

    Tuesday, November 4th, 2008

    If you were trying to create a system for controlling investment risk in equity investing, how would you do it?  What I would do is look at the factors that are the least positively correlated in terms of return generation, and focus on them.

    But what do investment managements consultants do?  They divide the world up into managers that look at two factors: large/mid/small capitalization, and value/core/growth.  This has been popularized by the Morningstar “Style Box.”

    Looking over the last 15 years, the style box is very correlated with itself.  The lowest correlation is 75%, between largecap value and smallcap growth.  That is not a reason to categorize managers; the difference between the average largecap value and growth manger is teensy. It is even true between largecap value and smallcap growth.  And in more recent years, the correlations have been tightening to nearly 90% at worst.

    So, consider country allocations.  Over the last 15 years, the correlations in developed markets have been 45% at worst, with the average being near 70%.  Looking at the last few years, both figures are higher.  My opinion: the advent of naive quantitative investing has pushed all correlations higher.

    But now consider correlations across economic sectors.  Over the past 14 years, the correlations have been 32% at worst.  Across industries, which are more diverse than sectors, some of the correlations are negative, perhaps affording true diversification.

    My point here is that those that look at capitalization size and value/growth are missing the boat.  If you classify managers based on that, you are focusing on minor concerns that do not aid much in diversification.  Better to focus on the industries that a manager invests in, and/or the countries that those companies are located in — there is a real oportunity to limit risks through either of those two methods.

    Now, as for me, when I pick stocks, I start with the industry.  I ignore the factors in the style box.  I look for industries that are near the bottom of their pricing cycle, and buy the highest quality companies there.  For industries that are doing well, but are undervalued, I buy companies with undervalued growth prospects, with good quality balance sheets.

    I strongly believe that the investment consultant community has shortchanged its clients by focusing on the “style box.”  Very little of the risks of the market result from factors in the style box, while much resluts from industry selection, which is a richer model.

    So, as for me, if I have to be squeezed into the style box, call me midcap value with some style drift, buying companies larger and smaller, and outside the US, as conditions dictate.  I’m looking for the best value over the next three years, and I don’t like non-economic factors distracting me.  Why should that be such a crime, that the ignorant gatekeepers screen me out?

    The risk model for the investment consultants is broken.  Let them find one that better reflects the way that the market works.

    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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