1) It is a wonderful thing to be the world’s reserve currency; we can milk the rest of the world until things change.  There is some push from emerging markets to have a change, but the effectiveness of that push is questionable.  Someone has to give the US an ultimatum, and no one is there yet.

2) With the decline in fixed income volatility, mortgage yields are falling.  Good for mortgages, but the real question is what happens when the Treasury starts borrowing like a maniac.

3) Many hedge funds have raised the gates.  Capital cannot easily exit.  GIven the weak balance sheets that hedge funds have, this is normal for a bear market.  The only surprise is that investors did not anticipate the troubles.

4) Perhaps the money to banks from the government is going only to relatively sound institutions.  That is consistent with the idea of making some institutions sound, and letting them buy up marginal banks.  Upshot: don’t expect an early increase in lending.

5) Analyze those that are on the other side of the table.  If they have a reputation for being smart, be extra careful.  Many municipalities and other entities lost money dealing with investment banks.  No surprise.

6) Many do not understand mark-to-market accounting.  First, GAAP is the least of the problems — collateral agreements require MTM.  Regulators can ignore MTM as they please. Second, MTM is misapplied by auditors; it does not mean “last trade,” but an estimate of where a liquid market would trade.

7) Shut the barn door after the cow has escaped.  Yes, loan underwriting standards have tightened, in the middle of a credit bust.

8 ) There is less cash flow to service; the financial sector should shrink.

9) S&P 500 at 600?  Not impossible, and not likely, but if profit margins crush down, possible.

10) where could longs make money in October 2008? Nowhere.  Real bear markets crush almost everyone.

In closing, I am not concerned about the victory of Obama.  The new president will have little freedom, and will face significant unsolvable problems.

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.

    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.

    Until I read the last sentence of this Wall Street Journal article on AIG’s risk models, I felt somewhat sympathetic for the guy who developed the models.  Having developed many models in my life, I have seen them misused by executives wanting a more optimistic result, and putting pressure on the quantitative analyst to bend the assumptions.  Here’s the last paragaph:

    On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: “There doesn’t seem to be a fundamental reason why.”

    When I read that, I concluded that the poor guy was in over his head for years, and did not have the necessary expertise for what he was doing at AIG.  All good credit models contain something for boom and bust.  Creditworthiness of borrowing entities is highly correlated, especially during the bust phase of the credit cycle.  That said, to get deals done on CDO-like structures, the modeler can’t assume that correlations are as high as they are in real life, or the deals can’t get done.

    But to my puzzled professor, there are fundamental reasons why.

    • Overlevered systems are inherently unstable.  Small changes in creditworthiness can have big impacts.
    • Rating agencies undersized subordination levels in order to win business.
    • Regulators allow regulated financials to own this stuff with low capital requirements, partially thanks to Basel II.
    • Much of the debt was related to Financials, Housing, and Real Estate, and all of those sectors are under pressure.
    • When financials ain’t healthy, ain’t no one healthy.

    Now, for another look at the problem from a different angle, consider this New York Times article on Wisconsin public schools buying CDOs for teach pension plans.  As a kid, I played against a number of the schools mentioned in sports, etc., so many of these names bring back old memories for me.

    Again, what is clear is that the guy advising the school one of the school districts barely understood the ABCs of what he was doing, and the district trusted him.  I’ll say it again, if you don’t understand it, or you don’t have a trusted friend on your side of the table who does understand it, don’t buy it. Also, relatively high yields on seemingly safe investments typically don’t exist.  Beware the salesman that offers high yields with safety; there is usually one of four things involved:

    • Financial leverage
    • Options sold short
    • Low credit quality of the underlying debt instruments
    • Foreign currency risks

    These deals fall far short of the “prudent man rule” in my opinion.  Not only is the salesman culpable in this case, so are the board members that did not do proper due diligence.  For something this complex, not reading the prospectus is amazing, even though it might not have helped, given the complexity of the beast.  At least, though, a board member should read the “risks and disclosures” section of the prospectus.  There is usually honesty there, because that is what the investment bank is relying on to protect themselves legally if things go bad.

    The districts should have accepted a lower rate of return on their investments, and asked the taxpayers for contributions to the pension plans, etc., to make up any deficits.

    We will probably see many more stories like this over the next year.  Politicians and bureaucrats are often short-sighted, and look for “that one little thing” that will magically close a gap in the budget.  It’s that little bit of fear of the taxpayers and other stakeholders that caused “that one little thing” to become so tempting.  But now they have to live with the bad results; heads will roll.

    1) Where are we?  Is the equity market cheap or dear?  Personally, I think it is cheap, and though it might rally in the short run, it could get cheaper.  When the financials are compromised, all bets are off.  Here are some article indicating that things are cheap:

    And, not cheap, consider the arguments of this humble student of the markets.  He considers survivorship bias and war as factors that investors should consider.  I agree, and I would urge all to consider that wars often occur as a result of economic crises.

    2) The trouble is, quantitative finance is tough.  We don’t have enough data.  Our models are poor, and until recently, often reflected two major bull cycles, and only one bear cycle.  My view is that the equity premium is more like 3% over the long run, and not the 6% bandied about by careless consultants.

    3) During the “great moderation,” I argued over at RealMoney that volatility and credit spreads were too low, and would eventually snap back.  Okay, we are there now.  Volatility is high, and so are credit spreads.  The brain-dead VAR models used by Wall Street have been falsified again.  Quantitative investors have gotten savaged again; it only works when implied volatility is flat/declining — it is an implicit credit bet.

    4) This is a global crisis.  Where is it appearing?

    5) As I have mentioned before , the IMF, previously seeming irrelevant, has a new lease on life.  But how much firepower do they have, and will countries in crisis send them money to aid foreigners?

    Consider their new plans for a short term lending facility, and the exogenous shocks facility.  They will have a lot to fund in this environment.

    6) Might government programs to guarantee bank deposits have caused a shift from stocks to bank deposits?  Possible, though for every seller, there is a buyer.

    7) How do we pay back what we borrowWho will borrow more from us?  Those are  the great unanswered questions as we attempt to bail out many troubled entities.  I’m a pessimist here, and think that we will have higher long rates as a result, and that “Bernanke” will become a cuss word.  (Among the cognoscenti, only “Greenspan” will do as a proper insult.)  On the despondent side, will the US default in 2009?  Doom-and-gloomers are always early, and ignore the flexibility in the financial system prior to failure.  I see default as more of a 2017-2020 issue.

    8 ) Uh, let Lawrence Meyer pontificate.  There is nothing good about a zero Fed funds rate.  Let him wax grandiloquent about Japan over the past two decades.  Consider how low interest rates destroy money markets funds.  Consider as well how much low rates destroy saving, sometyhing that we have had too little of.

    9) In an environment like this, every M&A deal is open to question.  M&A is credit sensitive, and higher volatility impairs the flow of credit.

    10) I don’t think that GAAP mark-to-market accounting has had a material impact on this crisis.  True, many accounting firms have interpreted mark-to-market as mark-to-last-trade, but that is not what SFAS 157 specifies, and firms can ignore their auditors (with some risk).  The truth is that the firms that have failed choked on bad balance sheets and inadequate cash flow.  It doesn’t matter what the accounting rules are when a company is running out of cash.  Cash is impervious to accounting rules.

    11) Want a closer view of the Fed and politics.  Read this piece at The Institutional Risk Analyst.  While at RealMoney I espoused a view that the Fed was more political than economic.  This article confirms it.

    12) How do I view Greenspan’s apology?

    13) At a prior employer, we often commented that credit risk in credit cards appears late in the credit cycle.  Well, we are there now.  It is seemingly the last form of credit to default on.  In this environment, one can lose their home, but losing financial flexibility can be bigger.

    14) The FDIC can modify many mortgages, at a cost to taxpayers.  It could cost a lot, and many people who made dumb decsions could be bailed out by the prudent.

    15) If John Henry were alive, he would be smiling.  Let humans make markets, and not machines.

    I have been on both sides of the table in equity money management.  I have hired and fired managers.  Now I am looking to be hired as a manager, and I face something that distresses me — the consultants that advise potential clients.  Personally, I think the consultants could do a lot better if they abandoned their overly simplistic model that categorizes managers on capitalization, value/core/growth, and domestic/international.  It does not serve their clients well — I believe the most fundamental risk model in a globally connected world considers industry exposures, and ignores other variables.

    Why?  Industries tend to occupy specific areas of the “style box.”  At one firm that I worked at, external consultants complained that our risk control procedures were nonstandard, because they were focused on industries and sub-industries.  I counter-argued that our methods were better, because with a given industry, there was little variation in market capitalization and value/growth, but industry performance varied considerably.  Though I am no longer with the firm, it continues to do well, while many that used the consultants’ model have died.

    Look at it another way. Isn’t investng about finding attractive opportunities, regardless of how big they are, where they are located, or how quickly they grow?  I think so, as does Buffett, Munger, Muhlenkamp, Heebner, Hodges, Rodriguez, Lynch, and many other successful fundamental investors.

    Sometimes largecap names are attractive, sometimes smallcap.  Sometimes deep value is attractive, sometimes growth at a reasonable price.  Good managers analyze where the best value is, regardless of non-economic factors.

    But if you have to cram me into the style box, fine, I am a midcap value manager that buys a few foreign stocks.  But there is a huge loss in constraining intelligent investors through the style box.  The better a manager is, the more one should ignore non-economic distinctions, and let him perform.

    Since I wrote my last portfolio update two months ago, it is time for a new report.

    New Buys

    • PartnerRe
    • Allstate
    • Assurant
    • Nucor
    • Genuine Parts
    • Pepsico
    • CRH
    • Alliant Energy

    New Sells

    • Avnet
    • Lincoln National
    • YRC Worldwide
    • CRH
    • Jones Apparel
    • Assurant
    • Group 1 Automotive
    • Smithfield Foods
    • MetLife
    • International Rectifier
    • Cemex
    • Officemax
    • Universal American

    Rebalancing Buys

    • Shoe Carnival
    • Charlotte Russe
    • Devon Energy (2)
    • RGA
    • SABESP
    • Ensco International (2)
    • Industrias Bachoco
    • Magna International
    • Valero
    • Kapstone Paper
    • Hartford International (3)
    • Cimarex Energy
    • Lincoln National
    • Smithfield Foods
    • Allstate
    • ConocoPhillips (2)
    • Tsakos Energy Navigation

    Rebalancing Sells

    • PartnerRe
    • Safety Insurance
    • Devon Energy
    • Ensco International
    • Hartford Financial (3)
    • Kapstone Paper
    • Cimarex Energy
    • Nam Tai Electronics (2)
    • Honda Motors (2)
    • Lincoln National (2)
    • ConocoPhillips
    • Charlotte Russe
    • Shoe Carnival

    I’ve had a lot of trades over the past two months, which is normal for me when volatility rises.

    I have been asked by a number of parties why I don’t write about the insurance industry in this environment, given my past experience.  My main reason is that I have left it behind.  When I became a buyside insurance analyst, I had strong opinions about what made a good or bad insurance company.  For the most part, those opinions were correct, but there is a fundamental opaqueness to insurance.  One truly can’t analyze it from outside.  No boss would hear that, even if true.

    I benefitted from the cleaning up of insurance assets 2002-3, and thought that the cleanup had persisted.  Largely, it has, but many life companies rely too heavily on variable products for profitability, and as the market has fallen, profits from variable products have fallen harder.  Thus my mistakes with Hartford, MetLife and Lincoln National.

    That brings up two other possibilities where things can continue to go wrong in life insurance.  If fees are permanently reduced the companies might have to write down the deferred acquisition costs [DAC] that they capitalized when originally writing the business, if the expected cumulative fees are less than the DAC.  The second issue is hedging the guaranteed living benefits.  I will never forget the look that the CEO of Principal Financial gave me when I asked him how well the futures/options hedges during a month where the S&P 500 is down 20-30%.  It was not a pleasant look.  Not that that scenario could ever happen. 😉

    My picks in pure P&C insurance have fared better.  Safety Insurance is a solid company; so is PartnerRe.  Would that I had done more there, and less in life companies, especially the equity sensitive ones.

    So what do I hold today among insurers?

    • Allstate
    • Assurant (bought after the marginally bad earnings announcement)
    • Hartford (yes 🙁 )
    • PartnerRe
    • Reinsurance Group of America
    • Safety Insurance

    Yes, I am overweight insurance, and I have paid the price, particularly with Hartford.  There is an uncertainty connected with life insurance holding companies about the ability to upstream dividends to service debt.  That uncertainty only appears in bear markets, and all the hubbub over optimizing the capital structure is so much hooey.  Assurant is in better shape because it ceased buying back stock because of the (somewhat bogus) investigation of a few of their executives.

    Two final notes to close.  I had a bad October, worse than the S&P 500 by a significant margin.  My exposures in life insurance and emerging markets drove that.  Second, I may have my first equity client, and so I may be curtailing some of my discussion of individual names in my portfolio, and deleting my portfolio at Stockpickr.com.  My clients come first.

    Full disclosure: long ALL AIZ HIG PRE RGA SAFT SCVL CHIC COP HMC NTE XEC KPPC ESV DVN TNP VLO MGA SBS CRH LNT PEP GPC NUE (what have I left out?!)