Month: July 2009

Morning Financials

Morning Financials

Posted on by David Merkel

I put out a short report each morning on financial stocks, giving a quick summary of the big movers, market tone, and what sub-industries are moving.? I am publishing a copy of it today here as a bonus for Aleph Blog readers.? Enjoy.? Comments welcome.

The information herein and the data underlying it has been obtained from sources that we believe are reliable, but no assurance can be given that this information , the
underlying data or the computations based thereon are accurate or complete or that the returns or yields described can be obtained. Neither the information nor any opinion
expressed constitutes a solicitation by us for the purchase or sale of any security. All prices are indications only.
David Merkel, CFA, FSA 16 July 2009
Morning Financials Update ? Big Movers
Top 20 Financial Stock Movers
Company [ticker]
News
Price Move
MGIC Investment Corp [MTG]
Adj. Loss/Shr $2.86 vs $1.04 Loss Est. Injecting $1 billion into in inactive subsidiary, allowing it to write new business. Wisconsin DOI goes along with it. Fitch Downgrades on Announced Restructuring Plan
12%
Pacific Capital Bancorp NA [PCBC]
No news materially driving the stock price
12%
CVB Financial Corp [CVBF]
Beats estimates. Adjusted EPS 19c vs 10c Estimate
11%
East West Bancorp Inc [EWBC]
Misses estimates. -1.83A v -0.42E. Aggressive credit management being employed — if true, problems may be smaller in the future.
11%
Umpqua Holdings Corp [UMPQ]
Beats estimates. Adjusted EPS 15c vs 9c Loss/Shr Loss Estimate
7%
Commerce Bancshares Inc/Kansas [CBSH]
Beats estimates. Adjusted EPS 49c vs 38c Estimate
7%
MB Financial Inc [MBFI]
Beats estimates. Adjusted EPS 16c vs 26c Loss/Shr Loss Estimate
6%
Charles Schwab Corp/The [SCHW]
Beats estimates 0.20A v 0.18E. Client assets down, which may push future earnings down.
-3%
Developers Diversified Realty [DDR]
No news materially driving the stock price
-5%
Host Hotels & Resorts Inc [HST]
Rated New `Underperform’ At Wedbush. Perhaps some sympathy from Marriott’s bad profit report.
-5%
Federal National Mortgage Asso [FNM]
Allison Says Housing Program Showing Signs of Success. Uh, really?
-5%
MBIA Inc [MBI]
No news materially driving the stock price
-6%
Cousins Properties Inc [CUZ]
Slashes 3Q dividend by 40 percent.
-6%
Stewart Information Services C [STC]
No news materially driving the stock price
-6%
Federal Home Loan Mortgage Cor [FRE]
Allison Says Housing Program Showing Signs of Success. I don’t see that at all.
-6%
First Commonwealth Financial C [FCF]
No news materially driving the stock price
-7%
CapitalSource Inc [CSE]
No news materially driving the stock price
-7%
American International Group I [AIG]
Prudential Said to Resume Talks Over AIG Japan Units. AIG Said to Ask Buyout Funds to Ally With Taiwan Firms on Taiwanese Life Unit.
-9%
Boston Private Financial Holdi [BPFH]
No news materially driving the stock price
-10%
CIT Group Inc [CIT]
US unlikely to aid CIT, which faces a likely bankruptcy. Can an independent commercial finance company survive tough times without a deposit franchise? I don’t think so.
-70%
The information herein and the data underlying it has been obtained from sources that we believe are reliable, but no assurance can be given that this information , the
underlying data or the computations based thereon are accurate or complete or that the returns or yields described can be obtained. Neither the information nor any opinion
expressed constitutes a solicitation by us for the purchase or sale of any security. All prices are indications only.
Thoughts:
? If CIT can?t get help, that means all entities seeking help should expect less help at the margin, or at least more sturm und drang.
? Banks and thrifts are leading and Commercial finance and GSEs are trailing.
? Speculative names doing badly today.
? Survivors in investment banking are picking up more business and profits.
? Rising unemployment is the biggest hidden risk to the financial economy at present. As jobs are lost, people default on more debts.
? Commercial and high-end residential real estate still under pressure.
? The short-term performance model for financial stocks recommends only Reinsurers here. They face lower risk on the asset side of the balance sheet.
? Whether insurers or banks, avoid equity-sensitive names here ? aim at companies that don?t have a high degree of sensitivity to stock market performance.
? The market in the short run is driven off of government policy, which is uncertain.
? Better to play it safe at this point. We have just experienced a very sharp bear market rally. Remember, sharp moves tend to reverse, slow moves tend to persist.
Group Price Movements for this Morning
Commercial Serv-Finance
1.3%
Other
-0.8%
REITS-Regional Malls
-1.3%
Commer Banks-Western US
0.6%
Property/Casualty Ins
-0.8%
Finance-Credit Card
-1.4%
Commer Banks Non-US
0.3%
Finance-Auto Loans
-0.8%
Diversified Banking Inst
-1.5%
S&L/Thrifts-Central US
0.3%
S&L/Thrifts-Eastern US
-0.9%
Commer Banks-Eastern US
-1.5%
Financial Guarantee Ins
0.1%
REITS-Forestry
-1.0%
Multi-line Insurance
-1.5%
Finance-Consumer Loans
-0.1%
REITS-Diversified
-1.0%
REITS-Shopping Centers
-1.5%
Fiduciary Banks
-0.2%
REITS-Health Care
-1.0%
REITS-Warehouse/Industr
-1.9%
Reinsurance
-0.3%
Real Estate Oper/Develop
-1.0%
Life/Health Insurance
-1.9%
REITS-Mortgage
-0.3%
REITS-Office Property
-1.0%
REITS-Apartments
-2.0%
Commer Banks-Central US
-0.5%
Grand Total
-1.1%
Finance-Invest Bnkr/Brkr
-2.5%
Insurance Brokers
-0.5%
REITS-Storage
-1.1%
Exchanges
-2.7%
Retail-Pawn Shops
-0.6%
Commer Banks-Southern US
-1.1%
REITS-Hotels
-3.9%
Real Estate Mgmnt/Servic
-0.6%
Invest Mgmnt/Advis Serv
-1.2%
Finance-Mtge Loan/Banker
-5.7%
REITS-Single Tenant
-0.6%
Super-Regional Banks-US
-1.3%
Finance-Other
-17.4%
I look at these companies for big news events that have occurred since the last close. Often there isn?t any, but big changes here can be an indication that someone knows something, or there is trading noise. After that, it is up to the analyst to dig. Often, the dog that does not bark is the clue, as stocks move up or down on no news, as well as unexplained large spikes in volume, CDS spreads, and implied volatility of options.
Disclosure: long ALL NWLI SAFT RGA AIZ PRE
The Equity Premium is No Longer a Puzzle

The Equity Premium is No Longer a Puzzle

Posted on by David Merkel

For a number of years, I have mused over the equity premium puzzle, and have generally written that the premium return that equities earn over stocks is less than most asset allocators assume. In January 2006, wrote an article on this topic at RealMoney: Kiss the Equity Premium Goodbye.? A few quotes:

This article won’t win me a lot of friends in the money management industry. Here’s the skinny: Stocks are unlikely to return much more than bonds over the next 10 to 20 years.Most investment consultants tell people to invest in equities because, in the long run, stocks beat bonds and cash. I agree, but how big is this advantage? Many studies suggest that the equity premium is somewhere in the vicinity of 6%; i.e., stocks beat cash by 6 percentage points a year. Against bonds, the advantage is said to be 4% or so.

However, there are persuasive arguments that the value of the equity premium will be much lower going forward. In the book Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Staunton argue that the future equity premium in the U.S. is likely to be closer to 4% over cash for two main reasons:

  • Corporate cash flows have grown faster in the last 50 years than in the prior 50, and investors have bid up stocks as a result. However, the authors believe that such high rates of growth will not continue. If corporate cash flow growth reverts to the rate of the first half of the 20th century, future returns based on current equity values will be poor indeed.
  • Perceived risk in stock investing has diminished. Investors have bid prices up in anticipation that the equity premium is higher than it should be, and on the belief that it is not risky to try to capture it.

The researchers Peter Bernstein and Robert Arnott draw similar conclusions, but they get there in different ways. They point out that over the years, the size of the future equity premium has varied with the level of belief in its existence. When market players deny its existence, equity valuations are low, past equity performance has probably been poor, and the future equity premium is large — think of 1931, 1937, 1974, 1982, November 1987 and 2002. When everyone believes in the inevitability of stocks, ? la “Dow 36,000” (we’ll get there by 2025 or so), equity valuations are high, past equity performance has probably been great, and the future equity premium is small — think 1929, 1972, August 1987 and February 2000.

I believe stocks have been bid up because of the benefit needs for the retirement of the baby boomers. Though the savings rate is low, investment vehicles such as pension plans have made large commitments to equities, partially because plan sponsors can justify lower contributions to benefit plans by assuming a high rate of return, which stems from assuming that the equity premium will persist.

and this:

This doesn’t directly generalize to the market as a whole, because all stocks are owned by someone at the end of each day. Isn’t there always a buyer for every seller, and vice versa? Yes, but they aren’t always public-market buyers and sellers. Cash comes into the market via IPOs (both primary and secondary), rights offerings and any other way that new shares get created for the payment of cash. Cash comes out of the market through dividends, buybacks and any other way that companies disburse cash to shareholders, whether directly or in exchange for shares.

Companies tend to sell stock when it is advantageous; IPOs happen more frequently when valuations are high, and buybacks happen more frequently when valuations are low. This suggests a project for future study: Calculate the dollar-weighted return for the public equity market as a whole, and compare it with the time-weighted return figures.

It’s a difficult but not impossible project, but I don’t have the time or resources to do it. If it hasn’t been done already, it might make a rare practical Ph.D. thesis for someone. Returns for the market as a whole would equal the change in market value, plus the cash cost of shares taken out of the market (buybacks, LBOs, etc.) and dividends, less the cash added to the market through IPOs and other forms of share issuance for cash (i.e., employee stock option exercise, rights offerings, etc.). I don’t have firm numbers, but my guess is that dollar-weighted returns are less than the time-weighted returns by 1 percentage point, give or take 50 basis points.

Though the composition of an index fund changes by period to reflect additional equity issuance/buyback by companies in the index, it misses the effect on returns from having to allocate more capital when valuations are high, and having to receive capital back when valuations are low. In a whipsaw period like that which we have had from 1998 to the present, it makes a lot of difference, because many investments during the bubble era put fresh capital into the market at a time of high valuations, with buybacks predominating as valuations troughed.

In short, though the academic studies rely on time-weighted rates of return for their conclusions regarding the equity premium, which represents buy-and-hold investors, dollar-weighted returns, which is what most investors actually receive on their investments, are lower. The difference occurs because corporations issue stock when valuations are high, and retire it when valuations are low.

Okay, here’s the punchline — with not just a hat tip, but a full bow to Eric Falkenstein at Falkenblog, Ilia D. Dichev has done the research that I wanted to see done.? The difference between time-weighted and dollar-weighted returns is around 1.3% for NYSE stocks (1926-2002), around 5.3% for NASDAQ stocks (1973-2002), and 1.5% for developed market stocks generally? (1973-2004).

Doing a very rough average, and considering that the NASDAQ was in a boom period for most of the study period, I am comfortable with a reduction in the US equity risk premium over bonds down to 1-2% on average, and over cash to 3-4% on average.

At that level, being in stocks works for long term investing, but it would almost never pay to be 100% in stocks.? The old 60/40 stocks/bonds allocation begins to look really intelligent over the long haul, but maybe not today because high quality bond yields are so low.

So, where does this leave me on the equity premium puzzle?? It is no longer a puzzle.? One can gain moderately over the very long haul in stocks versus bonds, but with significant volatility.? Don’t risk what you can’t afford to lose in the stock market, and other risky investment vehicles.

PS — this makes the old dictum on the cost of equity valid again — the cost of equity capital for a firm should be 2-3% above their longest bond yield.? Bye, bye, CAPM.

Goldman?s Gain, America?s Risk?

Goldman?s Gain, America?s Risk?

Posted on by David Merkel

Today I was featured at the New York Times “Room for Debate” blog, along with five others more notable than me.

The question was “about Goldman’s compensation pool, which will be? $11.36 billion (set aside) for the first half of 2009 (working out to about $386,429, on average, for each of the roughly 29,400 employees and?temps).

The average reader may be?perplexed?about huge bonuses making such a comeback.We’re asking?various economists,?whether it’s reasonable to be critical of this kind of payday at Goldman when the rest of the economy is still floundering? Or is this a sign that the?financial industry is stabilizing and?the federal government’s aid is doing what we want it to do?”

Word limit was 300.? I had more to say, because if you’ve read me for any length of time, you know that I am no fan of government intervention.? I was against the bailout from the start, preferring Resolution Trust-style solutions.

My view is that Goldman would have survived on its own without the bailout, though it would have scraped by.? That said, absent the bailout, Goldman might have ended up being a near-monopoly.? Bank of America would be gone, as would Citi, and Wachovia. Wells Fargo, JP Morgan and Morgan Stanley would be question marks.? The amount of increased pricing power to the remaining investment banks would be even larger than it is today.

Most of the government programs Goldman Sachs benefited from were available to many institutions of their size and class.? The government took the risk that some of the money would be used by healthy firms to make more money, in order to prevent panic regarding firms that needed the money to survive.? Other money, like the TARP, was forced on Goldman.

Does this mean I don’t think that Wall Street (and thus Goldman) has too much influence on government policy?? No, I believe that the US Treasury has been captured by those that regulate them.? This includes Pimco and Blackrock, who finance the government, and the investment banks, who try to profit from government policy.? There are too many appointees in high positions at the Treasury and Fed coming from firms that seek to influence the US government.

I don’t fault Goldman for its actions; they are a profit-seeking firm, and a very good one.? I fault our government for intervening where they should not have done it.

Let the bonuses be paid, why should the employees of Goldman be held responsible for the errors of the US Government?? That is water under the bridge.? Let us move on and try to make future government policy better (less interventionist).

PS — does that mean we shouldn’t investigate Goldman Sachs to see if they aren’t front running the market with their high frequency trading?? No, that’s worth looking into, but such an investigation would need some deeply smart people to be able to understand what is going on.

Book Review: The Myth of the Rational Market

Book Review: The Myth of the Rational Market

Posted on by David Merkel

There are few books that I read that leave me feeling as if I have taken a trip down memory lane.? The Myth of the Rational Market was that for me.

In my junior year at Johns Hopkins, I wrote my senior thesis on predicting splits in the stock market.? I had to do it in my junior year because I had applied to do a combined BA/MA in political economy in my senior year.

My thesis, springing from what I had learned in Dr. Carl Christ’s class on financial economics (which in itself was an anomaly in the political economy department), forced me to analyze the then-fresh literature on event studies on efficient markets, including the famous paper by Fama, Fisher, Jensen, and Roll on how it was impossible to make money off of stock market splits.

That paper was important, because prior research was not agreed on the topic, and it was an example of something not all that significant that could be a signal of greater things — that managements would only split the stock when they had confidence.

Young David, having been raised in a home where his self-trained mother had regularly beaten the market, found the efficient markets hypothesis less than compelling.? Like his mother, he felt that superior analysis of fundamentals should outperform.

But here was a situation where it was obvious that stocks that split outperformed before they split.? My thesis asked, “Could splits be predicted?”

Going through the literature, I came up with some variables that could be useful — some were valuation-based, some were technical (price, volume), and some were anomalies (insider trading).? I ended up finding that stock splits could be predicted more often than not, but more importantly, that the variables that correlated with stock splits were more generally correlated with outperformance (in the 7%/yr region).? Those variables included valuation, momentum, and insider trading — which for a paper written in 1982 was notable.? I concluded that the Efficient Markets Hypothesis was flawed, also notable for its time.

Wait — this is a book review.? As I read Justin Fox’s work, I admired its ambition.? This attempts to cover financial markets efficiency, with some efforts toward economic efficiency generally.? It covers a lot of ground — all of the major players in the efficiency of financial markets debate are featured, and written about in simple language — there are no equations to wade through as I once did.? This book is comprehensive, and touches on many of the more obscure critics of the Efficient Markets Hypothesis.? Bright men who are tangential to the Financial Economics profession get their play — Kahneman, Tversky, Minsky, Mandelbrot, and more

Many of these men that questioned market efficiency went down the same trail that I did; they were led by the data, which conflicted with neoclassical economic theory.? Many of them came to my view that the market is pretty efficient, but not perfectly so.? Efforts at finding inefficiency promote market efficiency.? Efficient markets make people lazy, which leads to inefficiencies that can be profited from.

I liked this book a great deal.? It gets a bit thin at the end when it tries to incorporate the current crisis into its framework.? More broadly, it is at its weakest where it merely touches on a significant contribution, but does not dig deeper.? That said, a book of 500 pages would be far less readable than one of 300+.

Who would benefit from this book:

  • Those who are too certain about their positions on market efficiency.
  • Those that assume that the market is always or rarely right.
  • Those that select asset managers, because there is a lot of volatility around investment returns.? What is luck? What is skill?? We know less here than we imagine.
  • Academics in economics that are not familiar with the finance literature, because this would give an outline of the questions involved.

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When I do book reviews, I actually read the books.? In the few cases where I scan a book, I reveal that in the review.? I also offer the easy ability to buy books through Amazon.com, and if you want to buy this book click here:? The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Full disclosure: if you buy anything through Amazon after entering through my site, I get a small commission, but your costs do not go up.

Some Practical Thoughts on Asset Allocation

Some Practical Thoughts on Asset Allocation

Posted on by David Merkel

When I think about asset allocation, I typically begin with my model that chooses between BBB corporate bonds and common stocks.? The model still favors corporate bonds.? After that, I look at the bond market, and ask myself where I think risks have more than adequate compensation.? I look at the following factors:

  • Duration (Average Maturity is similar, sort of) — do we get fair compensation for lending long?
  • Convexity — does the bond benefit or get hurt by interest rate volatility?
  • Credit — are we getting decent compensation for credit risk?
  • Structure — Structured notes always trade cheap to rating, but how cheap?
  • Collateral/Sectors — Are there any collateral classes or sectors that are trading cheap to their fundamentals?
  • Illiquidity — are illiquid issues trading stupidly cheap?
  • Taxes — How are munis trading relative to tax rates and creditworthiness?
  • Inflation — is the CPI expected to accelerate?
  • Foreign currency — if nothing looks good on the above (or few things look good), perhaps it is time to buy non-dollar denominated notes.? My view is buy foreign currencies when nothing else looks good, because foreigners will do the same.

At present, I am not crazy about corporate credit relative to other bonds.? I would move up in quality.

We are getting decent compensation for duration risks, so I would buy some amount of long Treasuries.? I would also hold some cash, running a barbell.

On convexity, I would be market weight in conforming mortgages.? If I had an edge in analyzing non-conforming mortgages, I would buy highly rated tranches of seasoned deals (2005 and before).

I would do a lot of analysis, and buy seasoned CMBS (2005 and before) — there are real risks, but the seniors should not get killed.

Munis offer promise for taxable accounts — the difficulty is doing the credit analysis on long bonds.

On inflation — I am not a fan of TIPS right now.? I would rather buy foreign bonds.? The actions of foreign nations lend themselves to dollar depreciation.

So, where would I go with a portfolio that has an intermediate horizon, say, 5-10 years out?

  • 30% global equities — half US, half foreign (emphasize value, but not financials)
  • 15% long Treasuries
  • 15% residential mortgages — seniors, conforming
  • 10% CMBS seniors
  • 15% cash
  • 15% foreign bonds

Yeah, I know this seems conservative, but I am not a believer in the current rally in stocks or corporate debt.? This is a time to preserve capital, not hunt for yield.

To Control Bubbles, the Fed Must First Control Itself

To Control Bubbles, the Fed Must First Control Itself

Posted on by David Merkel

I’ve written before about the Fed’s de facto triple mandate:

  1. Low goods-price inflation.
  2. Low labor unemployment.
  3. Protect the financial system in a crisis.

Number 3 is the implicit obligation of the Fed, for several reasons:

  • The Fed carries out monetary policy (in ordinary times) through the banks.
  • Banks in the Federal Reserve System have close ties to the regional Federal Reserve Banks.
  • Bankers and those sympathetic to bankers comprise a large portion of the leadership and staff of the Federal Reserve.
  • Regulating banks gives jobs to many at the Fed.

Stepping back, let me tell you a story.? In the mid-90s, I became worried about inflation going out of control again, given the degree of monetary growth that I saw.? I’m not sure where I got the idea, but eventually it struck me that in the ’70s, when inflation was running hot, we had a lot of spenders and few savers.? In the ’90s, more savers and fewer spenders.? (You have to add in agents of the baby boomers, including the defined benefit plans, and the growth in 401(k)s, and products like them.)? Goods weren’t inflating from excess money, assets were being inflated as the baby boomers were socking away funds for retirement.

(Note to stock investors: be wary when market P/Es rise dramatically — there are limits to what is reasonable in P/Es for any level of corporate bond yields.? This applies to price-to-book and -sales ratios as well.)

As one more example of how monetary policy affects the asset markets, consider how the Fed temporarily flooded the banks with liquidity to avert problems regarding Y2K, and the stock markets reacted to the excess liquidity with a two month lag.? The Fed helped put in the top of the tech bubble.? I don’t know how the money leaked out of the banks to the stock market, but excess reserves under good conditions will produce loans.

Thus, I came to the conclusion that the Fed ought to look at asset inflation as well as goods inflation somewhere in the late ’90s.? But doesn’t the implicit third mandate cover that?? Alas, no, the third mandate is reactive, not proactive.? It kicks in after a crisis hits — Greenspan then floods the market with liquidity, and only steps back when things are running hot again.

A proactive policy would limit the degree of easing that the FOMC could do — once the spread of ten-year Treasuries over two-year Treasuries exceeds 1%, all easing would stop.? The banks can easily make money with a yield curve that steep… not much money, but enough to keep them alive (the financial sector would shrink under these rules).? There would be a second rule that when he spread of ten-year Treasuries over two-year Treasuries is less than 0%, all tightening would stop.? During times of extreme inflation or unemployment, these rules could be waived by Congress for a year at a time.? But that lays the policy back at the door of Congress, which represents the people and the states, where the decision belongs.

A policy like this eliminates the risk that the Fed can steepen the yield curve dramatically, leading to bubble creation — the excess credit has to go somewhere.? Another limit on the Fed could be a limit on total leverage in the economy — above a certain limit, such as 2x GDP, the Fed raises the Fed funds rate, regardless of the unemployment situation, until indebtedness falls.

Bubbles are financing phenomena.? Controlling bubbles can be done by controlling credit, and that is what the Fed tries to do — control credit, which is money in our era.? (Until we go back to something better, and get the government out of the money business — some sort of commodity standard.)

The present Fed holding action inflates assets not goods.? By offering financing to asset markets that are in disarray, it supports asset prices.? For now, none of that balance sheet expansion leaks out to the general public, and thus, little goods inflation.? But also, little true stimulus.

In short, the Fed should limit its powers to reliquefy the economy, because sloppy efforts in the past 25 years produced the popped bubbles that we are now dealing with.? Better to leave policy tight longer, and not loosen so much in troubles.? Don’t worry, we might have to wait longer for recovery, but the recoveries will be sounder when they come.

Parting Shots

Toward a New Concept of Asset Allocation

Toward a New Concept of Asset Allocation

Posted on by David Merkel

To my readers: thanks for your responses to yesterday’s article.? I will do a follow up piece soon.? If you have more comments please make them — they will help me with the piece.? Main new concepts coming — need for a deliverable, speculators can’t trade with speculators, only hedgers.

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Longtime readers know that I am not a fan of modern portfolio theory.? It is a failure for many reasons:

  • It assumes there is one type of risk, the occurence of which is random.
  • It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
  • Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
  • In crises, correlations head to 1 or -1.? Assets divide into safe and “not safe.”
  • Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary.? Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
  • It does not recognize multiple time horizons easily.? Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
  • Risk is the same for all people, and their decision-making time horizons are the same as well.
  • And more…

I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:

  • Where am I getting paid to take risk?
  • Where am I getting paid to avoid risk?
  • What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there?? What major imbalances exist?? Where are dumb people making money?
  • Where options are available, how is implied volatility relative to long-term averages?
  • What asset classes have momentum to their total returns?

One good example of an approach like this is Jeremy Grantham at GMO.? Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates.? With domestic bonds, the estimates are relatively easy.? Look at the current yield, with a haircut for defaults and optionality.? Still there is room to add value in bonds, looking at what sectors are cheap.

  • Are corporate spreads narrow or wide?
  • How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
  • How steep is the yield curve, and where is Fed policy?
  • What is the speculative feel of the market now?? Bold? Scared? Normal?
  • Related, how are illiquid issues doing?? Are they permafrost, or are molasses not in January?
  • If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
  • Cash is underrated, and it is safe.

Understanding bonds is an aid to understanding the rest of the market.? The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.

With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities.? Tough.? With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds.? There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.

There is one more aspect to layer in here: illiquidity of equity investments.? With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:

  • Where is the sector in its speculative cycle?? Where are secondary interests being sold?
  • How much capacity do you have for such investments?? How much of your liability structure is near-permanent?? Is the same true of peer institutions?
  • Is the public equity market overvalued or undervalued?? Public and private tend to track each other.

Beyond that we get to the structure and goals of the entity neding the assets allocated.? Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.

This is just my initial brain dump.? It was spurred by this article in the WSJ, on how asset allocation had failed.? Add in the article on immediate annuities, which are a great aid in personal retirement planning.? For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance.? If the annuitant lives a long time, he might run out of assets, and might rely on his children for help.? The immediate annuity would be there to kick in something.

Why did asset allocation fail in 2008?? All risk assets failed.? Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up.? There were just varying degress of loss.? Oh, add in Real Estate, and REITs.? Destroyed.? Destroyed…

When the system as a whole has too much leverage, all risky asset classes get affected.? That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.

Sorry, Doctor Shiller, not Everything can be Hedged

Sorry, Doctor Shiller, not Everything can be Hedged

Posted on by David Merkel

Many people don’t think through questions systematically.? That includes very bright people like Dr. Robert Shiller, who said in this article in Fortune, “We should be able to hedge everything from the rising costs of health care and education to national income risk and oil crises.”

Ugh.? And this from an esteemed professor at a significant university?? And one with which I have sometimes agreed?

I’ve written about this before in some of my market structure articles, where I tried to dig into the difference between natural, hedging, and gambling exposures.? I’ll use an ordinary example to illustrate this: the bankruptcy of IBM.

I use IBM as an example because it is so unlikely to go under.? But who would be directly affected if IBM went under?

  • Stockholders, both preferred and common
  • Bondholders
  • Banks that have loaned money
  • Trade creditors
  • Workers

Let’s talk about the bondholders.? They could buy protection via credit default swaps [CDS] to hedge their potential losses.? In order for that to happen a new class of risk-takers has to emerge that wants to take IBM credit risk, that don’t own the bonds already.? It’s not always true, depending on the specualtive nature of the market (and synthetic CDO activity), but one would suspect that those that want to take on the risk of a default of IBM would only do it at a concession to current market bond pricing, or else they would buy the bonds and pay fixed, receive floating on a swap.

But often the amount of CDS created exceeds the amount of debt covered.? I’m not suggesting that everyone owning bonds has hedged, either, but when the amount of CDS exceeds outstanding bonds, that means there is gambling going on, because it means that there are market players that are not long the bonds that are taking the side of the trade where they receive income in the short-run if the company survives, and pay if the company fails.

I call this a gambling market, because there are parties where the transaction takes place where neither has a relationship to the underlying assets.? There is no risk transfer, but only a bet.? My view is such gambling should be illegal, but I am in a minority on such points.

Now think about another asset: my house.? Aside from being somewhat dumpy, beaten-up by my eight kids, the house has a virtue — I live in it free and clear, with no debts to anyone, so long as I pay my property taxes.? So what is there to hedge here?? I’m not sure, maybe future property taxes?

Aside from the county, and my insurance company, I’m not sure who has a real interest in my house.? If I knew that there were many people betting on the value of my house, I might become concerned.? What actions might people take against me in bad or good times?

But maybe no one would have interest in my house.? It’s just one house, after all.? Who would have a concentrated enough interest in it to wager on it?

Now, some would say, we don’t have an interest in your house specifically, but we do have an interest in houses on average? in your area.? That’s fine, but there is no one with a natural exposure to all of the houses in my area, aside from the county itself.

This is why I think that most real estate derivatives involve gambling.? There is no significant natural exposure hedged.? It is only a betting market.

And such it would be for most real assets.? Few would want to create markets where the owner know more than they do, or, where there a few options for gaining control if things go bad.

At the end of the day, all of the assets of our world are owned 100%.? Everything else is a side-bet.? Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system.? No tail chasing the dog.? Let derivative transactions go on where here is real hedging taking place; away from that, such transactions are gambling, and should be illegal.

To Dr. Shiller, many markets are thin.? The concept that everything can be hedged assumes deep markets everywhere, which is not the case.? Time for you to step outside the university bubble and taste the real world.? It’s not as hedgeable as you might imagine.

Post 1000

Post 1000

Posted on by David Merkel

Every 100 posts or so, I stop to talk to my readers more personally, thank them for reading me, reflect on where we have been, and where we might be headed.

From my heart, I thank you for reading me.? You have many things to do with your time, and you deign to read me.? Thanks.? In some ways, my blog is an acquired taste.? I cover many areas thinly, because I have a broad range of interests in finance, business and economics.? I’m sure that the average reader has to endure (or ignore) 50% of what I write, and that’s fine.

Where have we been

I am reminded of Psalm 66, verse 12 in the era we have been through: Thou hast caused men to ride over our heads; we went through fire and through water: but thou broughtest us out into a wealthy place. [KJV]? The wealthy place is not yet here.? This has been a chaotic time.? We have seen markets destroyed, and come back to life in more limited ways.? There has been a bounce-back from panic, but options are reduced compared to where we were when I started writing this blog.? Areas of over-leverage have been revealed, even in seemingly safe areas.? There is nothing certain in such an environment.? All of the old certainties get questioned, even if they survive.

Where we are now

Though I am a value investor, and a quantitative investor, I don’t write much about my stock picks, mainly because you don’t get much praise for it, and you get a lot of complaints when you are wrong.? I wrote a piece at RealMoney that reflected my frustration in writing there about my investments.? It was called: Investing Is About the Whole Portfolio.? Too many people are looking for stock picks, when they should be looking to learn thought processes.? With a stock pick, you don’t know what to do as markets change.? Learning the thought processes is more complex, but it prepares you in how to understand the market as it changes, albeit imperfectly.

I spend a lot of time on macroeconomic and fixed income issues.? Why?? The bond market is bigger than the stock market, and has a big effect on the stock market.? I keep toying with an idea that would replace Modern Portfolio Theory, with something that would use contingent claims theory to develop a consistent cost of capital model for enterprises.? Essentially, it says that in ordinary circumstances, the more risk one takes in the capital structure of a company, the higher the return required to invest.? Estimate the implied volatility of the assets, and then apply that to the liabilities and equity.

Another way of saying it is that we can learn more from the shape of the yield curve and credit spreads than by looking at backward-looking estimates of asset class returns.? I continue to be amazed at those that use historical averages for asset allocation.? Start with the yield curve.? That will give you a good estimate on bond returns.? When credit spreads are high, typically it is better to be in corporate bonds rather than stocks, but it does imply that stocks might be cheap relative to Treasury bonds.

Most of the time the markets as a group tell the same story.? It gets interesting where one is out of line from the others.? My current example is banks exposed to commercial real estate versus REIT stocks and bonds, and CMBS.? The banks are not reflecting the future losses, but the REITs and CMBS are reflecting the losses.? Chalk it up to accounting rules for the banks.

Where are we going?

Demographics is destiny, to some degree.? Countries that shrink, or have large pension/healthcare promises will have a hard time of it.

Defaults are rising in both the corporate and consumer sectors.? Anyone who thinks the financials are out of the woods is wrong.? Even as new housing sales rise, there are many defaulting on their mortgages because they can’t afford their mortgages, or think that they are stuck with too much payment for too little house.? Add onto that continuing problems with commercial mortgage defaults and corporate defaults.

The Dollar is a problem in search of a solution.? None of the solutions are any good, so changes get delayed until the pain can’t be stood anymore.? This could be decades or years — but the Dollar is in decline.

The world has more laborers, the same amount of capital, and declining resources.? Relatively, the price of labor should go down, and the price of resources up.? The value of capital will fluctuate in-between.

Where is this blog headed?

We are going in my own idiosyncratic direction.? That means when crises hit, I will be there.? Aside from that, I will talk about the issues that affect the markets more generally.? There will be book reviews.? The next two are from Justin Fox, and James Grant.

I have more models that I will trot out.? For example, I have a short-term investment model that I am developing, and I hope it will come out in the next six months.? I might also roll out my alternative to Modern Portfolio Theory, if I work it out (I am dubious that I will get there).? I also have a review of the people on the FOMC coming out.? There’s more… I always have a list of articles that I want to get to, but time is short.

Time is short.? My apologies to all who have written to me, but I have not responded to.? I can’t answer all of my e-mails.? I do read all of them, and I appreciate that you write to me.? I don’t read comments on other sites that repulish my works, so I urge you to write to me here if you want to bring something to my attention.

One last bit of thanks

I could have stayed behind the pay wall at RealMoney, but I wanted to interact with a broader audience.? Amid some criticism, the investment blogosphere is a very intelligent place, and more attuned to the real situation than most of the mainstream news media.? Give the New York Times, the Wall Street Journal, Bloomberg, and Reuters their due, but the world needs investment bloggers — we point out truths that are missed by many.? I am not speaking for me, but for the many that I respect in blogging.

And as for readers, I thank the following selection of institutions where I have readers:

  • Alexander & Alexander
  • AllianceBernstein L.P. (US)
  • AMAZON.COM (US)
  • American International Group
  • Bank of America (GB)
  • Banque Paribas (US)
  • Barclays Capital (GB)
  • Bharti Broadband (IN)
  • BLOOMBERG, LLP (US)
  • Bridgewater Associates
  • Cambridge MAN Customers (GB)
  • Charles Schwab & Co. (US)
  • CIBC World Markets (CA)
  • Citadel Investment Group
  • Citicorp Global Information
  • Credit Suisse Group
  • DBS VICKERS SECURITIES
  • Dean Witter Financial Services
  • DEUTSCHE BANK (US)
  • Dow Jones-Telerate (US)
  • Dresdner Kleinwort Wasserstein
  • Federal Home Loan Mortgage
  • Federal Reserve Board (US)
  • Fidelity Investments (US)
  • GOLDMAN SACHS COMPANY (US)
  • Google (US)
  • H&R Block (US)
  • Harvard University (US)
  • Hewlett-Packard Company (US)
  • HSBC Bank plc, UK (GB)
  • Intel Corporation (US)
  • INTERNAL REVENUE SERVICE (US)
  • Jefferies & Company (US)
  • Johns Hopkins University
  • JPMorgan Chase & Co. (US)
  • Knight Capital Group (US)
  • KOCH INDUSTRIES (US)
  • KPMG LLP (US)
  • LEHMAN BROTHERS (US)
  • MAN Financial (US)
  • Merrill Lynch and Company (US)
  • Michigan State Government (US)
  • Microsoft Corp (US)
  • MILLENIUM PARTNERS, L.P. (US)
  • Moody’s Investors Service (US)
  • Morgan Stanley Group (US)
  • Morningstar (US)
  • Mutual of Omaha Insurance
  • Nat West Bank Group (GB)
  • Nesbitt Burns (CA)
  • Nomura International plc
  • Northern Trust Company (US)
  • RBC CAPITAL MARKETS
  • Repubblica e Cantone Ticino
  • Royal Bank of Canada (CA)
  • Salomon (US)
  • Societe Generale (FR)
  • Speakeasy (US)
  • Stanford University (US)
  • STARBUCKS COFFEE COMPANY (US)
  • The St. Paul Travelers Companies
  • The Vanguard Group (US)
  • Thomson Financial Services (US)
  • UBS AG (US)
  • Union Bank of California (US)
  • United States Senate (US)
  • University of Chicago (US)
  • University of Virginia (US)
  • US Department of the Treasury
  • Watson Wyatt
  • WELLS FARGO BANK (US)
  • Yale University (US)

What a group.? I am honored.? Again, thanks for reading me, whoever you are, and whoever you work for.

Final note

I am still looking for a lead institutional investor for my equity fund, which is available in both a long only, and market-neutral form.? (I’ve beaten the S&P 500 8 out of the last 9 years.)? If any of my readers have a lead on any institutional investor who might want to invest $1 million or more in my fund, please e-mail me, and I will send you my pitchbook.? Whoever gets me my first institutional investor gets my undying gratitude.? Help me if you can.

Seven Notes, Primarily on the Financial Sector

Seven Notes, Primarily on the Financial Sector

Posted on by David Merkel

1)? I have been arguing for a while that commercial mortgages are an unresolved issue with most banks, who still hold their loans at par.? Contrast that with the pricing on Commercial Mortgage Backed Securities [CMBS] or REIT stock prices, which show commercial real estate pricing in the dumps.? Look at these articles: (one, two, three).? How many commercial properties are inverted?? Who knows, but when properties sell for significantly less than replacement costs, it is not a good scene.

Regarding CMBS, as the loss estimates ratchet up, the credit ratings ratchet down.? Securities sold in 2005 and after will suffer, as well as marginal CMBS from earlier vintages.

2)? Outside of conforming mortgages, losses in residential mortgages are considerable.? Consider how S&P is raising its loss assumptions on alt-A loans.? Or consider how being underwater, or close to underwater affects the willingness of people to default.

3)? That last article helps point out a truth that is neglected.? Defaults predominantly happen when borrowers are underwater, or nearly so.? Changing? the mortgage interest rate is cheaper in the short run, but does not cure? the situation as well as reducing the principal (forgiving part of the loan).? Why less loan forgiveness?? Two reasons: Accounting would require a bigger short-term loss, and the government prefers subidizing a piece at a time, so it prefers smaller annual subsidies, rather than a once-and-for-all cure.? They would rather pay over time, and overcommit future budgets, than pay the full freight now, even if it is cheaper in the long run to do so.

4)? But many defaults are strategic.? The owners know which side their bread is buttered on, and they default when their properties are too far underwater (one, two).

5)? The states can’t print money like the Federal government can.? Excluding California, of course, which has its new currency, the IOU.? (We are still waiting for a secondary market to arise.? Perhaps some enterprising bank? will offer to buy IOUs at a discount.? As it is, banks either honor in full or refuse to honor the IOUs.)? The states represent the current troubles better than the Federal government does, because they must meet the challenge through expense cuts and tax increases, both of which are painful.

All that said, next year may be more painful, because of greater unemployment, and lower taxes from real property.

6)? Beware junior debt.? I know that at other times I have used trust preferred securities offensively to make money as the credit cycle turned in 2002, but that is a very hard game to play, and we aren’t there yet for this cycle.

7) I’ve had many people writing me for investment advice, and in the near term, I will try to write a piece that summarizes my views of what to do now.? In broad, I lean toward reducing risk exposure, and sitting on high quality short term debt.? For those that hedge, quality will be rewarded, and structure penalized over the next? 6-12 months.? And, avoid financials, aside from exchanges and insurers with clean assets.

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