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Archive for September, 2009

Plan for Failure

Wednesday, September 30th, 2009

Imagine for a moment that you are managing a large corporate bond portfolio for a major institution.  One of the first things you should internalize is that you will be wrong.  You will buy bonds of companies that will get into unexpected trouble, and their prices will decline.  Or, you play it safe as a panic deepens, and then as the fog lifts, you underperform because you did not hold onto risky bonds that would recover.

Face it: in volatile times we get it wrong.  We panic at troughs, and chase the rabbit when the market runs contrary to our bearish expectations.  But what do you do when you are on the wrong side of a trade?

The first thing to do is sit down with all concerned parties and ask their opinions.  (If you are working on your own, this point is moot.)  If everyone who has an opinion agrees, and the position still worsens, the final step must be taken.  Look at all external analytical opinion, and find someone that disagrees.  Circulate the disagreeing opinions out, and ask all concerned parties what they think.  Or, simply ask, what arguments have they made that we haven’t heard?  Do those arguments make any sense?  If they make sense, close out the position.  If not, it may be time to add more amid the pessimism.

But it is better to prepare in advance for bad times than to react on the fly.  Good investment processes plan for failure.  They realize that not every investment will win, and so they limit the downside of possible bad investments through:

  • Diversification
  • Hostile review when the investment falls by a given amount.
  • Limitations on size of positions.
  • Holding safe assets

Good investment management considers where asset values could go in the short run, and the possibility that money could be pulled if performance is bad enough.  But it also looks to the long run value of the assets, and is willing to sell when values are too high, and buy when values are too low.

As a corporate bond manager, when I got on the wrong side of a trade, I would call my analyst to me and ask her for her unbiased opinion.  If she was certain that things were good, and gave good answers to my questions, I would add to my positions.  But if she gave me the sense that things were falling apart, I would take my losses.

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When I went to work for a hedge fund in 2003, one of the first questions I was asked was  how I would position the portfolio.  I found myself to be the lone bull.  When asked why, I said that we were in the midst of a liquidity rally, and that short positions were poison when liquidity was adequate to finance marginal companies.  My argument was not bought, but I focused my part of the portfolio on marginal insurance companies that would benefit most from the liquidity wave.

Today, there are many bearish hedge funds that are licking their wounds.  What to do?

1) First, assess your funding base.  Estimate how much assets will leave if the underperformance persists.

2) Look at your positions relative to your expectation of prices two years out.  Eliminate the positions with the lowest risk-adjusted expected returns, whether short or long.  Keep the positions on (or add to them) that offer the most promise.

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Bad times offer an opportunity to concentrate on best ideas.  Good times offer opportunities to avoid risk.  In this time of liquidity prompted by the Fed, take the opportunity to lessen risk, because eventually the Fed will have to shift its position, and suck liquidity out of the economy.

Recent Portfolio Actions

Tuesday, September 29th, 2009

Sorry, it’s been a while since I listed my equity portfolio moves.  I made the following trades yesterday:

New Buys:

  • Chubb
  • Computer Sciences Corp
  • Dominion Resources
  • Northrup Grumman
  • National Presto (beware, less liquid)
  • SCANA Corp
  • Safeway Corp
  • Total SA

New Sells:

  • iShares Brazil Fund
  • General Dynamics
  • Honda Motors
  • Mosaic Inc
  • Nucor
  • Vishay Intertechnology

And over the past few months, I made the following trades:

Rebalancing Buys:

  • Conoco Phillips
  • Mosaic Co
  • PartnerRe
  • Pepsico Inc
  • Safety Ins Group Inc
  • Shoe Carnival Inc
  • Valero Energy Corp
  • Vishay Intertech Inc

Rebalancing Sells:

  • Assurant Inc
  • Companhia De Saneamento Basico Do Estado De Sao Paulo
  • Conoco Phillips
  • Dorel Inds Inc
  • Ensco International Inc
  • Industrias Bachoco SA ADR
  • iShares Inc MSCI Brazil Index Fund
  • Magna Intl Inc
  • Mosaic Co
  • Nam Tai Electronics Inc
  • National Western Life Insurance
  • PartnerRe
  • Pepsico Inc
  • Reinsurance Group Amer Inc
  • Shoe Carnival Inc (2)
  • Valero Energy Corp
  • Vishay Intertech Inc (2)

Thoughts

1)  I try not to trade too much.  For those that are new to my writings, rebalancing buys and sells are meant to bring the positions back to target weight after they have moved 20% away from the target weight.

2)  I consumed some cash today, enough to get me inside my 20% cash limit.  I don’t believe in the rally, but I maintain my discipline that I don’t let cash get too large.

3) I tried to take some cyclicality off of the table today.  I end up with a little more insurance, utility, and energy exposure, but less of industrials and basic materials.

4) Assurant and SABESP are still double weights.  The rest of the portfolio is equal-weighted aside from that.

5) In terms of balance sheets, and industry factors, this is my most conservative portfolio ever.

6) I still don’t trust the financial sector aside from insurers here.

7) I had some runners-up in my analyses: ACE AEE EE HELE TFX UGI

8 ) I think my portfolio is cheaper and more defensive now.

9) That said, I also raised my central band by 11% today, raising all of my target weights by that amount.  That makes me more likely to be a buyer than a seller, though the change caused no buys yesterday.

10) Dropping the iShares Brazil Fund seemed to be wise.  The run in the emerging markets has been huge, and Brazil is more export and commodity dependent than most.

Full disclosure (here is the whole portfolio): ADM AIZ ALL CB CNI COP CSC CVX D DIIB ESV GPC IBA LNT MGA NE NOC NPK NTE NWLI ORCL PEP PRE RGA SAFT SBS SCG SCVL SWY TOT VLO

On Vanilla Products

Saturday, September 26th, 2009

Though Congress may not mandate the sale of vanilla financial products to consumers, it is worth thinking about the concept in general. I have written two articles that argued that consumers should only simple products from insurers:

Life Insurance: A Bet You Don’t Want to Win
The Pros and Cons of Buying Annuities

Men (this includes women) are good at analyzing questions of more and less with one variable.  Stick to that, and most men do well.  When there are two or more variables, the rationality breaks down, because the average man does not know how to analyze the pricing tradeoffs.

Term insurance and deferred annuities are relatively simple; the markets are competitive because men can make simple price comparisons across similar products.  That’s why insurers try to sell unique combination products.  The more unique a product is, the harder it is to compare against products that might be cousins.

The same applies to banks.  I don’t believe that any bank should be forced to sell a product, but it would be smart for some banks to market themselves as “basic banks.”  No products are marketed as bundles, every product is sold separately.  Products are sold at cost plus risk-adjusted profit margin.

Some banks could bring in a lot of business if they did this.  I had a similar idea regarding variable annuities, where a life insurance company would charge a mere 40 basis points per year to wrap a variable annuity, with no guarantees.  It would create the generic tax-deferred mutual fund.

In the same way, some backs could win a lot of business offering generic credit cards, simple mortgages, etc.  The only difficulty is getting through gatekeepers, because the average American does not search for the best deal.  Gatekeepers often offer what compensates themselves best.

Aside from complex tax planning reasons, simple products are usually the best.  I encourage my readers to look over the financial services that they use, and aim for simplicity.

Book Review: Fallen Giant

Saturday, September 26th, 2009

I am glad I read this book, but I found it less than satisfactory.  Why?  Wait a moment on that question, while I tell you about the book’s strong points, which I appreciated.

AIG’s founder was Cornelius Vander (C.V.) Starr, sometimes called Neil Starr.  (Alas, but the book does not explain the nickname.)  He was an amazing guy who worked like crazy to create an insurance brokerage in China for US companies, and then brokered insurance in many other places in the world.  The success was so significant that the company returned to the US and bought up some of the companies that it had placed business with.

C. V. Starr was a fascinating man who appreciated art, skiing, golf, global travel, and was open-minded toward other cultures, incorporating bright local managers into his firm.  He had an aptitude for sensing management talent, which seemed to correlate with willingness to embrace multiple cultures.  He was also a business animal, which led to a tight-knit culture with his top lieutenants, and an inability to keep a wife acquired later in life happy.

He created a complex corporate structure to reward significant long-termers with AIG.  That would later prove to be a major source of contention when Greenberg was forced out.

The book divides into four sections:

  1. The Life of C. V. Starr
  2. The Arrival and Success of Maurice Raymond (M. R. “Hank”) Greenberg.
  3. The author’s experiences working for AIG (1973-mid-80′s).  He was a lieutenant of Hank’s dealing with foreign affairs.
  4. The fall of Hank Greenberg and the demise of AIG.


Do you see the big gap?  The story jumps from the mid-’80s to 2005.  There is a 20-year gap of which little is said.  There are snippets, yes, but there is nothing comprehensive.  The book is written chronologically in a micro-sense, but not in a macro sense.  Chapters are topical, but chronological within the chapters.  The chapters are chronological, but the periods overlap, chapter to chapter.

There are other weaknesses to the book as well:

  • It doesn’t really explain how Greenberg became so influential at AIG, and gained the trust of Starr.  (There are stories that I heard, but I have no idea how true they were.)
  • It doesn’t tell the story of growth in the middle years.  Why did they succeed?  What of the takeovers that they missed?
  • It doesn’t deal with critical business decisions like why AIG acquired ILFC, SunAmerica, and American General.  With the latter two, why was Greenberg willing to pay up?  That was not his style in prior days, which was why AIG did not buy The Equitable.
  • How the strategy of AIG changed from nimbleness (entering and leaving markets at will) to omnipresence (we do business everywhere.
  • Not recognizing the continuing increase in debt at AIG.
  • The author sees the “small” issues that led to the ouster of Greenberg, but does not find anything larger that merits attention.  The Financial Products unit gets a mention, but the insolvency of the life companies does not.
  • For the lawsuits that emerged after Greenberg’s ouster, the author takes a slightly pro-Greenberg slant.

Who would benefit from this book?  Anyone who wants to learn about the amazing C.V. Starr.  That is the main benefit of this book.  If you are looking for a history of AIG, well, this may be the best book out there, but it has the inadequacies that I listed above.

Unlike other reviewers, I read every book I review, and in the few cases where I scan a book, I disclose it.  Any reader entering Amazon through my site and buying anythig there, I get a small commission.  You can buy today’s book here: Fallen Giant: The Amazing Story of Hank Greenberg and the History of AIG

Name Your Poison

Friday, September 25th, 2009

Last night I wrote a longish post, and the system ate it.  Probably I had not established a firm connection with the server, and when I hit the publish button, it disappeared.  My main point was to ask where the limits were for all of the borrowing and spending  going on from the Treasury, and all of the lending going on with the Fed.

I have talked about this before in articles like It is Good to be the World’s Reserve Currency.  Both China and OPEC have their political reasons for lending to the US, and those keep the dollar afloat for now.

I began last night’s doomed post by declaring to readers that they were part owners in the largest hedge fund (or CDO) in the world — the US Government.  Very distant from the founders’ designs, the government lends to private enterprises in a big way, clipping a spread, while still being exposed to default.

The US government has absorbed many private debts into the government’s debt in exchange for many private debt and equity claims.  Given that the government is clipping a spread, and borrowers are obtaining better terms than the market could give, could there be any problem?

Yes, there are several problems:

  • The federal credit is not infinite — dare we risk the survival of our government to rescue special interests?
  • The ability of the Fed to stretch the currency is not infinite — price inflation has not come yet, but when it does come, it will likely accelerate from all of the promises made.
  • There is some degree of favoritism in who gets funds.  The larger banking firms have been bailed out at their holding companies, which is a travesty, because only regulated subsidiaries are to be protected, not the interests of holding company stock and bondholders.  Small banks have been left to fail.
  • Private lenders who would lend at higher rates are getting cheated by the government, who has no business being a lender.  (Yes, I know, they have been doing it for decades, but that does not make it right.)
  • There is little ability for the government to know whether they are offering fair terms or not as far as the taxpayer is concerned.  What is the right tradeoff between offering more loans, and taxing the populace more?
  • The FDIC trades on the creditworthiness of the US.  They offer guarantees using the Federal credit, rather than surcharge the banks to make up for losses.  Letting banks lend to them at Treasury rates is clever to replenish the reserve funds, but what happens when there are more large defaults?  The hole will be deeper, and the climb out more challenging.
  • So long as the productive capacity of the US is not expanding, arguing about how it is financed is not a fruitful endeavor.

Leaving aside the mutual suicide pact of those that own a disproportionate amount of US Treasuries, the risks that exist stem from an over-indebted economy, and the inability of consumers to resume their role of excess consumption, with accumulation of debt.

Aside from that, should we have a resumption in the decline of housing prices, an acceleration in corporate defaults, or commercial mortgage defaults that affect the big banks, it doesn’t matter that the government is clipping an interest spread, because the losses will be worse.

As a final note, let’s watch the end of the Quantitative Easing from the Fed.  Together with the Treasury they already own over 30% of all 30-year GSE-conforming mortgages, if not more.  What?  Do we want the government to absorb every bad debt?  Where is the responsibility to those that contracted the loans, expecting profit or pleasure?

This will not end well. The only question is whether it ends in inflation or greater taxation.  Name your poison.

Redacted Version of the September FOMC Statement

Wednesday, September 23rd, 2009
August 2009September 2009Comments
Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out.Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn.The FOMC thinks that the economy is growing.
Conditions in financial markets have improved further in recent weeks.Conditions in financial markets have improved further, and activity in the housing sector has increased.The FOMC thinks the residential housing market is improving.  The bond and stock markets are definitely better.
Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.Slightly more certainty that spending is stabilizing.
Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales.Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.Labor employment and capacity utilization are still falling, but less rapidly.  Inventory correction is still underway.
Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.The FOMC believes that current policy will strengthen an existing trend toward growth.
The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.Labor employment and capacity utilization are still falling, and the FOMC believes that that will contain inflation.  They also believe that expectations of inflation have stabilized.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.They will no long use “all available tools,” but instead “a wide range of tools.”  They are looking at scaling back the range of quantitative easing.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.No change.
As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt.  The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.No significant change.  This draws out the timing by one quarter – perhaps they want flexibility to scale back if necessary.
In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October.As previously announced, the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009.No big change.
The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.No change.
The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.No change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.No change.

PDF version with highlighting here.

Quick Hits:

  • The Fed is more bullish than I am.  I would be less certain about growth prospects.
  • I would also be wary of saying that residential housing is improving when the only improvement has  been transaction volume increasing on the low end.
  • In a global economy, I would not be so sanguine that price inflation can be kept under control through labor unemployment and low capacity utilization.  Remember the ’70s.
  • The Fed funds rate doesn’t mean anything at present.
  • They are looking at the end of quantitative easing, but are not yet considering the beginning of quantitative tightening.
  • There’s little policy difference between the August and September statements.  Maybe the FOMC will do less quantitative easing than they have stated, but that would surprise me.  They won’t stop easing until labor unemployment starts to decline significantly.

Two Notes

Wednesday, September 23rd, 2009

This was a horrible day for me.  I tried to fix my shaky internet connection, which troubled my access to Bloomberg.  After some time I had some success, but it pushed me into the late hours of the day, even for me.  For now, it seems stable, and for that, I am grateful.

A few notes:

1)  I’ve read Caroline Baum for about 15 years now, and have consistently benefited from her insight.  Her current piece makes the point that the Fed should not have entered into such policies of easing, because now we face the results of those policies, which include low interest rates, and little reason to borrow.  A liquidity trap, courtesy of the Fed.

2)  Okay, so a Rep. Towns of New York proposes that we ease the terms on the bailout of AIG.  Why should the US do this?  There is no good reason — AIG has stabilized, though it has stabilized at a level where common shareholders will get nothing, eventually, unless valuations on financial asset rise even more.

Can’t the US government make up its mind?  It has voluntarily given up value from bailing out AIG twice.  Must it do so a third time?

No, it must not do so , but my odds that they will do so are 50/50.  The US government is given toward bailing out economically sensitive  institutions whether it makes sense or not.

That’s all for the night.  We are in a tough situation, and the US government leans toward politically sensitive institutions, and favors them versus other financial institutions.  It’s bad policy, but it can be good politics for some politicians.

In Defense of the Rating Agencies — IV

Tuesday, September 22nd, 2009

I guess I am a glutton for punishment, but I am going to take the opposite side of the argument from what most have been saying of late regarding the rating agencies.  Those who want historical context can read my earlier three pieces:

And let me repeat my five realities:

  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
  • Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.

First, please understand that institutions own most of the bonds out there.  Second, the big institutions do their own independent due diligence on the bonds that they buy.  We had a saying in a firm that I managed bonds in, “Read the writeup, but ignore the rating.”  The credit analysts at the rating agencies often knew their stuff, giving considerable insight into the bonds, but may have been hemmed in by rules inside the rating agency regarding the rating. It’s like analysts at Value Line.  They can have a strong opinion on a company, but their view can only budge the largely quantitative analysis a little.

So there are systematic differences and weaknesses in bond ratings, but the investors who own most of the bonds understand those foibles.  They know that ratings are just opinions, except to the extent that they affect investment policies (“We can’t invest in junk bonds.”) or capital levels for regulated clients.

On investment policies, whether prescribed by regulators or consultants, ratings were a shorthand that allow for simplicity in monitoring (see Surowiecki’s argument).  Now, sophisticated investors knew that AAA did not always mean AAA.  How did they know this?  Because the various AAA bonds traded at decidedly different interest rates.  The more dodgy the collateral, the higher the yield, even if it had a AAA rating.  My mistake: I, for one, bought some AAA securitized franchise loan paper that went into default long before the current crisis hit.  Many who bought post-2000 AAA securitized manufactured housing loan paper are experiencing the same.  Early in the 2000s, sophisticated investors got burned, and learned.  That is why few insurers have gotten burned badly in the current crisis.  Few insurers bought any subprime residential securitizations after 2004.  But, unsophisticated investors and regulators trust the ratings and buy.

Recently, the rating agencies have lost some preliminary arguments in a court case where a defense they made is that ratings are free speech has been shot down.  I must admit, I never would have made such an argument, because it is dumb (See Falkenstein’s logic on the matter).  People and corporations cannot say what they want, and say that they are immune from prosecution because of free speech.  Fraud, and implied fraud from speech is prosecutable.

But what are rating agencies to do when presented with novel financial instruments that have no significant historical loss statistics?  Many of the likely buyers are regulated, and others have investment restrictions that depend on ratings, so aside from their own profits, there is a lot of pressure to rate the novel financial instrument.  A smart rating agency would punt, saying there is no way to estimate the risk, and that their reputation is more important than profits.  Instead, they do some qualitative comparisons to similar  but established financial instruments, and give a rating.

Due to competitive pressures, that rating is likely to be liberal, but during the bull phase of the credit markets, that will be hidden.  Because the error does not show up (often) so long as leverage is expanding, rating agencies are emboldened to continue the technique.  As it is, when liquidity declines and leverage follows, all manner of errors gets revealed.  Gaussian copula?  Using default rates for loans on balance sheet for those that are sold to third parties?  Ugh.

But think of something even more pervasive.  For almost 20 years there were almost no losses on non-GSE mortgage debt.  How would you rate the situation?  Before the losses became obvious the ratings were high.  Historical statistics vetted that out.  No wonder the levels of subordination were so small, and why AAA tranches from late vintages took losses.

When prosperity has been so great for so long, it should be no surprise that if there is a shift, many parties will be embarrassed.  In this case both raters and investors have had their heads handed to them. And so it is no surprise that the rating agencies have no lack of detractors:

I may attend a meeting this Thursday on the rating agencies and the insurance industry, if my schedule permits.  If I get a chance to speak, I hope I can make my opinion clear in a short amount of time.

As for solutions, I would say the following are useful:

  • Competition (yes, more rating agencies)
  • Compensate with residuals and bonuses (give the raters some skin in the game)
  • Deregulation (we can live without rating agencies, but regulators will have to do a lot more work)
  • Greater disclosure (sure, let them disclose their data and formulas (perhaps with a delay).

In economics, where there are more than two players, easy solutions are tough.  I only ask that solutions to the rating agency difficulties be reasonably certain that they do not create larger problems.  Ratings have their benefits as well as problems.

No economic interest

Ten Notes on Current Market Risks

Saturday, September 19th, 2009

1)  You hear me talk about this more than most, but liquidity risk needs more emphasis.  This is true whether you are a retail or institutional investor.  As the old saying goes, “Only invest what you can afford to lose.”  The basic operations of life require liquidity.

That even applies to the abstract mathematicians who developed much of modern finance.  The moment they assume a simple arbitrage argument, it implies that liquidity is free, or nearly so, in the markets.  I remember asking questions of my professors over Black-Scholes 25 years ago, because equity markets did not trade continuously, except for large companies.

My view is that introducing liquidity risk will be difficult for academic finance, because it will blow apart the simple models that they need in order to write their research.  Once markets do not trade continuously, the math gets tough.

2)  Insiders are selling, should you worry?  Perhaps a little, but I would wait until the price momentum starts to fail.  Like value investors, insiders tend to be early.

3)  What works in a time of rising leverage will not work well when leverage is decreasing.  Or, a strategy that requires liquid markets does not so well in a time of deleveraging.  Consider Citadel, then.  The period from 1991-2007 was pretty care-free.  What crises occurred were not systemic, and were quickly snuffed out by the Fed, as it edged us closer to a liquidity trap.  In 2008, the trap was sprung and Citadel had a lousy year.  Amid the carnage, they were forced to sell into  falling market.  Now they are running at reduced leverage, and planning products that would have been smart eight months ago.

4)  Average retail investors don’t understand regulated investments well enough to invest in them.  It would be stupid to allow them to invest in hedge funds, then.  If we would do such a thing, then deregulate the simpler investments first, telling people that they are on their own, the ineffective SEC is being disbanded, and that “caveat emptor” is the only risk control remaining.

I can’t see that happening in my lifetime.  The nature of American culture abhors implicit fraud, and thus we regulate most of those that take money and offer uncertain promises, when those offering the money don’t have much.  (The culture abhors little investors being fleeced by bigger institutions.)

5)  Auction rate preferred securities — when I was younger, I wondered how they worked.  By the time I figured that out, the market failed.  Now the lawsuits fly.  Yes, they were marketed as money market equivalents, but none of them made it into money market funds.  Now, having read many of the prospectuses, the risks that eventually emerged were disclosed in advance.  Few believed them because it had worked so well for so long.  My view is this — investors needed to read the “risk factors,” and did not.  ARPS were designed to be investment vehicles that could survive a storm, but not a tornado.  Tornadoes do happen, and those that assumed that such volatility would never happen lost.

6)  My, but the high yield market and lower investment-grade corporate markets have moved higher.  What observers miss is that yields for sensitive financials are a lot higher than they were in early 2007, about the time I started this blog.  Systemic risk is still high.

7)  Spreads have fallen for high yield; I have previous suggested to lose the overweight in credit.  I now suggest that credit be underweighted.  This is not a time to stretch for yield.

8 )  After many other crises, junior debt gets grabbed when seniors have rallied a great deal.  The need for yield is significant, much as I think it is premature to buy those junior debts.

9) The same is true for high yield.  When does the rally end? Now?  Typically near a market peak, there is confusion, and a diminution in volume.  I think we are close to the end, but as I usually say, honor the momentum.  If it is still going up, hold it.

10)  This article is a little unusual for me, but it points out something that I often talk about in different terms.  Trees don’t grow to the sky.  In almost any process, the results are not linear as one increases effort, but there comes diminishing returns because improvement is not costless.  Exponential growth meets the constraint that resources are not infinite, and so growth follows more of an S-curve.  So it is with business, and much of finance.

When the Sirens Sing, How to Avoid Giving in…

Saturday, September 19th, 2009

When I wrote What Stories Aren’t Being Told?, I did not expect a big response.  But I got 53 responses, more than double the responses of my next-most-responded-to article.  Many bloggers linked to it, and responses continued on for almost four days.

But after Dr. Jeff’s comment, I decided to write a second piece, What is Going Right? Now, part of that also sprang from an e-mail that Rolfe Winkler sent asking what is going right, but I did it as a kind of test to see if asking for optimism would yield a response.

Alas, but only eleven responses came and a few were negative in nature.  I only received one link.  What should that tell me?  The most obvious answer to me is that people by nature are more inclined to complain than to praise.  Though I could resort to the Bible for proof here, instead I will cite two researchers I first bumped into 28 years ago (before they were cool), Daniel Kahneman and Amos Tversky.  They found that losses delivered roughly three times the pain, when compared to pleasures of an equal-sized gain.  (Side note: this has many applications, and in our day and age, most of them are politically incorrect.  As investors, though, we know it — avoiding losses is a better motivator than seeking gains.  At least, those that avoid losses stay in the game.)

Look, I see it in myself.  I tend toward the negative in this era, because I think it is under-told.  Would it surprise you if you knew that I was one of the more bullish guys in my last three firms (1998-2007)?  But even if under-told, there is something that always makes the bear case sound smarter.  Skeptics almost always seem smarter than optimists.  But, the optimists usually win, except when there is war on your home soil, famine, plague, or extreme socialism.

Where does that leave me?  It leaves me with rules.  I have trading rules.  I have asset allocation rules.  I can lean against something that I think is wrong, but I can’t put all of my weight on it.  I listen to the Sirens, but I tie myself to the mast.  Discipline trumps conviction.

So, to close, I offer an old CC post to illustrate:


David Merkel
I Listen to the Sirens, but Like Ulysses, my Hands Are Tied to the Mast
12/27/2006 2:31 PM EST

When I had dinner with Cody two weeks ago, he asked me (something to the effect of): “If we have so many problems, why are you so net long?”

I told him about a hedge fund friend of mine who let his bearishness drive his macro bets over the last four years. The only thing that has bailed him out is that his analysts are really good stock-pickers… their fund has been in the plus column despite being an average of 25% net short, but not positive by much.

I tie my hands when it comes to asset allocation policy. After determining what I think the neutral policy should be for someone that I advise, I allow myself to tweak it by no more than 10% to reflect my overall levels of bullishness or bearishness. This keeps my emotions from taking over, and protects me and those that I manage for.

Besides, absent a major war on home soil, or a Communist takeover, markets have a tendency to eventually bounce back. (even if the bounce takes 25-odd years, as in the Great Depression). The question is whether one’s asset allocation is conservative enough to be around for the “bounce back.” So, it generally pays to play along with the optimists in the long run. Or, as Cramer has said, the bear case always sounds more intelligent. That can trap bright people who let legitimate fears of something that may happen a ways out get treated as a clear and present danger.

At present I am slightly bullish on the US markets and think that 2007 will produce moderate gains, 5-10%. There are things to worry about, but don’t let it blind you to opportunities that will emerge if disaster doesn’t happen. Instead, diversify. Stocks and high quality bonds. (Maybe even some municipal bonds.) Domestic stocks and foreign. There are ways to reduce risk that don’t cost that much in terms of performance. Use them, and don’t worry about the big, bad event. That event will happen, but it will usually be further out, and less bad than expected.

Position: none

Cramer wrote a piece two days later where he said:

I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.

I asked him via e-mail whether he had read my piece, and he said he had not. Quite a coincidence. Before I asked him, though, I wrote this response:


David Merkel
More Things Can Go Wrong Than Will Go Wrong
12/29/2006 1:21 PM EST

I reflected on what I recently wrote when I read this bit of Jim’s piece this morning:

I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.

At my last firm, we conflated two maxims into: “Great minds think alike, but fools seldom differ.” Jim and I disagree on housing. In this case, though I still have many reasons to be bearish on housing, I don’t let it affect my investing to any great degree. For my broad market portfolio, I still own Cemex, Lafarge, and St. Joe. I even own a mortgage REIT, Deerfield Triarc. I’m not bullish on the consumer, but I still own Sonic Automotive and Lithia Motors.

The point is, it’s too easy to say “I’m too worried about the macro environment,” or, “I can’t find anything cheap enough to buy.” Will there be down years? Yes. Might the first decade of the 2000s have a negative total return? Possible, but unlikely. Like the farmer in Ecclesiastes 11, we have to cast the seed into the muddy spring soil, and not worry about the bad weather that might come. Diversification reduces risk, but not taking risk is possibly the biggest risk of all. The advantage belongs to those who take prudent risks.

Now, after all this, if you still want to worry, the biggest risks among the somewhat likely risks out there a breakdown in global trade and an error in Fed policy. I watch these things, but I’m not losing sleep over them.

PS — regarding Ulysses, he put wax in the ears of his sailors, but he tied himself up so that he could listen to the Sirens, but not do anything… it’s a tough discipline to maintain, but it helps me do better in the markets.

Position: Long CX LR JOE DFR SAH LAD

A very different era, that, but I am now bearish, and Cramer is still bullish.  I try not to change my positions often, and even then, I limit my behavior.  Discipline triumphs over conviction.

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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