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1) Credit cycles tend to persist for more than just one year.  That is one reason why I am skeptical of the run in the high yield corporate bond market at present.  Sharp short moves are very unusual.  To use 2001-2003 as an example, we got faked out twice before the final rally commenced.  So, as I look at record high defaults after a significant rally, I am left uneasy.  Yes, defaults have been less than predicted, but defaults tend to persist for at least two years, and current yields for junk don’t reflect a second year of losses in my opinion.  S&P is still bearish on default rates.  I don’t know if I am that bearish, but I would expect at least one back-up in junk yields before this cycle ends.

2) Of course, there are bank loans in the same predicament.  Most bank loans are not listed as trading assets, so they get marked at par (full value) unless a default occurs.  Along with Commercial Real Estate loans, this remains an area of weakness for commercial banks.

3) Where should your asset allocation be?  Value Line is more bearish than at any time I can remember — though the last time they were more bearish was October 2000.  Good timing, that.

David Rosenberg favors high quality bonds over stocks in this environment, which is notable given the low yields.  For that bet to work out, deflation must persist.

One reason this still feels like a bear market is that there are still articles encouraging a lesser allocation to stocks.  Though one person disses the traditional 60/40 stocks/bonds mix, in an environment where complex asset allocations are getting punished, I find it to be quite reasonable.

4) Maybe demographics are another way to consider the market.  When there are more savers/investors vs. spenders, equity markets do better.  I’ve seen this analysis done in other forms.  So we buy Japan?  I’m not ready for that yet.

5) Illiquid assets require a premium return.  After the infallibility of the Harvard/Yale model, that rule is on display.  As their universities began to rely on their returns, even though there was little cash flowing from the investments, they did not realize that there would be bear markets.  Harvard and Yale may indeed have gotten a premium return versus equities.  It’s hard to say, the track record is so short.  One thing for certain, they did not understand the need for liquidity; a severe present scenario has revealed that need.  As such, investors in alternative investments are looking for more liquidity and transparency.

6)  There are limits to arbitrage.  As an example, consider long swap rates.  30-year swap yields should not be less than Treasury yields — they are more risky, but do do the arbitrage, one would need a very strong balance sheet, with an ability to hold the trade for a few decades.

7) One thing that makes me skeptical about the present market is the lack of deployment of free cash flow in dividends or buybacks.  When managements are confident, we see that; managements are not yet confident.

8 ) I would be wary of buying into a distressed debt fund.  Yields have come down considerable on distressed debt, and I think there will bew better opportunities later.

9) It seems that the US Dollar, with its cheap source of funds for high quality borrowers, is attracting some degree of interest for borrowing in US Dollars in order to invest in other higher yielding currencies.  I’m not sure how long that will last, but many see the combination of a low interest rate and a potentially deteriorating currency as attractive to borrow in.

10) The difference between an investor and a gambler is that an investor bears risk existing in the economic system in order to earn a return, whereas the gambler adds risk to the economic system that would not have existed, aside from his behavior.

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I have never been a fan of VAR (Value at Risk), but I recognize that mathematical techniques are only as good as those that use them.  Questions arise with any quantitative risk technology:

  • What’s my time horizon?  (What’s your longest asset or liability?)
  • Do I have to be good over this entire time horizon, or just the end?  (The whole thing, sorry.)
  • How do I work with options in assets or liabilities?  (Assume optimal exercise by the option holder.)
  • What are the worst losses can I take from this business activity?  (Much worse than you can assume, and this present crisis is an example of that.)
  • How do I model liquidity of liabilities?  (Assume they exit when it is in their interest.)

With one employer, he invited me to consult for the Asset-Liability committee of his bank.  Having been a risk manager inside two life insurance companies, when I reviewed the documents, I was surprised, because they were so much less sophisticated than what life companies of a similar size did.

With banks, the grand weakness is in the assets, and the analysis should focus on two things:

  • Liquidity of the assets versus liquidity of the liabilities.
  • Potential credit losses of the assets versus the surplus of the bank.

I write this because of the commentary of Taleb and Bookstaber.  They are bright men, but they have never managed the risks of a financial institution.  Leverage ratios are not enough.  One must dig into the loss experience and analyze whether emerging losses might overwhelm the capital of the institution.  One must also look at risk-based liquidity — what is the likelihood  of running out of cash?

There is always a tension between rules versus principles.  What must first be admitted is that both can be fuddled by sinful men.  Rules can be observed, and cheaters bring items that meet the letter of rules, but violate the spirit of the rules.  Principles can be bent by those that implement the principles.  Neither is a perfect solution — better to settle on one way of regulating, though, and understanding the soft spots, than to vacillate.

Perhaps the banks need to employ actuaries.  I don’t say that so that friends might find work, but because many banks do not get how to preserve their existence.  Actuaries think longer-term; they think about scenarios where loss experience might prove to be unsustainable.  They are more skeptical on risk compared to most bankers.

With that, I commend all who read this to be careful, and to analyze financial situations carefully.  Don’t follow the crowd.