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 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.