I never thought the deal where Sam Zell bought Tribune was fair, because it relied on the savings of workers in their ESOP [employee stock ownership plan].  Here is what I wrote in the past:

Well, now Mr. Zell is getting sued by Tribune employees, and he deserves it.  Zell could not have bought out Tribune without the support of the ESOP, but his actions harmed the economic interests of the ESOP, and thus the employees.  Many will agree to anything if their job is threatened.  The semi-coercion plus failure will not work out well for Mr. Zell.

-=-==–==–==–==-=–=-==-=-=-=-=–=-=-=

And, speaking of not working out well, we have the NYT Op-ed on AIG.  I say good, let AIG, the Fed and the Treasury disclose what they said during the bailout.  We already know that many areas of AIG would have gone under without the bailout.  Though the Treasury Secretary has changed his tune on why AIG was bailed out, originally it was only and ostensibly for AIGFP, the derivatives subsidiary.

Let AIG and the Government reveal what they said  regarding the bailout.  The American people deserve to know it.

Dear David,

Quick question in case you find yourself with time to spare on your blog (ha!! ) :
You have a large family. What do you teach your children?  How do you prepare them using the economic back drop? What are the hopes, the fears that a parent has for their youngsters ?

It is the real-life application that so often is skipped over in financial blogs.  Maybe that’s as it should be – not every reader might find it of interest.  But isn’t that where the rubber meets the road?

So, I’ll send this off and maybe one of these days, the question ties in with something you were going to write.

Thanks a lot for your insights.

Regards,

A.S.

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As the snow starts to fall, and Baltimore is in the eye of the storm (18-24 inches of snow predicted), I think it is a good time to sit back and think about the bigger things of life.  I’ll be spending all day tomorrow with my family.  Now, that’s normally true.  I work from home, and my wife and I homeschool.  We have two graduates, one drop-out (a sad tale, and what made me start working from home to protect my family until we told him he had to leave), an eleventh grader, ninth grader, two sixth graders, and a second grader.  Five of the eight are adopted, and are African-American to varying degrees.  All of them have very different ability levels, and different levels of being willing to work hard.  The one that left was bright, but lazy, and that was part of his undoing.

I’m not a natural parent, but I have learned to control my temper better as the years have gone by.  I never realized how much I like things quiet until I had a lot of kids. 😉  My wife and I work as a team.  She does most of the teaching, and I do most of the discipline, but each of us does both.  My wife is bright, but I can still do Algebra 2 through Calculus.  I pick up the slack there.

My kids do get some economic training from me in a variety of ways:

1) Informally at dinner, I explain what is going on in the world.  The eleventh grader gets a lot of it, while the college students can’t be bothered.  The ninth grader and sixth graders get a decent amount of it.  But it is precious when one of the kids comes and says “Dad, can you explain to me what happened during the Great Depression?”  That said, it was even more precious when I tried to explain what I did as a corporate bond manager to my kids seven years ago (100 phone call per day), and the then eight-year-old said, “It’s like ordering pizza all day, right?”

2) There is the “Bank of Dad.”  This is not original to me, but I tell the children that they can deposit their money with me, and I will pay them 5% interest (annual equivalent yield).  Oh, and to get started, they must amass $100.  That is psychologically important, because it is a barrier to getting into an exclusive club.  The rate has been 5% for the last 10 years — the rate is subsidized to encourage children to save.

My children are not all natural savers.  Half are and half aren’t.  The ability to earn interest makes them all more inclined to save.  What we try to put forth to those that are not natural savers is to spend less than all that they earn, and save the rest.  If all Americans did that our economy would be much better off.

3) Work hard.  That applies to schoolwork and chores.  Basic chores get no pay but there is an allowance if those normal chores are done.    Then there are other tasks that are available for pay, and those have varied over the years:

  • Cutting the yard.
  • Yard work.
  • Analyzing documents, and shredding the useless ones.
  • Sorting financial documents.
  • Shredding documents.
  • Checking derivative confirms.
  • Entering ABS cashflows for delivery to Bloomberg.
  • Entering industry rank data into spreadsheets.
  • Washing/waxing the cars.
  • Fixing the cheap Ikea furniture around the home.
  • Killing crickets and other vermin in the home.
  • Teaching math, or other subjects to younger children.
  • And more… if their schooling is done, neighbors often employ them for tasks, because the children are very reliable.

4) I spend time regularly explaining to my children what careers are in demand, and which are not.  I also explain the basic ideas of how companies make money, or not.  Then they follow what is happening in my career, with the media appearances, talks and other things that go on with me.  In any case, I try to explain to them to be practical, which is not generally taught in the schools.  Yes, do what you love, but don’t be dumb… no one will pay for useless bits of knowledge, and there are few teachers needed in such areas.

5) I do drop in on the homeschooling to provide greater background on history, economics, theology, and science.  I see my wife smile as I give greater depth to topics as I motivate them.

6) We have dinner together every night, and the discussion helps the children grasp on to what is going on in the world, as does subscribing to The Economist, and The Wall Street Journal.  I have subscribed to both for the last 20+ years.

7) Hopes and fears?  Ugh.  My third child made my life a mess.  I loved him so, but he gained a bunch of evil friends and turned against us.  But that is just one child.  My goal is not to create clones of me, but to create people who can be productive in the world, and faithful to Jesus Christ.

I have fears that the future won’t be as good for my children as it was for me, but I also know that my children are better prepared than most.  I can’t control the external macroeconomy; even my predictions are only a vague help.  My goal is to turn out children that are better prepared than most, and willing to work.  Beyond that, I pray to Jesus, but that is the best that anyone can do.

In the end I know that my efforts are valuable but not determinative.  I can’t make anything happen.  I can only teach my children, and trust in God for the rest.

Before I start, I would like to toss out the idea of an Aleph Blog Lunch to be hosted sometime in January 2010 @ 1PM, somewhere between DC and Baltimore.  Everyone pays for their own lunch, but I would bring along the review copies of many of the books that I have reviewed for attendees to take home, first come, first served.  Maybe Eddy at Crossing Wall Street would like to join in, or Accrued Interest. If you are an active economic/financial blogger in the DC/Baltimore Area, who knows, maybe we could have a panel discussion, or something else.   Just tossing out the idea, but if you think you would like to come, send me an e-mail.

Onto the comments.  I try to keep up with comments and e-mails, but I am forever falling behind.  Here is a sampling of comments that I wanted to give responses on.  Sorry if I did not pick yours.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=–==-=–==-

Blog comments are in italics, my comments are in regular type.

http://alephblog.com/2009/12/16/notes-on-fed-policy-and-financial-regulation/#comments

Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov’t would could happen – seeing that result all but solidified the ‘too big to fail’ mantra.

2. Second, they will be forced to raise rates – that’s right folks, 0% – 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road – perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed’s paid interest on excess reserves – the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.

Thoughts????

UD, I think you have the Fed’s Order of Battle right.  The questions will come from:

1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up.  Bank profits have become very reliant on low short term funding.  I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

http://alephblog.com/2009/12/15/book-reviews-of-two-very-different-books/#comments

David,
A few years back you mentioned to me in an e-mail that Fabozzi was a good source for understanding bonds (thank you for that advice by the way, he is a very accessible author for what can be very complex material.)  In the review of Domash’s book you mention that he does not do a good job with financials. I was wondering, is there an author who is as accessible and clear as Fabozzi, when it comes to financials, who you would recommend.

Regards,
TDL

TDL, no, I have not run across a good book for analyzing financial stocks.  Most of the specialist shops like KBW, Sandler O’Neill and Hovde have their own proprietary ways of analyzing financials.  I have summarized the main ideas in this article here.

http://alephblog.com/2007/04/28/why-financial-stocks-are-harder-to-analyze/

http://alephblog.com/2009/12/05/the-return-of-my-money-not-the-return-on-my-money/#comments

Sorry to be a bit late to this post, but I really like this thread (bond investing with particular regard to sovereign risk). One thing I’m trying to figure out is the set of tools an individual investor needs to invest in bonds globally. In comparison to the US equities market, for which there are countless platforms, data feeds, blogs, etc., I am having trouble finding good sources of analysis, pricing, and access to product for international bonds, so here is my vote for a primer on selecting, pricing, and purchasing international bonds.

K1, there aren’t many choices to the average investor, which I why I have a post in the works on foreign and global bond funds.  There aren’t a lot of good choices that are cheap.  It is expensive to diversify out of the US dollar and maintain significant liquidity.

A couple of suggested topics that I think you could do a job with:  1) Quantitative view of how to evaluate closed end funds trading at a discount to NAV with a given NAV and discount history, fee/cost structure, and dividend history;   2) How to evaluate the fundamentals of the return of capital distributions from MLPs – e.g. what fraction of them is true dividend and what fraction is true return of capital and how should one arrive at a reasonable profile of the future to put a DCF value on it?

Josh, I think I can do #1, but I don’t understand enough about #2.  I’m adding #1 to my list.

http://alephblog.com/2009/12/05/book-review-the-ten-roads-to-riches/#comments

I see that Fisher’s list reveals his blind spot–how about being born the child of wealthy parents. . .

BWDIK, Fisher is talking about “roads” to riches.  None of us can get on that “road” unless a wealthy person decided to adopt one of us.  And, that is his road #3, attach yourself to a wealthy person and do his bidding.

I am not a Ken Fisher fan, but I am a David merkel fan—so what was the advice he gave you in 2000?

Jay, what he told me was to throw away all of my models, including the CFA Syllabus, and strike out on my own, analyzing companies in ways that other people do not.  Find my competitive advantage and pursue it.

That led me to analyzing industries first, buying quality companies in industries in a cyclical slump, and the rest of my eight rules.

http://alephblog.com/2009/11/28/the-right-reform-for-the-fed/#comments

“The Fed has been anything but independent.  An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

This seems completely wrong to me.  First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power.  Perhaps they will in the future, but it is a bit early to assert that, I think.

Matt, even in their mandates for full employment and stable prices, the Fed should have no mandate to do bailouts, and sacrifice the credit of the nation for special interests.  No one should have special privileges, whether the seeming effect of purchasing power has diminished or not.  It is monetary and credit inflation, even if it does not result in price inflation.

¨Make the Fed tighten policy when Debt/GDP goes above 200%.  We’re over 350% on that ratio now.  We need to save to bring down debt.¨

David, I fully agree (as with your other points).
However, I do not see it happening.

Why would we save when others electronically ´print´ money to buy our debt?

See todays Bloomberg News:
¨Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.¨

Please note that last year the amount auctioned was much lower (so foreign central banks bought a much lower percentage of a much lower total).

Please also note that all of a sudden, earlier this year, the definition of ´indirect bidders´ was changed, making it more complicated to follow this stuff. What is clear however, is that almost half of the incredible amount of $ 2 trillion, i.e. $ 1000 billion (!!), is being ´purchased´ by the printing presses of foreign central banks.

This could explain both the record amount of debt issued and the record low yields.

As the CBO has projected huge deficits PLUS huge debt roll-overs (average maturity down from 7 years to 4 years) up to at least 2019, do you think we could extend the ´printing´ by foreign central banks  — CB´s ´buying´ each others debt — for at least 10 more years?
That would free us from saving, enabling us to ´consume´ our way to reflation of the economy (as is FEDs/Treasuries attempt imo).

I´d appreciate your, and other readers´, take on this.

Carol, you are right.  I don’t see a limitation on Debt to GDP happening.

As to nations rolling over each other’s debts for 10 more years, I find that unlikely.  There will be a reason at some point to game the system on the part of those that are worst off on a cash flow basis to default.

The rollover problem for the US Treasury will get pretty severe by the mid-2010s.

http://alephblog.com/2009/11/13/the-forever-fund/#comments

Any chance of you doing portfolio updates going forward? I’d be curious to see if you still like investment grade fixed incomes, given the rally.

Matt, I would be underweighting investment grade and high yield credit at present.

As for railroads, I own Canadian National – unlike US railroads, it goes coast to coast, and slowly they are picking up more business in the US as well.

Long CNI

http://alephblog.com/2009/11/10/my-visit-to-the-us-treasury-part-7-final/#comments

Did none of the bloggers raise the question of the GSEs? I can understand Treasury not wishing to tip their hands as to their future, but I would have expected their status to be a hot topic among the bloggers.

I also don’t buy the idea that the sufferings of the middle class were inevitable. Over the past 15 or so years the financial sector has grown due to the vast amount of money that it has been able to extract. Where would we be if all of those bright hard working people and capital spending had gone to the real economy? I’m not suggesting a command economy, but senior policymakers decided to let leverage and risk run to dangerous levels. Your comment seem to indicate that this was simply the landscape of the world, but it seems more to be the product of a deliberate policy from the Federal government.

Chris, no, nothing on the GSEs.  There was a lot to talk about, and little time.

I believe there have been policy errors made by our government – one the biggest being favoring debt finance over equity finance, but most bad policies of our government stem from a short-sighted culture that elects those that govern us.  That same short-sightedness has helped make us less competitive as a nation versus the rest of the world.  We rob the future to fund the present.

http://alephblog.com/2009/11/07/my-visit-to-the-us-treasury-part-6/#comments

it’s not clear from your writing whether the treasury officials talked to you about the GSEs or whether your comments (in the paragraph beginning with “When I look at the bailouts,”) are your own. could you clarify?

q, That is my view of how the Treasury seems to be using the GSEs, based on what they are doing, not what they have said.

http://alephblog.com/2009/10/31/book-review-nerds-on-wall-street/

“There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.”
David, take a look at equilcurrency.com.

Jesse, I looked at it, it seems rather fanciful.

http://alephblog.com/2009/10/27/book-review-the-predictioneers-game/#comments

David,
Just wondering if there’s an omission in this line:

“The last will pay for the book on its own. I have used the technique twice before, and it works. That said, that I have used it twice before means it is not unique to the author.”

Did you mean to write “that I have used it doesn’t mean it is not unique….”

In the event it is, I’ll look it up in the book, which I intend to buy anyway.
Otherwise, may I request a post that details, a la your used car post,your approach to buying new cars?

Saloner, no omission.  I said what I meant.  I’ll try to put together a post on new car purchases.

http://alephblog.com/2009/10/22/book-review-the-bogleheads-guide-to-retirement-planning/

thanks for the book review. it sounds like something that i could use to get the conversation started with my wife as she is generally smart but has little tolerance for this sort of thing.

> unhedged foreign bonds are a core part of asset allocation

i agree in principle — it would be really helpful though to have a roadmap for this. how can i know what is what?

I second that request for help in accessing unhedged foreign bonds – Maybe a post topic?

JK, q, I’ll try to get a post out on this.

http://alephblog.com/2009/10/20/toward-a-new-theory-of-the-cost-of-equity-capital-part-2/#comments

to the point above, basically just an IRR right?

JRH, I don’t think it is the IRR.  The IRR is a measure of the return off of the assets, not a rate for the discount of the asset cash flows.

When I was an undergraduate (after already having been in business for a long time), I realized that M-M was erroneous, because of all the things they CP’d (ceteris paribus) away. For my own consumption, I went a long way to demonstrating that quantitatively, but children, work and family intervened, and who was I to argue with Nobel winners.

But time, experience and events convince me that I was right then and you are right now. As you’ve noted the market does not price risk well. In large part this is due to a fundamental misunderstanding of value. The professional appraisal community has a far better handle on this, exemplified by drawing the formal distinction between “fair market value as a going concern”, “investment value”, “fair market value in a orderly liquidation”, “fair market value in a forced liquidation” and so on. One corollary to the foregoing is one of those lessons that stick from sit-down education, that “Book Value” is not a standard of value but rather a mathematical identity.

Without going into a long involved academic tome, the cost of capital (and from which results the mathematical determination of value per the income approach) has a shape more approaching that of a an asymmetric parabola (if one graphs return on the y axis and equity debt weight on the x.).

If I was coming up with a new theorem, risk would be an independent variable. So for example:

WAAC = wgt avg cost of equity + wgt avg cost of debt + risk premium

You’ll note the difference that in standard WAAC formulation risk is a component of the both the equity and debt variable – and practically impossible to consistently and logically quantify. Yes, one can look to Ibbottson for historical risk premia, or leave one to the individual decision making of lenders, butt it complicates and obscures the analysis.

In the formulation above, cost of equity and cost of debt are very straightforward and can be drawn from readily available market metrics. But what does risk look like? Again if you plot risk as a % cost of capital on the y axis and on the x axis the increasing debt weight, on a absolute basis risk is lowest @ 100% equity. From there is upwards slopes. However, risk however is not linear, but rather follows a power law.

The reason risk follows a power law is that while equity is prepared to lose 100%, debt is not. Also, debt weight increases IRR to equity (in the real world) contrary to MM. Again, debt is never priced well, because issuers don’t understand orderly and forced liquidation, whereby in “orderly”, e.g. say Chapter 11,recoveries may be 80 cents on the dollar, and forced, e.g., Chapter 7, 10 cents on the dollar. One really doesn’t begin to understand the foregoing until you’ve been through it more than a few times.

So in the real world, as debt increases, equity is far more easily “playing with house money.” A recent poster child for this phenomena is the Simmons Mattress story. In the most recent go round equity was pulling cash out (playing with house money) and the bankers were either (depending on one’s POV) incredibly stupid for letting equity do so, or incredibly smart, because they got their fees and left someone else holding the bag. I’m seen some commentators say that ‘Oh it was OK because rates were so low, the debt service (the I component only) was manageable.’ Poppycock; sometime it’s the dollar value and sometimes it’s the percentage weight and sometimes it is both.

But you’ve already said that: “company specific risk is significant and varies a great deal.” I would also add that – or amplify – that in any appraisal assignment the first thing that must be set is the appraisal date. Everything drives off that and what is ‘known or knowable’ at the time.

Gaffer, thanks for your comments.  I appreciate the time and efforts you put into them.  This is an area where finance theory needs to change.

http://alephblog.com/2009/10/10/pension-apprehension/

I have a DB plan with Safeway Stores-UFCW, which I’ve been collecting for a few years. I’m cooked?

Craig, not necessarily.  Ask for the form 5500, and see how underfunded the firm is.  Safeway is a solid firm, in my opinion.

Long SWY

http://alephblog.com/2009/09/29/recent-portfolio-actions/#comments

David, I am curious about your rebalancing threshold. Do you calculate this 20% threshold using a formula like this:

= Target Size / Current Size – 1

I have a small portfolio of twenty securities. A full position size in the portfolio is 8% (position size would be 1 for an 8% holding). The position size targets are based generally on .25 increments (so a position target of .25 is 2% of the portfolio and there are 12.5 slots “available”). I used that formula above for a while, but I found that it was biased towards smaller positions.

Instead I began using this formula:

= (Target – Current Size) / .25

So a .50 sized holding and a full sized holding may have both been 2% below the target (using the first formula), but using the second formula, they would be 8% and 16% below the target respectively. I found this showed me the true deviation from the portfolio target size and put my holdings on an equal footing for rebalancing.

I was curious how you calculated your threshold, or if it was less of an issue because you tended to have full sized positions. For me, I tend to start small and build positions over time. There are certain positions I hold that I know will stay in the .25-.50 range because they either carry more risk, they are funds/ETFs, or they are paired with a similar holding that together give me the weight I want in a particular sector.

Brian, you have my calculations right.  I originally backed into the figure because concentrated funds run with between 16-40 names.  Since I concentrate in industries, I have to run with more names for diversification.  I don’t scale, typically, though occasionally I have double weights, and rarely, triple weights.  The 20% band was borrowed from three asset managers that I admire.  After some thought, I did some work calculating the threshold in my Kelly criterion piece.

A fuller explanation of the rebalancing process is here in my smarter seller pieces.

http://alephblog.com/2009/09/04/tickers-for-the-latest-portfolio-reshaping/

Have you seen DEG instead of SWY?
Extremely able operator. Some currency diversification as well. I’d like to know your thougts.

MLS, I don’t have a strong idea about DEG – I know that back earlier in the decade, they had their share of execution issues.  It does look cheaper than SWY, though.

Long SWY

http://alephblog.com/2009/06/11/problems-with-constant-compound-interest-2/

I like your post and want to comment on a couple of items.  You point to the peak of the 1980’s inflation rates and the associated interest rates.

Robert Samuelson wrote a book called The Great Inflation and it’s Aftermath.   http://tiny.cc/z9H9V

Basically you can explain a great deal the US stock market history of the 40 years by the spike in interest/inflation until the mid 80’s and the subsequent decline.  Since you need an interest rate to value any cash flow, the decline in interest rates made all cash flows more valuable.

The thing that is odd and sort of ties this together is the last year.  After interest rates crossed the 4% level things started blowing up.  The amount of debt that can be financed at 3% to 4% is enormous.  That is, as everyone knows, on of the root causes of the housing bubble.  Anyway, starting last year, treasury interest rates continued to decline and all other rates went through the roof.

I was looking at this chart yesterday.  _ http://tiny.cc/eCZzF The interesting thing to me was that when the system blew up, treasury rates continued to decline and all non guaranteed debt rates went through the roof.

Most of this is obvious and everyone knows the reasons.  The one thing that seems novel is thinking of this as the continuation of a very long secular trend — or secular cycle.  I don’t want to get overly political, but the decrease in inflation/interest in the 90’s to the present was a function of productivity/technology and Foreign/Chinese imports.  Anyway, one effect of these policies was a huge rise in asset values, especially in the FIRE (finance, insurance, real estate) sector of the economy at the expense of our industrial and manufacturing sectors.  This was also a redistribution of wealth from the rust belt to the coasts.

It is much more complicated then the hand full of influences I mentioned, but the one thing i haven’t seen discussed a lot is the connection of the current catastrophe to the long term decline in inflation/interest rates since the mid/late 1980’s.  If you think about it, declining interest rates increase the value of financial assets and are an enormous tailwind for finance.  I suppose if you had just looked at the curve, it would have been obvious that the trend couldn’t continue.  Prior to the blowup, there were lots of people financing long term assets with short term, low interest rate liabilities. That was a big part of the basic playbook for structured finance, hedge funds, etc.

The reason that the yield spread exploded is well known.  Here is a snippet from Irving Fisher.  http://capitalvandalism.blogspot.com/2009/01/deflationary-spirals.html

CapVandal – Great comment.  A lot to learn from here.  I hope you come back to blogging; you have some good things to say.  Fear and greed drive correlated human behavior.

Some people are hard to buy gifts for.  With books, there is often a trade-off between books that say a lot, and those that people are willing to read.  One book that I think hits the sweet spot is 100 Minds That Made The Market, by Ken Fisher.

Why do I think this?  This book is 100 little books in one volume.  You can pick this book up for five minutes, and read a well-written 3-4 page biography of person who has had a significant impact on how our markets work today.  Then you can put it down, get back to work, and think that you have learned something significant.

When I read this book back in the late ’90s, I recognized about half of the people who were profiled in the book.  I felt that I learned a lot in a short amount of time.

Consider the categories of people that the book deals with:

  • The greats of the distant past (late 18th Century to mid 19th Century)
  • Investment Writers and Data Publishers
  • Famous investment bankers
  • Bankers
  • Central Bankers
  • New Deal Regulators
  • Swindlers, Scamps, Rogues, and Thieves
  • Statisticians, Economists, and Nuts
  • Successful  Entrepreneurs and Speculators
  • Unsuccessful Entrepreneurs and Speculators
  • Notable Oddballs
  • And more

The biographies are well-written and concise.  They illustrate eras in Western, and in particular, American Capitalism.  Many of the names are obscure in the present day, but after you read the biography, you have no doubt that they were important to their era.

I enjoyed the book greatly, and hope that you will too.  If you want to buy it, you can get it here: 100 Minds That Made the Market (Fisher Investments Press).

Full Disclosure

I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.  Win-win.

November
2009
December
2009
Comments

Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up.

Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating.

They think that the labor market is getting
worse but at a very slow rate.

Activity in the housing sector has
increased over recent months.

The housing sector has shown some
signs of improvement over recent months.

No real change.
Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.Shading up income growth, shading down unemployment.
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.Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. More shading unemployment downward.

———————————————————————————————————

Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period.Financial market conditions have become more supportive of economic growth.Sentence moved from higher up in the statement. More optimistic.
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.
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 contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.
No real change.
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.
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.
No change.
In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery
and to preserve price stability.
A useless sentence eliminated.
The Committee will maintain the target range for the federal funds rate at 0 to ¼ 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 ¼ percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. This gives you the trigger for when they will raise the Fed Funds rate. As I said last month, watch capacity utilization, unemployment, inflation trends,
and inflation expectations.
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.To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. No real change. We knew this from prior announcements.
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.
Sentence no longer needed.


—————————————————————————————————

In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term
Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap
arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities
Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by
all other types of collateral.
New sentence. This was well-disclosed in advance. That part of the Fed balance sheet has been shrinking for some time. The real elephant is what the Fed does with the MBS.
As previously announced, the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009. Treasury program is done.
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.
A useless sentence eliminated.
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 prepared to modify these plans if necessary to support financial stability and economic growth.No real change. Another useless sentence.
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.


Comments

  • The FOMC sees unemployment and GDP growth improving in the near term.  I would not be so sure.
  • Ignore the long new sentence about the liquidity programs going away.  We knew that was coming.  The critical issue at present is what the Fed will do with all of the MBS it owns.  There is no easy way to shrink that without affecting the long end of the yield curve negatively.
  • The Fed is more optimistic about the financial markets, but I am not sure why.
  • As I said last month, the trigger for when the Fed will raise the Fed Funds rate is this:
    • watch capacity utilization
    • unemployment
    • inflation trends
    • inflation expectations.

I’m not likely to be able to comment when the FOMC announces its lack of action today.  The Fed will continue to keep policy loose, while slowly closing down ancillary lending programs, and bloating their balance sheet with mortgage backed securities [MBS] guaranteed by Fannie and Freddie, and ultimately by the Federal Government, which gets the profit or loss from the Fed’s financing (of the mortgages at 0% interest for now).

Going back to last night’s post, strip away the complexity, and what you have is the Federal Government intervening in the MBS market, and forcing down yields, at a cost of indebting future generations (should they decide to make good on those).  This will eventually fail as a strategy.  Unless the Fed wants to keep its balance sheet permanently larger, yields on MBS will rise when they stop buying.  And, the moment that they hint that they will start unloading, rates will back up significantly.  They are too large relative to the MBS market.

They can engage in fancy strategies where they try to remove policy accommodation either through rates or the size of the balance sheet, but one thing Fed history teaches us is that the Fed doesn’t know what will happen when a tightening cycle starts, but usually it ends with a bang — some market blowing up.

Two more notes: it doesn’t matter who the Fed Chairman is.  The structure of the Fed matters more than the man.  That said, Bernanke has promised transparency but has not given it at the most crucial times — those dealing with the bailouts.  All of the talk to audit/limit/shrink/end the Fed comes from abuse of those powers, which should be done by the Treasury and Congress, so that voters can hold them accountable.

Finally, one quick note on regulation of financials.  Laws don’t mean squat if regulators won’t enforce them.  There was enough power in prior laws for regulators to have curbed all of the abuses.  The regulators did not use their powers then; what makes us think that they will use expanded powers?  Regulatory capture has happened in the banking industry; regulators will have to get ugly with those that they regulate if they genuinely want to regulate.

This includes changing risk-based capital formulas to remove the advantage of securitizing debt.  I’m not saying penalize securitization, but put it on a level playing field so that the inherent leverage involved in securitization gets a higher capital charge relative to straight debt of a similar risk class.

That also includes not letting banks fudge asset values to give the appearance of solvency, but more on that tonight.  I gotta fly now on business.

Twenty years ago, I hit upon the idea that I should analyze entitlement programs by assuming that the dividing wall between the trust funds and the government did not exist.  That’s a useful idea, because OASDHI [Old Age, Survivors, Disability, Health Income] taxes and benefits are statutory in nature, and not guaranteed.  The “trust funds” are a legal fiction.  So, consider the entitlement programs as an extension of the federal budget, because that is what they are.

Time for a new blurring of distinctions.  The two parties in this case are the US Government and the Federal Reserve.  Let’s pretend they are one entity.  Why is this reasonable to pretend this?

  • Profits from the Federal Reserve go to the US Treasury.
  • The US Government appoints most of the critical members of the Fed’s governing board.
  • During the crisis, the Fed and Treasury worked hand in glove to achieve their ends.
  • The Fed takes actions that an ordinary Central Bank would not.  Why bail out Bear Stearns and AIG?  Why aid Fannie and Freddie?  Why buy mortgage-backed securities?  There is no reason for a central bank to own anything but the highest quality securities.

Much as Bernanke and others have protested about central bank independence, they have acted like an arm of the Treasury in most of 2008-2009.  So let’s stop the act, or let’s bring back men in the nature of Volcker, Martin and Eccles.  Tell Congress and the Executive that we are going to preserve sound money, and if they don’t like it, don’t reappoint us.

But suppose we continue on in the limp-wristed way that we have been going.  Maybe the US doesn’t have a Central Bank.  Maybe it has an additional financing arm.  Think of the Dollars you hold as o% 0-day commercial paper.  Think of the Fed encouraging banks to lend to them for the rate of less than 0.25%/year annualized on an overnight basis.  Consider their purchases of longer dated securities as similar to that of a hedge fund, admittedly a clumsy one, pasted onto our government.

So long as there is slack labor, slack capital, and slack resources, the cheap lending rates to the US government can persist.  But in the ’70s resources were not slack, and inflation occurred while there were recessionary conditions.  If the global economy is markedly stronger than the US economy, that could be our situation again — stagflation.

Central banks by their nature abhor two risks, credit risk, and lending long.  In the present environment, the Fed is doing both. Bagehot said to lend against impeccable capital at a penalty rate.  In the current crisis, the Fed, far from being independent, is absorbing credit risk, and lending long risk, and is doing so without abnormal compensation, indeed the compensation is sometimes subpar.

My sense is that when the Fed stops its purchases of mortgage bonds in the next few months, the longer-dated debt markets will cease to be so friendly, and rates will rise.  That is what should be happening.  It is risky to lend for long periods in US Dollar terms, and those that do so should be amply rewarded.

There are many who are arguing that the US should borrow more and spend with abandon.  They are fools; fools believe that the government can create prosperity through legislative or regulatory actions.  As it is, the creditworthiness of our government declines as we use its credit to bail out private interests.

We might not be as bad off as Greece, but what assurance do creditors of the US have that they will be repaid in purchasing power similar to that which they lent?  I don’t see the assurance.  Better to invest in the debt of non-PIIGS euro-debt. [PIIGS — Portugal, Ireland, Italy, Greece and Spain]

There is a lot of stress in the global economy as it attempts to reconcile economies that must export, no matter what, with those that must run deficits, no matter what.  The exporters take in debt from the nations that borrow in order to make books balance.  I don’t know when that system will break, but it will break, delivering losses to the exporters, much as that happened in the era of mercantilism.

That said, when the exporters lose, so will the countries that relied on the cheap financing, including the US.  Interest rates will be higher, and the US economy will be that much weaker, aside from exporters benefiting from a weaker dollar.  This may not take place for years, but it will eventually happen.

In other words, the cheap finance that the US has will eventually fail.  I don’t know when that will be, but eventually the world will tire of handing over goods for promises.

Tonight’s book reviews are of two very different, yet very similar books: Fire Your Stock Analyst!: Analyzing Stocks On Your Own (2nd Edition) and, Far from Random: Using Investor Behavior and Trend Analysis to Forecast Market Movement.

Why different?  Well, the first relies on fundamental analysis, and the second on technical analysis.  Why similar?  They are both very single-minded in the way they present how to win in investing.

There are other differences, though.  Fire Your Stock Analyst, by Harry Domash, is a very complete fundamental investing guide for both value and growth investors.  Very complete, to the degree that most average investors will not be able to do all that Harry recommends.  There is a lot to do, and not all of it is of highest importance in my opinion.  Many professional investment shops ignore steps that he prescribes.  I don’t do half of what he prescribes, and I do better than most.  Also, much of what he prescribes is not applicable to financial stocks, but he does not seem to realize that.

Far from Random has a different flaw.  It spends 75% of the book talking about what does not work, and only 25% on what he thinks works.  In the last quarter of the book, the author asserts that trend channel analysis works  through giving stylized examples.  There are no academic studies to prove the point, or, audited track records, as Michael Covel is fond of.  (This makes me want to recommend Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets; there is more logic behind it than Far from Random.)

Who could benefit from these books:

With Fire your Stock Analyst, someone who wants an introduction to fundamental analysis could benefit.  Far from Random, I’m not sure anyone could benefit.  There are much better books on technical analysis.

Full disclosure:  Publishers send me books for free.  I review some of them, the ones that I think are most interesting.  If you enter Amazon through my site and buy anything, I get a small commission.  Don’t buy anything you don’t want.  I do this as a service to readers, and am not looking for remuneration as much as tips for what I have written more generally.

It is getting close to the time for my next portfolio reshaping, and so I look at my industry models, because industry performance is critical to the performance of stock portfolios.  Here is the main model that I use:

This model uses industries from Value Line, and as such, the rankings incorporate earnings surprise, earnings momentum, price momentum, and analyst opinion, and a few other things as well.  But here is another model that is mostly intermediate-term (10 month) price momentum:

These ranks are based off of the industry ranks in the S&P 1500.  But both of these rankings tell a similar story.  As I have said before, the red zone is for momentum players and the green zone for mean-reversion players (usually, value investors).  Given the relatively hard run-up over the past nine months, I am inclined to favor safety over aggression.  I am considering more stocks in the green zone, which has more stable defensive stocks, than the red zone, which has stocks that will do well if the economy has a strong recovery.

All that said, I tend to be eclectic — I look for industries where conditions can’t get much worse, and industries where the current trends are under-discounted.

What you want to do here is your choice, but I am aiming at the “green zone” and will lean against the idea of a sharp recovery.

James Picerno writes the popular blog  The Capital Spectator. One of his main topics is asset allocation.  He has a book coming out in February called Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.

Asset allocation is important.  It determines much of the returns investors will receive.

This book goes into a long discussion of modern portfolio theory, and the author finds MPT to be valuable, but needs to be supplemented by other factors other than the market portfolio.  Market capitalization, individual stock valuation, and overall market cheapness/dearness plays a role in asset allocation.  This rectifies the main complaint of value investors regarding asset allocation, in that relatively lower prices should lead investors to allocate more to an asset class.

There are elements of my own view here, which says that asset allocation should look at sustainable yield levels adjusted for the likelihood of those yields occurring, and the potential for downside risk.

Also, the author spends time on the special situations of asset allocation for the individual or institution — how old you are, or, what industry you are in.  I experienced that at one firm I was at where I managed the profit sharing assets.  We underweighted financials because our firm did well when financials did well.  We did not want employees worrying about their assets if the firm was having a bad year.

I recommend the book, but it is not a popular book.  Average people will not get a lot out of it.  The book requires a moderate knowledge of finance to make it valuable to the reader.

Who would benefit from this book: those who have a strong interest in asset allocation, and like or are willing to tolerate a decent amount of academic discussion of modern portfolio theory.  As academic views go, this is a better one.  That said, many people will find this book a tough slog because they don’t want to deal with the academic arguments.

If you want to buy it, you can get it here: Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor.

Full disclosure: I earn a small commission from Amazon for anyone entering Amazon through my site, and buying anything there.  Your price does not rise from my commission.  Don’t buy anything you don’t want to buy if you want to reward me for my writing.  Only buy what you need if Amazon offers you the best deal.

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