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Archive for January, 2011

The Best of the Aleph Blog, Part 3

Saturday, January 29th, 2011

In hindsight, I’m not happy about what I wrote August-October 2007.  As the bubble built I criticized it in fainter ways than it deserved.  Given the implosion of money markets, I should have been more bearish.  Part of that faintness stemmed from the stigma that came to bears in that era.  But here are articles from that era:

More Slick VIX Tricks

Attempts to explain the relationships between implied volatility and equity, and also corporate bonds.

Speculation Away From Subprime, Compendium

Subprime was getting blamed, but there were many areas where markets were very speculative at the time.  I call them out here, and I was not often wrong.

The FOMC as a Social Institution

I got a lot of publicity over this one.  I may do another one in 2011.  It is important to understand that those on the FOMC are not geniuses.  They are bright, but slaves to a view of the world that is not accurate.  The Fed drinks their own Kool-aid.

The Current Market Morass

As the markets declined, there were a lot of signs of the oncoming trouble that were ignored.  Following market liquidity was an aid to avoiding some of the crisis that was to come.

The Collapse of Fixed Commitments

I anticipate a lot of what will happen in the next 18 months, while not taking that much action.

A Moment of Minsky?

I get some publicity for being a little ahead of the crowd in suggesting that Minsky was correct in the way he viewed economic cycles.  I also anticipate what will happen one year later.

Sticking with the Short End, or, The Short End of the Stick

In the midst of the money market panic, the Fed added liquidity, whether it was right to do so, or not.

The Four Rules of Currency Intervention

These are the rules regarding currency interventions, ignored by hubristic governments that go their own way, and lose value as a result.

Ten Years From Now

In this article, I attempted to estimate what variable drove stock market performance in aggregate ten years out.  I discovered:

My Upshots

  1. Note that it was a bullish period, and that stocks did not lose nominal money over a ten-year period to any appreciable extent.
  2. Stocks almost always beat bonds over a ten-year period, except when inflation and real interest rates 10 years from now are high.
  3. Investing in stocks during low interest rate environments can be hazardous to your wealth.
  4. Watch for inflation pressures to protect your portfolio. Stocks get hurt worse than bonds from rising inflation.
  5. Inflation and real rate cycles tend to persist, so when you see a change, be willing to act. Buy stocks when inflation is cresting, and buy short-term bonds when inflation is rising

If Hedge Funds, Then Investment Banks

I argued that if many hedge funds had mismarked assets, then many investment banks would as well.  Definitely worked out that way, but bigger than I expected.

Society of Actuaries Presentation

This was a forty minute talk that I gave to the Society of Actuaries at their Annual Meeting.  Very big picture, and very prescient.  Worth a look if you have 15 minutes sometime.  I put a lot of work into this one.

Stocks Don’t Care Who Owns Them; Social Insurance and Private Markets Do Not Mix

Every now and then, some crank like Bill Clinton comes up with the idea that “all we gotta do is invest the Social Security trust funds in the stock market, and the funding problem will go away.”  This is the antidote to that malarkey.

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But, as the markets approached their recent highs during this period, I was skeptical, but insufficiently skeptical.  Further, I blew it on Deerfield, National Atlantic, and my view of how FOMC policy would evolve.  So for this era of my blogging, I have my regrets — I should have done better, even though I got some interesting things right.

On Human Fertility

Saturday, January 29th, 2011

Fertility

When I gave a presentation to the Society of Actuaries three years ago, I was amazed that the Total Fertility Rate had fallen to 2.9 globally.  I am now amazed that the CIA Factbook estimates that rate at 2.5 for the world on average.

Background: recently I had a disagreement with my father-in-law who is brighter than me.  I alleged that global population growth was declining more rapidly than the politicians/activists were stating.  I suggested that global population would peak out around 2040 at a lower level than many suggest — less than nine billion.

He is brighter than me, but I am more street-smart.  Demographers are trailing indicators, and are slow to revise their forecasts.  There are many reasons why the total fertility rate is declining:

  • Educating females makes many of them want to have fewer kids, whether the reason is pain, effort, wanting to work outside the home, etc.
  • Contraception is more widely available.
  • The marriage rate is declining globally.  Willingness to have children is positively correlated with marriage.
  • Governments provide an illusion of support, commonly believed, that the government can support people in their old age, so people don’t have kids for old age support.

I don’t aim for controversy; it finds me as I try to explain reality.  But the most frosty time I have had in economics was 27 years ago, when I argued to my development economics class that people in the third world were rational in the number of kids that they had, because they had no way to save for their old age.  This was totally at variance with the development economics literature, but was utterly fact-based in terms of the way people behaved. (I got a friendlier reception preaching the Gospel on the UC-Davis quad.)  As people in developing countries have found more peace and stability, and markets allowing for long-term investment, family sizes have declined.

It is my assertion that estimates of peak global population will come sooner than most expect, and at lower levels.  But what would happen to the economy of a world where the total population peaks out and starts to decline? It will be a global Japan.  Per capita growth will slow, and those who are younger will find fewer opportunities to advance as oldsters hang onto their jobs longer.

Personally, I believe that mankind can overcome resource limits.  We’re smart, but we don’t figure out ways to overcome limits until we are forced to do so.  Thus I am not worried about overpopulation or shrinking population.

Mean Reverting Momentum, or, a Dead Cat Bounce?

Friday, January 28th, 2011

There have been debates between those who argue for momentum and mean-reversion.  I say, “Why Choose? You can benefit from both.”  Stock performance tends to persist after 12 months of outperformance, and tends to mean-revert after 48 months of underperformance.  Tonight’s screen reveals 33 stocks that were in the bottom quartile over the last 4 years, but in the top quartile over the last year, with market capitalization over $100 million.

A few of the larger stocks I look at here like Citigroup and AIG make me sick, but that is a part of the exercise.  If you don’t  get a “gag reflex” from some stocks as a value investor, you may not be taking enough risk.  I am certainly not a fan of the financial guarantors, but they are here.  They survived, at least for now.

I would would consider the following stocks to be a “disbelief” portfolio.  High risk, high opportunity.  There are few people that wake up in the morning and say, “This is the portfolio that I want to own.”

Mean Reverting Momentum

Too many financials.  Too many overlevered, dodgy companies.  But maybe they will do well over the next month.  The probabilities favor it, but I will try to measure it over the next month.  Portfolios that outperform rarely look normal.

Redacted Version of the January 2011 FOMC Statement

Wednesday, January 26th, 2011
December 2010January 2011Comments
Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment.Information received since the Federal Open Market Committee met in December confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions.Shades their view of unemployment to include the phenomenon of discouraged workers.
Household spending is increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.Growth in household spending picked up late last year, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.Shades their view of the consumer upward, but I fear for no good reason.
Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls.Business spending on equipment and software is rising, while investment in nonresidential structures is still weak. Employers remain reluctant to add to payrolls.Shades their view on business spending up, but I think they are too early.
The housing sector continues to be depressed.The housing sector continues to be depressed.No change.
Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward.Although commodity prices have risen, longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.Notes the rise in commodity prices, and continues to misread both inflation and inflation expectations.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.No change.
Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.Translation: we have no idea why our policy is not working, and we don’t know what to do about it.  Monetary policy works with long and variable lags, so we won’t say that our policy isn’t working.  It’s just slow in taking effect.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November.To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November.No change.
The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.No real change.

They will stealth-fund the US Government to the tune of $600 Billion.

The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.No change to this meaningless sentence. What? You would do otherwise?
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, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for 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, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.No change.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.No change to this meaningless sentence.

Would you do otherwise?  If we know that the opposite is impossible, why have the sentence at all?

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; 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; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.Changing of the guard with the regional Fed Presidents.
Voting against the policy was Thomas M. Hoenig. In light of the improving economy, Mr. Hoenig was concerned that a continued high level of monetary accommodation would increase the risks of future economic and financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.No dissent.  Interesting because because many pundits speculated over how many would dissent, such as Kocherlakota, Plosser and Fisher.

Comments

  • They shaded their views up on business and consumer spending, and commodity prices, and down on labor unemployment (i.e. unemployment will be harder to eradicate than they used to think.
  • No dissent this time; perhaps the new regional Fed Presidents are giving the Board members a pass at this first meeting of 2011.
  • They highlight that they have a “statutory” mandate, and a “dual” mandate.  They are trying to say that they are required by Congress to do these things, and that it is a tough job.  The flip side is that they admit the Congress has the right to tell them what to do, which Ron Paul may make clear as the Chair of the House’s subcommittee on Monetary Policy.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
  • Beyond that, if they succeed, how will it be received on Main Street, especially if price inflation is not accompanied by increases in employment, or is accompanied by higher interest rates or lower stock prices?  Stagflation is not popular.
  • That said the economy is not that strong.  In my opinion, policy should be tightened, but only because I think quantitative easing actually depresses an economy.  It does the opposite of stimulate; it helps make the banks lazy, and just lend to the government.
  • The question is this: will the mechanisms of credit transmit inflation to goods and services?  So far, it has not.  Lowering the policy rate does little to incent borrowing when enough people and financial institutions are worried about their solvency.
  • They have no idea why their policy is not working, and they don’t know what to do about it.  Monetary policy works with long and variable lags, so they won’t say that their policy isn’t working.  It’s just slow in taking effect.

The Best of the Aleph Blog, Part 2

Wednesday, January 26th, 2011

This second period goes from May to July 2007.  Here we go!

A Modest Proposal to Raise Taxes on Mr. Buffett (and me)

Points out how the problems with the tax code are really more about defining income rather than tax rates.  It is easy for the rich to defer/shelter income — far better to tax increases in net wealth, and tax all people like traders, who are marked-to-market at the end of each fiscal year.

Talking to Management

One of my “labor of love” pieces written for RealMoney — five parts, dealing with how to interrogate management teams.  A lot of the game is asking the wrong questions, and seeing how management answers them.

Back From Bermuda

Uh, this post made me persona non grata in Bermuda for 2-3 years.  I think I could return now.  Part of the difficulty was that I was not told that sessions were supposed to be “off the record.” That said, my blog was the most popular blog in Bermuda for a day.  Apologies, HF, and thanks for inviting me; sorry to embarrass you.

Thinking About What Might Blow Up

Fascinating to see all of the markets that were going to blow up within 15 months trotted out for display.  Also, the basics of my theory on how one detects bubbles.

What Brings Maturity to a Market

Failure brings maturity to a market; risk-based pricing follows the realization of risk.

PIMCO in Theory and Practice

Important piece, because people watch PIMCO on the tube, and think that they make money off of their economic predictions, which are often wrong.  PIMCO is really a bunch of intelligent fixed income quants, who make their money off of mispriced out-of-the-money volatility.

Private Equity: Short Term versus Long Term Rationality

Analyzing comments of Cramer and others as to when the Private Equity bull market would end.

Speculation Gone Wrong, Or, Tops are a Process

I was commenting on how it is hard it is to call a top, because they are processes rather than events.  Who can tell how long foolish liquidity can last?

Trailing E/P as a Function of Treasury Yields and Corporate Spreads

Part one on my “Fed Model.”  Analyzing secondary factors in stock and bond performance.

Subprime Credit, Illiquidity, Leverage, Contagion and Concentration

I suggested that a small number of players would get hit by losses in subprime.  True enough, but what I did not know was how much risk was still being held by investment banks.

Efficient Markets Versus Adaptive Markets

A post I cite frequently, mainly for the joke at the end, but a post that tries to make the point that markets are not fully efficient, but they are somewhat efficient.

Quantitative Analysis is not Trivial — The Case of PB-ROE

In some environments, PB-ROE and low P/E investing will be similar, but that will not always be true. Do not accept a false simplification, even though it may be true at present. The PB-ROE model is richer, and works in more environments, after adjusting for the limitations listed above. PB-ROE is a very useful tool, and not “gobbledygook.”

Defends the PB-ROE model while admitting its limitations.

The “Fed Model”

Defends a version of the dividend discount model, and shows the simplifications that the “Fed Model” imposes are unrealistic, while showing that a more realistic model can add value over the long run.

A Fundamental Approach to Technical Analysis

Tries to explain how an intelligent fundamental investor would think about technicals, particularly in markets that are less liquid.

Twenty-Five Ways to Reduce Investment Risk

This article got me an invite to write an article for a Canadian business magazine.  But this article encapsulates the many ways I think about risk in investing.

Dissent on Dividends

Roger Nusbaum ably pointed out how demographics favors an increasing amount of dividends being paid to retiring Baby Boomers.  That is true.  We have ETNs being set up to do that (beware of Bear Stearns default risk), and hedge fund-of-funds crowding into strategies that synthetically create yield.  Beyond that, we have Wall Street creating funky yield vehicles that gyp facilitate the yield needs of buyers (while handing them capital losses).

My main point is this.  Approach yield the way a businessman would.  If you see an above average yield, say 4% or higher, ask what conditions could lead them to lower the yield. History is replete with situations where companies paid handsome dividends for longer than was advisable.

Back in 2002, I heard Peter Bernstein give an excellent talk on the value of dividends to the Baltimore Security Analysts Society.  At the end, privately, many scoffed, but I thought he was on the right track.  I still like dividends, but I like businesses that grow in value yet more.  Aim for good returns in cash generating businesses, and the dividends will follow.  Stretching for dividends is as bad as stretching for yield on bonds.  That extra bit of yield can be poisonous, leading to capital losses far greater than the incremental yield obtained.

Dividends are good, but they are a very imperfect way to approach the market.

Is the S&P 500 30% undervalued?

A somewhat whimsical piece that looked at implied equity volatility alone, and suggested that either the equity market was low, or equity volatility was high.  The truth was neither.  Equity volatility would blow out and go higher still, along with credit spreads.  Fortunately I was not dogmatic about my model’s conclusions.  I was more bearish in general in late July.

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So much for that era.  It was an interesting time as the bubble neared its apex.

On Bonds in Retail Accounts

Tuesday, January 25th, 2011

One small added benefit that I offer clients is extra advice.  The following would be an example:

By the by, I wonder if I can ask you for some bond advice.  I currently use Fidelity for most of our investments, but have become quite dissatisfied with the breadth of their individual bond offerings.  Can you suggest an alternative that would have better bond breadth along with reasonable bid/ask spreads?  I’m not particularly interested in bond funds as I want to be in control of buy/sell timing for tax purposes.

Regarding bonds – bonds are tough in a retail context.  I grew up spoiled as a bond manager, having never done bonds in a retail context, but reading horror stories from those who were “getting their eyeballs ripped out” by their brokers.  Now, from what I heard, Fidelity was among the better in the retail bond area, but I know that most retail bond areas are the “home for misfit bonds.”  Odd lots, tag ends, bonds that are cheap for a reason… and whatever is allocated to retail for those that can or want to ask for bonds that are newly issued, for which you have to be on your toes, in the right place at the right time.

So, I’m used to the relatively good liquidity available on the institutional side, where once you get up to trading $1 million at a time, the bid/ask spread is around 3 basis points in yield, and selection and other tools are considerable.  If I were forced to manage the bonds of a smaller portfolio (which I did for a prior employer… only had $7 million in bonds), I would do one of the following:

  • Outsource it to Vanguard, PIMCO, or Loomis Sayles.
  • Or, what I actually did… buy Treasuries directly, and use closed-end funds and ETFs to allocate the rest.  If I had less than $20 million of bonds under management, that’s what I as a manager would do… even with the added fees and limited palette of colors to paint with, it beats the costs and limitations of retail bonds.

Now, someday I’d like to bring out a bond fund/strategy, but I want to get this portfolio established first.  Now, I could try to crowdsource the opinions of others, and ask where others think they get a good deal in retail bonds by turning this into a blog post (leaving your name out of course).  Would you like me to do that?

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So with that, I ask my readers, what would you do?  Are there better alternatives for retail investors in bonds?  Let us all know in the comments.

The Best of the Aleph Blog, Part 1

Friday, January 21st, 2011

We’re coming up on the fourth blogoversary for the Aleph Blog next month, so I wanted to do something a number of readers asked me to do — create a list of my best posts, with a little commentary.  I’m going to do it in segments of three months each, so that should be 16 posts by the time I am done.

Our first period goes from February-April 2007.  I wrote a lot on the panic after the Chinese market fell dramatically.  I also got Cemex and Deerfield Capital dreadfully wrong.  But here are the high points of that quarter:

What is Liquidity?

Liquidity is not a simple concept.  Depending on the situation, it can mean different things.

Helpfully, Martin Barnes, of BCA Research, an economic research firm, has laid out three ways of looking at liquidity. The first has to do with overall monetary conditions: money supply, official interest rates and the price of credit. The second is the state of balance sheets—the share of money, or things that can be exchanged for it in a hurry, in the assets of firms, households and financial institutions. The third, financial-market liquidity, is close to the textbook definition: the ability to buy and sell securities without triggering big changes in prices.

Pretty good, but it could be better. These are correlated phenomena. Times of high liquidity exist when parties are willing to take on fixed commitments for seemingly low rewards. Credit spreads are tight. Credit is growing more rapidly than the monetary base. Banks are willing to lend at relatively low spreads over Treasuries. Same for corporate bond investors. And, if you are trying to generate income by selling options, it almost doesn’t matter what market you are trading. Implied volatilities are low, so you realize less premium, while giving up flexibility (or, liquidity).

Yield = Poison

When everyone is grasping for yield, that is the time to avoid it, and aim for capital gains.  That is what I am doing now.

Bicycle Stability Versus Table Stability

A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

The main point there was to ask yourself what happens to your investments if the finance markets ever shut for a while.  Not that that scenario was likely to happen.

Getting Your Portfolio in Better Shape

Getting Your Portfolio in Better Shape, Part 2

Two part series on how I make changes to my portfolio.

Your Money or Your Job! (Or Both!)

Commentary on the buyout of Tribune.  Sadly, I was proven right on this one.  Sam Zell ended up making those at Tribune worse off.

Let Them Eat Yield!

More in the vein of Yield = Poison.  Sage words in a hot fixed income market that was about to blow.

Too Many Vultures, Too Little Carrion

I got it right that subprime auctions were not a sign of strength.

International Diversification

It’s a good thing, but it is not a free lunch.

Why Financial Stocks Are Harder to Analyze

The main problem is that the cash flow statement is meaningless, but I try to put a little more meat on the bones.

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So much for the first three months.  I hope you enjoy this series, as I highlight the best of the past.

The 54th

Friday, January 21st, 2011

This is a little different.  Those who have read me for a long time know that I have a large family — eight children, with five adopted African-American children.  We also homeschool in the great State of Maryland, which, for all of its liberalism (so blue that it is indistinguishable from indigo) is actually quite free and permissive relative to many other states with respect to homeschooling.

Taking it a step further, we live in Howard County, which arguably has the best school district in the State.  Most of our homeschooling friends are not evangelical Christians like us (homeschooling grew among evangelicals, after it being a province of the diplomatic corps, child actors, and the loony left); they are as secular as can be, and have left Howard County public schools for reasons of perceived quality.  Our estimate is that homeschooling in Maryland is predominantly secular.

But, we have nothing but praise for our interactions with the local school district.  They are unfailingly friendly and helpful with the standardized tests, etc.  Our oldest still at home may run on the Track team.

So, when my wife asked me where one of our kids could submit his poem, I said, “We could look into a bunch of kids magazines.  But I could post it at my blog, and it would probably be read by more people.”

So she asked me to post it.  The following was written by my son Matthew, who is a native tinkerer and experimenter.  One more thing to commend homeschooling: boys who learn slowly initially get labeled “learning disabled” in the public schools.  Matthew would have been one of those, but in seventh grade at age 13, he is at grade level on average for all subjects.  Tutoring (homeschooling) has overcome a native disadvantage, and he presses on.

So, it is with pleasure that I present his poem about the 54th Massachusetts Volunteer Infantry.  Recently my wife read a book aloud to the children about them, and Matthew found it inspiring.  With no further ado or comment, here it is:

The 54th

Charge, ye men, charge!
Blood and death all around.
Everything fell, but not the 54th.

Honor and bravery
Gun and cannons roared.
All fell.
But not the 54th.

Into the halls of Fort Sumter.
Into the halls of Fort Wagner.
Many fall.
But not the 54th.

Who is so brave?
Why do they fight?
They fight for freedom.
Who does?
The 54th.

-Matthew C. Merkel

Book Review: The Little Book of Sideways Markets

Thursday, January 20th, 2011

I appreciate the cleverness and rigor that Vitaliy Katsenelson brings to value investing.  Value investing needs its popularizers, and Katzeneson does a very good job in explaining how good investing is a search after quality, growth, and value.

I don’t view value investing quite the same way… my views of value investing are a hybrid of the continuing concern view of Katzenelson and Dreman, and the resource conversion view of Marty Whitman.  Both views are correct, but depend on the market situation to make either one work.

I like the author’s views a lot.  I get to the same place he does, but I don’t follow the exact same procedures.  If you need more data, refer to his prior book, and read it in detail, because it is more comprehensive.

Quibbles

The book is a small improvement over his last book Active Value Investing, with some of his blog essays tossed in.

Who would benefit from this book:

Almost any investor would benefit from this book, aside from those that have read his prior work, Active Value Investing.  That was one of the first books I reviewed here, and it is still a good one.

If you want to, you can buy it here: The Little Book of Sideways Markets.

Full disclosure: This book was sent to me, because I asked for it, after Vitaliy offered it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Why We Don’t Need the Fed

Wednesday, January 19th, 2011

I agree with Daniel Indiviglio about half of the time; I think he is a bright guy, but I disagree with him over certain principles.  He recently wrote a piece called Why We Need the Fed.  I am here this evening to take the opposite side of the argument.

We need to divide the argument, because there are two things being argued about:

  • What do we use as a currency?  Should currency have intrinsic value (privately determined), or is it just a social convention, a forcible notional unit of account (legal tender)?  If it is notional, should we let a bunch of largely unaccountable bureaucrats manipulate its value, ostensibly for our good, but more often for the ends that the bureaucrats prize?
  • How do we regulate banks?  Credit policy is more important than monetary policy.  How does a free society rein in the ability of financial companies from making financial promises that average people don’t realize that they can’t keep.

The second question is more important, because that is what drives our credit booms and busts.  If banks did not engage in maturity transformation, borrowing short and lending long, we would have almost no banking crises.  Crises happen because there is a run on liquidity.  Banks rupture when they don’t have liquidity to pay depositors or repo lines.  Banks that are matched have the short-term assets to liquidate to repay exiting lenders/depositors.

The thing is, we have rarely regulated our banks well in US history, whether we have a central bank or not, and whether our currency is backed or not.  We allow for too much leverage, and too much asset-liability mismatch.

I can hear a banking executive say, “But if you do that, we won’t be able to earn decent returns.  Our ROEs will be in the single digits.”  To which I would say, “Yes, in the short run, until enough excess capacity in banking exits, and your ROE gets into the low single digits because pricing power improves.  This would parallel what happened to the life insurance business when it improved its risk management.”

Indiviglio cits four core functions of the Fed, from the Fed website:

1. Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rate

2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers

3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

4. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system

Let me take them out of order.  On point 2, the Fed played a leading role in the various banking regulators not doing their jobs during the booms in the 1920s, late 80s, and 2000-2007.  As I argued in my piece Who Dares Oppose a Boom?, the incentives are wrong unless regulators are willing to be tough as nails, and stand in the way of a wave of liquidity-driven seeming-prosperity. And in times of moral laxity, like the 20s and the last 30 years, regulators go with the flow.

On point 3, the Fed added to systemic risk again and again 1984-2007 by always loosening rates to defuse the unwinding of some area of overleverage.  This gave the markets a sense of complacency, such that in the last wave of speculation, almost everything was overlevered.  The name for this was the “Greenspan Put;” if the Fed is always willing to provide more liquidity to financial players after a crisis, guess what?  The financial players will take advantage of that.

If I had the power to change the mandate of the Fed, I would change its mandate to restraining leverage in the economy.  Ignore price inflation and labor unemployment — there is little evidence that the Fed has much direct influence there.  Faster growth happens when leverage is low; more disasters happen when leverage is very high, like in the 20s and today.  Debt-based systems are inherently inflexible; equity based systems deal with volatility better, and force managers to seek out organic growth opportunities, as opposed to financial engineering.

Thus on point 1, because the Fed allowed a borrowing bubble to build up twice, in the 20s and today, they ended up poisoning labor employment, because in a period of debt deflation, few companies want to hire on net.  We would have been better off if the Fed had allowed prior minor crises (LDCs, Continental Illinois, Commercial Real Estate, RMBS, Mexico, 97 Asian Panic, LTCM, Tech Bubble) to break ugly, so that bad investments would be liquidated, and capital released to more profitable ventures.  Then the crises would not have grown, and there would have been sufficient fear in the markets to restrain undue speculation.

The bust phase of the credit cycle has to be given the opportunity to do its work, and deliver losses to speculators without the Fed interfering.  If so, there will be less of a tendency to make money through speculation, and more made through organic growth.

Finally, on point 4, you don’t need the Fed to provide those services.  The Treasury could do it itself, or, as in much of US history, it could contract with a private commercial bank to do it for them.  That’s not all that important of a reason for the Fed to exist anyway.

If Not the Fed, Then Whom?

Commodity standards have problems, but so does fiat money.  And the problems are two-sided.  Why should we favor debtors over savers, or vice-versa?  If we view it this way, there is no answer, it only becomes a question of what do we favor as policy?  Hard money and savers, or easy money and debtors?  Is it just a class war thing, because the wealthy have assets and the poor don’t?

Yes it is partly that, but the poor don’t benefit from instability, and instability flows from high overall debt levels, which stem from easy money.  My view is that everyone benefits in the long run from hard money, whether we have a currency board, a tight central bank following a Wicksellian mandate, or yes, a commodity standard.

The nice thing about any of the prior three, is that the currency becomes inelastic, a store of value, allowing for rational calculations by businessmen, allowing the economy to grow more rapidly in the long run, so long as we don’t let bank credit get out of control.

I agree with Indiviglio here — toughen bank regulation.  Whether we have a central bank or not is a lesser matter, but the current Fed has blown it royally, and is no example for what we should have for monetary policy.

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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