The Best of the Aleph Blog, Part 13

This portion goes from February 2010 to April 2010.

Probably the biggest new thing I did at the blog was start “The Rules” series.? Personally, I think all of them are best articles, because they proceed from deeply held beliefs of mine.? So I start with those:

The Rules, Part I

There is no net hedging in the market.? At the end of the day, the world is 100% net long with itself.? Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

The Rules, Part II

Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.? If the speculator is undercapitalized, risks to the financial system rise.

The Rules, Part III

The assumption of normality for asset price changes is wrong in virtually every financial market setting.? The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

The Rules, Part IV

Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform.? (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)? The five stages of grieving apply here.

The Rules, Part V

Massive debt issuance on a sector-wide basis will usually have a slump following it, due to a capacity glut.

The Rules, Part VI

History has a nasty tendency to not repeat, when everyone is relying on it to repeat.

History has a nasty tendency to repeat, when everyone is relying on it not to repeat.? Thus another Great Depression is possible, if not likely eventually.

When people rely on the idea that a Great Depression cannot occur again, they tend to overbuild capacity, raising the odds of another Great Depression.

The Rules, Part VII

In a long bull market, leverage builds up in hidden ways within corporations, and does not get revealed in any significant way until the bear phase comes.

The Rules, Part VIII

Illiquidity is a function of total transaction costs, which can be considered barriers to entry.

The Rules, Part IX

Attempting to control a system changes it.

The Rules, Part X

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.? This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

The Rules, Part XI

Could an investment bank go to junk status?

The Rules, Part XII

Growth in total factor outputs must equal the growth in payment to inputs.? The equity market cannot forever outgrow the real economy.

And that’s the end of the “rules” posts for now.? They express deeply held beliefs of mine.

My next group of posts dealt with banking reform:

Most of it comes down to getting the risk-based capital formulas right, raising capital levels, and most of all avoiding borrowing short to lend long.? The asset-liability mismatch is the core of why banking crises happen, because the liabilities run when asset levels are depressed.

The next group deals with debts and liabilities of nations and other lesser governments:

Debt-based economic systems are inherently inflexible.? Governments that make long-term promises without pre-funding them scam their taxpayers, and those to whom they make promises.? All solutions are ugly once the willingness of a government to pay on its promises is questioned.

What is Liquidity? (IV)

My point is that you can?t take illiquid assets and make them liquid.

Moat, Float, Growth

Warren Buffett labors to preserve the company he has built, so that it can last far longer than he will.? An impossible task, but what is Buffett if not one that does things far beyond what most of us can do?

In Defense of the Rating Agencies ? V (summary, and hopefully final)

I never did go on CNBC for this.? They figured out what I told them: “This wouldn’t make for good television.? It’s too complex.”? But it does come down to my five realities:

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

5 thoughts on “The Best of the Aleph Blog, Part 13

  1. Hi David. I admire the way you think hard about the big picture investment issues, and are willing to deal with them along the entire range from the most concrete to the most abstract issues. However, I’ve been thinking about your related points expressed as 1) “The World net is 100% long with itself” (from Rules Part I) and 2) “We eat dollar weighted returns”, and I want to argue against part of the point I think you are trying to make. My view is as follows. We can distinguish between notional and fungible assets like money, stock, credit, real estate, gold, etc and assets which relate to directly providing for future consumption – in the broadest sense – but are sometimes either non-fungible or not easily fungible. The latter class includes, for example, a young persons ability to provide an hour of skilled labor in the year 2025, a scientists ability to develop a more disease resistant or better tasting apple tree/seed, land that productively grows food, a treatment for a diesease, etc. We should notice that, by definition, the stuff in the future consumption category is what we actually “eat”/use, it is not always investable/fungible/easily priced, and it can come into existence, go out of existence, or get-repriced for many different reasons that are beyond the influence and control of market exchanges – e.g. new inventions, new supply, an unforseen change in demand, etc. In the case of the recent housing bubble, some amount of home price support was based on forecast demand for consumption of a certain type of shelter asset which is going to fall short in reality – not so many people are actually going to consume quite so many large houses. When things shake out, it is not simply a question of who owns fungible assets, who has credit, and who has debt – though that stuff gets well shaken too. The actual consumption picture also changes – some houses sit empty, other land is not developed, resources available for remodeling go unused within the expected time frame, etc.

    The theory I am trying to put forward is consistent with a different understanding of the phenomena described by Reinhart and Rogoff. I would say that part of the reason the economy take long to recover after speculative bubbles is because society as a whole has mis-allocated resources based on faulty consumption/demand projections; both debt repayments and future income based on those projections are often not realized.. It’s not simply a question of some balance sheets taking a hit and others getting a break.

    1. Hi izimbra,

      When I say, “we eat dollar weighted returns,” that is a limited statement trying to get people to notice that few but and hold, and as a result, returns that average people receive in their passive investing are less than the advertised “buy-and-hold” returns.

      Outside of public markets, theoretically the same rules apply, but we don’t measure it. There is a private company that I have invested in that went through hard times, and recovered. Who was the only investor willing to invest during the hard times? Me.

      In this case, the IRR will look stupendous, and the buy-and-hold cruddy. But that illustrates my point. Since so few have that stomach to take risk when times are horrid, it is no surprise that time-weighted returns exceed dollar-weighted returns. It is the nature of man, so it seems unless they retrain themselves, as I have done, with varying success.

      1. Hi, Thanks for the reply.

        Yes, I was, I think, substantively arguing against one particular interpretation of the concept that ?The World net is 100% long with itself?, was not debating the valid point that most people fail at market timing or the fact that the latter point was the interpretation you had in mind in your note titled “We Eat Dollar Weighted Returns – III”. I would have given that note a different title to avoid some other interpretations (which I think are wrong), and those other interpretations are interesting to point out when thinking about investment strategies: 1) the stock// fund universe doesn’t contain anything like a 100% claim on the future of commerce (one sees that wrongheaded idea all the time in theme investing), 2) the stock//fund universe doesn’t even allow one to be 100% the future of commerce (some future commercially important supply for consumption will hurt/supplant current equities), 3) there may be significant utility in investing in ways that hedge not only a uni-dimensional measure of “inflation” but also specific aspects of one’s estimated future cost of living, 4) there is value in holding investments denominated in other currencies (e.g. an investment denominated in Australian dollars might be a must better protection against inflation than a U.S. based TIP), and 5) coming back to the topic of market timing, measures like portfolio beta are more relevant than “dollar weighted” (probably a small factor in the stats, but a trader who sometimes held SPY *should* swap that out for higher beta names after the market has fallen by a lot, and that would have skewed the reported statistics towards the wrong conclusion though of course neither of us believe that is what’s driving the reported effect.

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