I am glad I began investing 20+ years ago.  If I were considering starting now, I would likely not do it.  Why?

1) Too much data.  There are too many factors to consider in investing. That there is a wealth of data to consider is certain, but what are the right factors to look at?

2) Crowded.  More people and firms are investing.  The competition is higher.

3) There are more games in trading.  Makes it a lot harder to get good executions.  The low costs of transaction have created monsters.

4) ETFs affect the market as a whole.  They allow average people to speculate on broad trends, without telling most of them that they are noise traders, and are getting taken for a ride.  Dollar-weighted returns are far less than that for buy-and-holders in ETFs.  The traders are getting creamed.

5) Social media leads to groupthink, which lowers overall returns, at least for those that get there late.

6) ETFs allow investors to play well outside their circle of competence.  Beyond that, some ETFs don’t always do what they promise because of the derivatives that they use, roll, etc.

7) We are in a macroeconomic environment where we are delevering.  That is not the best environment for making money.

In general, I think most individual investors are cows for the institutions to milk.  But there are a few ways to immunize  yourself from this:

a) Hold very short or very long.  I lean toward the latter.  Don’t give up quickly on your investment ideas.  Buy and hold for years, not months.  Ignore the chatter, and read the data from the company and trusted third parties.

b) Use a value bias, and focus on companies where there is a margin of safety.  Buy the shares of companies with lesser growth prospects, that are selling cheaply.  Who cares if earnings aren’t growing if the earnings yield is over 15%.



Do you want to read an entertaining book about risk and insurance?  Right, I know that it is not likely that anyone could do that, but this book succeeds at the the task.  How does it do that?

1) It approaches the topic without using a lot of math.

2) It introduces you to the practical problems that anyone would face in trying to insure against any catastrophe.

3) It offers an entertaining story at the end of each chapter, some of which build off of prior stories.  The stories have farfetched elements to them, but they illustrate the main points that the chapter has made, while making you laugh.

The author gives no hints to his views on religion, but uses the concept of “acts of God,” to describe events which are out of our control, and thus need risk pooling (insurance), to contrast with “acts of man,” which potentially are controllable, though often not practical to do so.  Insurance may still have a role there, but there will be many more terms and conditions in the insurance contract.

One dominant theme of the book is how one estimates likelihood in the absence of a large amount of data.  Do you:

a) take what little data you have, and calculate an estimate? or,

b) get expert opinion on the matter, and let the small amount of data modify the experts?

The book takes the second position.  I lean toward the first position, but am not dogmatic about it.

When you are done reading this book, you will likely have skepticism toward much economic, sociological, and biometric research, because their foundations are very weak.  Estimates made are not from repeatable processes.

This is a good book.  It takes some effort to read, because the concepts are dense, but the structure of the book lightens things up.


Math error on page 89 — 1.5 should be 1.25.

Who would benefit from this book: Those who want to understand insurance, probability, or research better would benefit from this book.  If you want to, you can buy it here: Acts of God and Man: Ruminations on Risk and Insurance (Columbia Business School Publishing).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent 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.


Joe Mysak is one of the true experts in the municipal bond markets, journalist or not.  He has covered municipal bonds at Bloomberg since 1999, and has covered municipals since 1981.  I have read his work for over 12 years, and I have been impressed.

So when he writes an encyclopedia of Municipal Bonds, it’s gonna be dull, right?  There are entries that are short to define simple but important concepts, but the glory of the book are the long articles, because they describe how the municipal market evolved its structure.

It’s not a dull book, if you want to understand how the Muni market came into existence, and how it acts today.

The long articles are the best, and they include:

  • The Arkansas Default in 1933
  • Auction-rate securities
  • Bell California pay scandal
  • Chapter 9
  • Convention Centers (stop the madness)
  • Default (and why it is different for munis)
  • Escrowed to Maturity
  • Garbage bonds
  • The Implosion at Heartland
  • House Museums
  • How Initiatives and Referendums Could and Could not affect muni financing.
  • Muni bond insurance — a topic I have often criticized.
  • Jefferson County, Alabama
  • Pension bonds, particularly those of New Jersey
  • Orange County’s default
  • Pension obligations, and their effect on munis
  • Moody’s changing their ratings for munis in 2010.
  • The effects of derivatives on naive municipal executives, who thought the got it.
  • Tobacco bonds.
  • Tourist attractions (bad bets for muni bond financing)
  • Yield-burning. (using the tax-exemption to earn arbitrage profits of some kind.)

It is the controversies and legal cases of the bond market that have had the most impact on how the market behaves today, and that is how the book covers its topics.

I learned a lot from reading this, and most muni investors would learn still more.  This book is well written, and explains the issues in detail, without resorting to unnecessary verbiage.



Who would benefit from this book: Most investors in muni bonds would benefit from this book.  If you want to, you can buy it here: Encyclopedia of Municipal Bonds: A Reference Guide to Market Events, Structures, Dynamics, and Investment Knowledge (Bloomberg Financial).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent 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.

I’ve seen a number of articles recently arguing that high yield bonds are still cheap. Today I began an investigation to analyze this claim.

Here’s my bias: at the first investment shop I worked in, the high yield manager told me that there is a nominal yield for high yield bonds which reflects the risk.  It doesn’t matter where Treasury yields are, high yield bonds don’t care.  As a result, when people in the media, or writing blogs those argue that high yield is cheap because yield spreads are wide, it is time to disregard then when Treasury yields are artificially low, because of government interference.  (Financial Repression)

High yield bonds do care about credit conditions.  High yield bonds do care about the stock market.  From all of my research, high yield bonds are highly sensitive to credit conditions, particularly those of its industry.  They are also sensitive to the stock market.  After all, if the high yield bonds are doing badly, the stock is doing worse.

And here’s the rub: high yield bonds do not react to yields on Treasuries, except negatively, because when Treasuries rally hard, times are not good, and high yield bonds do poorly, with yields rising.

Here’s a graph to show how yields have done over the last 15 years for various corporate bond ratings.

My data this evening comes from the Federal Reserve Bank of St. Louis’ website FRED.  Been using it for 20 years, it is one of the best economic data repositories on the web.  Even used it during the bulletin board era, pre-web.

Merill Lynch has recently provided many of its bond yield indexes to FRED.  Previously, all that was there were two long yield series from Moody’s.

Now, if the concept of yield spreads is valid, when I do regressions of treasury yields on corporate index yields, I should see tight correlations of the yields versus Treasuries, and beta coefficients near one.  Here’s what I obtained:

AAA-CCC refer to ratings categories.  HYM is High Yield Master II, which is an average of high yield bond yields, and is usually very close to single-B yields, no surprise.

As you will note, spreads work reasonably to poorly for investment grade bonds.  The yields on investment grade bonds do not fall as much as yields on Treasury bonds do.  The yields on high yield bonds are barely affected when Treasury yields fall.  Look at the R-squareds on the regressions versus Treasuries only, high yield bonds do not have any economically significant relation ship to Treasuries alone.

Thus, it doesn’t make sense to talk about high yield bonds in terms of spreads over Treasuries.  High yield bonds react more to lending conditions, and derivatively, how well the stock market is doing.

But if we introduce credit spreads into the analysis, everything changes, and R-squareds skyrocket.

To me, BBB bonds are the touchstone for credit conditions.  Why?  They are on the edge of investment-grade creditworthiness.  They are also a large part of the corporate bond market.  When their yields rise or fall, it is a sign that financing rates for corporations are changing.

So, when I did regressions including BBB yields in addition to 5-year Treasury yields, guess what?

  • Junk yields were highly geared to BBB yields.
  • When Treasury yields fall, junk yields rise, and vice-versa.
  • These relationships are in general more statistically significant than those of high investment grade corporates versus Treasuries.

So what does this prove?

  • Yield spreads over Treasuries are not a good way to define value in bonds, and particularly not junk bonds.
  • Better to analyze high yield bonds versus BBB bond yields, and consider Treasury yields as a negative factor when rates are low.

So, is high yield cheap or dear at present?

Whether I look at the Merrill High Yield Master 2, BBs, or Bs, junk bonds look expensive.  CCCs look a little cheap.  The yields on the High Yield Master 2 look about 0.8% expensive in terms of yield (that’s the residual in the above graph).  I will be lightening credit bond/loan positions in the near term.  Of course this is just my opinion, so do your own due diligence.

And, please realize that movements in the stock market may swamp my observations.  If the stock market runs, high yield can run further… but there will be an eventual snap-back.   The bond market is bigger than the stock market, eventually the stock market reacts to bond market realities.


US Economy


  • Two bright spots in the US Economy: Manufacturing http://t.co/ypyMuQ6D Oil & Gas http://t.co/kMqYETNa Is housing next? $$ #cyclicals Feb 09, 2012
  • @The_Analyst That’s one reason why I typically don’t comment on nonfarm payrolls; calculation of the number is complex; hard to analyze. $$ Feb 08, 2012
  • Farmers Plan Biggest Crops Since 1984, Led by Corn http://t.co/fpS3Ftys Farmers put Vegas to shame when it comes to risk. #rolldembones $$ Feb 08, 2012
  • Total Says SunPower Can Withstand China Solar Panel Competition http://t.co/oWPxaYrZ FD: long $TOT ; Watch other solar companies fold $$ Feb 07, 2012
  • American exposure http://t.co/bI6FR9hp What r the odds that continued European crisis will throw sand in2 the gears of America’s recovery? Feb 07, 2012
  • I think CR is right if we limit it to the housing that the GSEs lend on; I don’t think it is true of the… http://t.co/9bjWKPPQ Feb 07, 2012




  • A few thoughts about the Euro snafu… http://t.co/IVQ525GO The cost of Greece leaving the Euro would be very high… but so is the status quo. Feb 10, 2012
  • Inside the Head of Mario Draghi http://t.co/2LkA1ZUL Favors large banks and an expanded role for central institutions in the Eurozone $$ Feb 10, 2012
  • On Banknotes http://t.co/LghRIk35 Of safe boxes & paper money, particularly 1000 CHF-notes. Quick, hide $$ 4 a store of value against chaos! Feb 10, 2012
  • Graphic detail: European banks five-year subordinated CDS http://t.co/HQI1njNf HT @Alea_ The LTRO has decreased EZ-bank CDS & raised stocks. Feb 10, 2012
  • Euro Finance Chiefs to Defer on Greece http://t.co/okFLAYbb They await the deeds, rather than hearing the words $$ Feb 09, 2012
  • Sarkozy Most Unpopular as Election Nears Confronting Unprecedented Rebound http://t.co/PAn88rE0 Broader EZ effects: policy disagreements Feb 09, 2012
  • Homeowners Who Would Be Moguls Make Comeback in UK http://t.co/cdCxHeyo Back a lot sooner than I expected or hoped. Spec leverage rises $$ Feb 09, 2012
  • UK Failure, Contagion, and Musings on Switzerland http://t.co/wIFZlcO9 Euro Banking crisis -> Swiss crisis -> like Iceland ^ Banks/GDP $$ Feb 09, 2012
  • European repo has been contained! http://t.co/rzFKRou2 The ink on the LTRO is still wet, what happens when it the refi date comes? $$ Feb 09, 2012
  • Europe Crisis Cuts at French Welfare State http://t.co/5bCYU6QI Pretty gloomy article. No wonder Sarkozy is doing badly in the polls. $$ Feb 09, 2012
  • Merkel Approval at Highest Level Since ’09 http://t.co/xHazv1AZ Coalition wouldn’t have a governing majority if elections were held now $$ Feb 08, 2012
  • Irish Urge Children to Leave as Export Gain Masks Lost Jobs http://t.co/StOYG2xi Perhaps we should call this the Irish export jobs famine. Feb 07, 2012
  • Denmark’s Credit Crunch Worsening as Retrenching Banks Spur Vicious Circle http://t.co/fU8kf1c0 What did Soros say? http://t.co/ShMY4LWN Feb 07, 2012


Quantitative Investing/Methods


  • @kyles09 Where do you get figures for implied correlation? Pretty certain the figure I cited was for realized. Feb 10, 2012
  • Jeremy Grantham’s investing strategies for 2012 http://t.co/eOgHqgth Favors: Quality & Value stocks, developed mkts. Dis: Bonds & Emerg mkts Feb 10, 2012
  • Defensive Stocks Lose First Time Since 1999 as Equities Resume Bull Market http://t.co/LlGPWxFs Odd, but telling of how surprised most are Feb 09, 2012
  • @tomkeene Simple ARMA models are used by those that have no structural model, & r highly subject to abuse, torturing data to make it confess Feb 09, 2012
  • The Inner Broker Resurfaces http://t.co/raWp25LN Correlations r down. Stock-picking returns. But why have correlations fallen? Ideas? $$ Feb 09, 2012
  • @DavidSchawel @PlanMaestro When I ran option hedging auctions among inv banks, we got the best execution when we limited the # & went AON $$ Feb 09, 2012
  • Technical indicators point to need for caution http://t.co/3KxlReTy I’ve been selling little by little into the rally. $$ Feb 09, 2012
  • Contra: PRESENTING: The Great Market Disconnect Seen All Around The Globe http://t.co/qGlUl0qq No reason y they should b connected $$ Feb 08, 2012
  • A Market Timing Rule that Works http://t.co/ntVw7hiz Volatility timing reduces portfolio volatility by 1/3 w/o sacrificing total return $$ Feb 08, 2012
  • Contra: Is the 4% Rule Still Viable? http://t.co/Qz85NqIt I expected better from Smartmoney; a 4%/yr distribution is liberal if anything Feb 08, 2012
  • Stocks are cheap! http://t.co/AOezqb95 Expensive! http://t.co/e9kVzPgh Comes down to your view on where profit margins are going $$ Feb 08, 2012
  • Dividends Are All The Rage – The Clamour For Equity Yield http://t.co/pC1nlWVJ Low growing dividends w/strong BalSht is the preferred combo Feb 08, 2012
  • Hedge Fund profits flow mostly to Industry Insiders http://t.co/I73p7vUK W/2 & 20%, it takes a lot of gross returns 2 give big net 2 clients Feb 07, 2012
  • Contra: Junk Bonds Still Offer Margin for Error http://t.co/NW6q32fa When Tsy rates r low, normal junk spreads s/b higher & reflect risk Feb 07, 2012
  • Buy growth and inflation hedge vehicles http://t.co/0q0QoqlD Model moves from neutral to Inflation. Commodity prices jumpy of late $$ #boing Feb 07, 2012

Fed Policy / Banking


  • Fed’s ‘Operation Twist’ Tangles Treasury Trade http://t.co/nxCMTCqa Fed has acquired 20-30Y Tsys = 91% of new issuance post-Twist. $$ Feb 10, 2012
  • Banks Not Off Hook With $25B Mortgage Agreement http://t.co/Q6ObUnyA Only takes care of securitization, & not origination/underwriting $$ Feb 10, 2012
  • Why Dodd-Frank has already failed http://t.co/CZm7qnoP Regulators didn’t use their tools in the last boom, so better tools won’t help. $$ Feb 09, 2012
  • Bernanke Talks His Book http://t.co/romgydli Inflation implied by TIPS has been rising over the last four months, w/Ben Bernanke silent $$ Feb 09, 2012
  • Investors too complacent with the Fed’s pledge? http://t.co/G7c1yKDV Volatility on a number of swaptions r multiple standard devs cheap $$ Feb 08, 2012
  • Global liquidity fail — the role of skewed incentives http://t.co/Ehgu0Ajm Liquidity is more tenuous when leverage is layered $$ #dominos Feb 08, 2012
  • Bernanke Economy Shows Critics Wrong on Fed http://t.co/18CYlDZc Too early. Sterilized base money takes 5-7 years 2 produce inflation $$ Feb 08, 2012
  • The Fed’s next hike will come at the end of 2014 http://t.co/UNW0mo0g Too definite. The economy is always more volatile than expected $$ Feb 08, 2012
  • The Fed Votes No Confidence http://t.co/qps0mbbD Charles Schwab argues that overly loose Fed policy unnerves economic decisionmakers $$ Feb 07, 2012
  • Banks Pay Homeowners to Avoid Foreclosures http://t.co/t8xQpEq7 ‘Bout time. Now we can clear the decks on the low end of housing $$ Feb 07, 2012


Politics / Governement


  • Judge Suggests US Misled Court on Immigration Policy http://t.co/jaRY1V2f What happens when #SCOTUS is deceived & issues opinion off it? Feb 10, 2012
  • I’ve interacted with Bruce Bueno De Mesquita over his book. It’s a good book, but a lot… http://t.co/CXmUh349 Feb 10, 2012
  • USPS Loses $3.3B, Warns of Cash Drain http://t.co/d8DKwMzC The loss is for the last quarter; somthing is going to have to give here. $$ Feb 09, 2012
  • Contra: Live, From the Nation’s Capital, the Supreme Court http://t.co/3Ob69SHI Big mistake if #SCOTUS televises; cheapens deliberations. Feb 09, 2012
  • World Food Prices Rose Most in 11 Months http://t.co/jJ5EHmAG #Agflation continues; we can print $$, credit, but can’t print food. Feb 09, 2012
  • Misreading Catholic Barometer Is a Political Risk http://t.co/42JGnZWo Amer Catholics favor contraception, but dislike dissing bishops Feb 09, 2012
  • @ToddSullivan “Voting no were Reps. John Campbell (R-Calif.) and Rob Woodall (R-Ga.)” $$ http://t.co/LoU2rUQz Wonder what they own? Feb 09, 2012
  • “Can you imagine if you had to exchange your currency every time you crossed the state line?” The Confederation come… http://t.co/4C1crjn4 Feb 09, 2012
  • LA’s Six-Figure Carpenters Show Clout of Utility Union http://t.co/GuHB4OOc Nice work if you can get it; pity the poor taxpayers though $$ Feb 08, 2012
  • Buffett Wants to Pay Higher Taxes—on Less Than 1% of His Income http://t.co/HB5rzRin Buffett asks for tax raises where he does not earn Feb 08, 2012
  • Is falling U.S. unemployment a statistical mirage? http://t.co/JTuqoKXF More on the falling labor participation rate & discouraged workers Feb 08, 2012
  • Not a Fan of Santorum, but anything that deadlocks the Republican Convention is a good thing. Here is for someone totally new. Feb 08, 2012
  • The optimal endgame for the Republicans is that the convention deadlocks, & they choose someone else. The four remaining r fatally flawed $$ Feb 08, 2012
  • 6 Catholics he may not want 2 offend: #SCOTUS RT @BloombergView: @RameshPonnuru on Obama’s smackdown of Catholics $$ http://t.co/eJkuQRRN Feb 07, 2012
  • For Sale: AIG’s Subprime Bonds http://t.co/zs89CIJy Color me wrong on this one; never thought the loan would get paid back at par $$ Feb 07, 2012
  • Are Credit Ratings Massively Overrated? http://t.co/YtOLGnj2 Acid test: will regulators outsource the credit risk function to a formula? $$ Feb 07, 2012
  • Answer: Unlikely, because then they have no one to blame when something goes wrong. $$ Feb 07, 2012


Asset Management


  • Vanguard’s Forex-Hedged Foreign Bond ETFs http://t.co/194ZRxI2 Frustrating to see them finally do a foreign bond fund & then they hedge. Ugh Feb 09, 2012
  • Buffett: Bonds Among Most Dangerous Assets http://t.co/x5sJUaak Loss of purchasing power, default, w/no upside. $$ Feb 09, 2012
  • The Difference Between Owners and CEOs http://t.co/0Vtg8bmZ Companies w/dominant shareholders are typically more price-sensitive on buybacks Feb 09, 2012
  • everything is connected http://t.co/XADlN5wL Very difficult to improve overall processes inside investment firms w/o looking @ everything $$ Feb 09, 2012
  • The twilight of the Bond King http://t.co/2SthSbdU Long article, but way 2 early 2 write off Bill Gross. Pimco primer: http://t.co/SUXjeKhz Feb 09, 2012
  • RT @Frank_McG: @AlephBlog reminds me when nortel mkt cap eclipsed sum of same for all cad banks, back in 2000 – the new math….for a w … Feb 08, 2012
  • Merely to claim that $AAPL is an outlier begs the question of data reasonableness. Anyone know what had the largest negative surprise? Feb 08, 2012
  • Apple Results Distorting S&P 500 Earnings, Golub Says http://t.co/i9qJ2rpT If you’re going to remove the best, then remove the worst too Feb 08, 2012
  • sudden shifts in capital flows – a risk for EM investors http://t.co/oVHjYiJb Increases in reserves can lead to asset bubbles. $$ Feb 08, 2012
  • BlackRock’s Fink Says Be 100% in Equities http://t.co/KmXXIFXY That’s quite a call; leaven it with short hi-qual debt and long Tsys $$ Feb 08, 2012
  • Gold not a reliable inflation hedge http://t.co/XofX5KBX A lot depends on how long the hedge horizon is; noisy in short-run certainly $$ Feb 08, 2012
  • The End of Wall Street As They Knew It http://t.co/takMaT4e Continued delevering means opportunities in finance r limited & so is future pay Feb 07, 2012
  • Just wanted to highlight a blog that has been having a discussion w/ @epicureandealmaker : Synthetic Assets http://t.co/iCMb0VXQ Good stuff Feb 07, 2012
  • Gorman Embracing Vegemite in New Wall Street’s 15% Bogey at Morgan Stanley http://t.co/drNTToLN $MS looking more promising currently $$ Feb 07, 2012
  • @BarbarianCap $FNF is one bizarre company, almost like a merchant bank. Now that mortgages aren’t a gravy train, they go elsewhere $$ Feb 07, 2012
  • Why Dividend Stocks Aren’t the New Bonds http://t.co/FiK2kPnV Just because a stock pays a div doesn’t mean it ceases 2b a stock #caploss Feb 07, 2012


Money Market Funds (Resulted in this article)


  • @MarcHochstein worth to be published daily? Didn’t think so, and I am generally one that favors FMV acctg. FM NAV is a useful internally. Feb 09, 2012
  • @MarcHochstein I say that b/c a published floating NAV would cause more instability. Would bankers like the fair market value of bank net + Feb 09, 2012
  • @MarcHochstein Reinforces my view that academic economists r more frequently wrong than those working in business. We deal w/real world. $$ Feb 09, 2012
  • Money market mutual funds provide more transparency than banks http://t.co/SIXd9Yq2 frequent disclosure down 2 the individual security level Feb 09, 2012
  • Will SEC Rules Make Treasurers Flee Money-Market Funds? http://t.co/yrgSqFta If I were a treasurer, I would probably buy CP directly. $$ Feb 09, 2012
  • Simplifies my logic & pushes it forward RT @MarcHochstein: @AlephBlog you’re the Blog of the Day, hope I did it justice http://t.co/Uu18unUF Feb 08, 2012
  • @MarcHochstein You did it justice. Thanks, many thanks. Feb 08, 2012
  • @MarcHochstein Had some interesting arguments with the folks at ICI.org . They seem to be playing for all marbles, and will lose. Feb 08, 2012
  • @MarcHochstein I’m an actuary by training, and have developed stable value funds w/more complex protections, this one is simple, FWIW Feb 08, 2012
  • @MarcHochstein I’ve actually talked w/some in the MMF industry; they prefer that nothing be done; I don’t think that’s realistic politically Feb 08, 2012
  • @MarcHochstein So if the loss at the MMF had the NAV down to .9925, renormalizing to 1.0025 means ~1% of shares would disappear. Feb 08, 2012
  • @MarcHochstein But it has to be lower than 1.005, or you’d have to set the NAV @ 1.01, which MMF don’t want. 1.0025 is the average. Feb 08, 2012
  • @MarcHochstein 1.0025 is artificial; it just has to be great than 1 so that a run increases the NAV, and biases yields higher in the future Feb 08, 2012
  • @MarcHochstein Yes, the number of shares is reduced, and the NAV re-normalized @ 1.0025, so that if there is a run, the MMF strengthens Feb 08, 2012
  • Ready for the next great ETF? Because of the undue persecution of money market funds,there is a lack of demand for A2/P2 commercial paper $$ Feb 08, 2012




  • Blogosphere, We Get It… http://t.co/EDBeJoJi Checked my blog. Only said “we get it” twice in 5 yrs & always followed by the word “wrong.” $$ Feb 08, 2012
  • And the point is, I get it wrong. Frequently. In economics & investing, the game isn’t simply 2 avoid errors, but 2 minimize their damage $$ Feb 08, 2012
  • Kauffman Blogger Survey: Economic Sexiness Coming http://t.co/2SLEfv2B A mixed group of forecasters sees better times ahead $$ Feb 07, 2012




  • How to Be a Better Boss? Spend Time on the Front Lines http://t.co/0w90dQJG Mgrs can learn a lot by spending time in the trenches $$ Feb 10, 2012
  • Best Disclaimer Language Ever http://t.co/orYSFN2k “The future is unknowable. We have good intentions but all of our projections and…” $$ Feb 09, 2012
  • MF Global Trustee Sheds New Light on Chaos at Firm http://t.co/bTRwHARE Key Q: how much $$ transferred in final 5 days can b clawed back? Feb 07, 2012


From a reader who is a dear friend of mine:

There are obvious many disparate approaches to asset allocation.  Similar to the disparate approaches of any style of investing, each asset allocation approach has its own particular pitfalls.  Some of these you can plan for and perhaps hedge against or at least mitigate the potential negative impact from those pitfalls, while some booby traps spring up out of nowhere.  Risk Parity issues revolve around leverage, negative skew, and potential negative returns from certain levered asset classes.  Long-term strategic asset allocation may suffer from the quality of initial assumptions and typically relies on stable volatility profiles and correlations between asset classes.  And so on.  Every professional investor – let’s take an endowment for instance – diversified its portfolio among several asset classes and styles of management.  But what is interesting to me is that I’m not sure I’ve ever seen an institutional (or even HNW) investor diversify its portfolio among multiple asset allocation approaches.  Theoretically, splitting up a portfolio between 3-5 different AA approaches (strategic, risk-based, tactical with an opportunistic value lens, tactical with a momentum/trend-riding lens, etc.) mitigates the pitfalls of each one.  What are your thoughts here?  I have a few of my own, but I don’t want to muddy your own intellectual waters ahead of time.  🙂

My personal approach to asset allocation is similar to Warren Buffett, or Value Line.  I invest mostly in stocks, and keep a bunch of safe assets for liquidity.  As the market rises, I add to my safe assets.  As the market falls, I buy stocks.  In October of 2002, things were so bad that I depleted my safe assets, an everything was in stocks.

In general, I think most complex asset allocation strategies are overly complex.  In general, there are safe and risky assets.  Asset allocation should first focus on the division between the two.  Typically the safe assets are high quality bonds and cash equivalents.  Sometimes there are more opportunities, sometimes fewer.  Safe asset levels should reflect that.

The second focus of asset allocation should be liquidity needs.  Even if there are a lot of promising opportunities to deploy cash, if the liability that funds the assets needs cash, have cash ready for it.  If you invest in limited partnerships or private companies where the assets are locked up for a period of time, have a sense of what your maximum level of illiquidity is (what will you with certainty never need to tap?), and ladder the investments so that like a laddered bond portfolio, you always have some illiquid investments maturing each year, providing fresh cash for deployment where current opportunities are most promising.  These top two ideas are very basic, but even experts neglect them at times.

The third focus of asset allocation is choice of risk assets, which is how I view your question.  There my view of asset allocation is like that of GMO.  Forecast future returns off of free cash flow yields; invest accordingly.

Don’t pay much attention to volatility, but aim for what is most likely, and bend a little in the direction of what can go wrong.  Most of the time, over longer periods of time, what is most likely happens on average; that’s why it is most likely.

Maybe “Too many cooks spoil the broth.”  I have enough trouble trying to work with momentum versus mean reversion.  I would lean toward having one AA strategy that fits with my broader asset management practices.  But on the other hand…

Suppose we did have five asset allocation models, and what their results were encouraging various investors to do.  If we thought that one of the models had been too hot of late, and was attracting too much money, and distorting ordinary market relationships, maybe that could give us a signal to make sure our asset allocation de-emphasized the results of that method.  Timing of course would be difficult, it always is, but seeing the results of the five methods could provide a fuller view of choices faced by our competitors.

I’m not sure that using the average of a number of asset allocation models will provide the best result, but I think that understanding what other players in the market are doing could lead to better decisions.

I’m open to your thoughts, and the thoughts of other readers here.  Anyone have a better idea?

I have great admiration for Warren Buffett, even though I am critical of him at a number of points.  When I read the piece in Fortune where he talks about asset allocation issues, I agree with him 75%.  Where should money be invested?  Stocks.  And as for me, 75% of my net worth is there.  Nonetheless, I see value in bonds, gold, and cash, even though I don’t own any gold, aside from my wedding ring.

Gold is valuable because of its scarcity, and that it is beloved by most cultures in the world.  Gold is beautiful.  Compare it with other metals, gold stands out because it has little economic usefulness.  But that is a feature, not a bug, because it makes gold immune to economic cycles.

Review the gold medal gold model.  The price of gold reacts to real interest rates.  When they are low, the price of gold flies because the cost of carrying gold is negative.  If I could say one thing to Buffett on the topic, I would say read this article, and you will learn why the price of gold is rational and correct in this environment.  Negative real interest rates means the government does not care about the value of its currency, and thus scarce things (think of truly scarce collectibles in the 70s) appreciate in value dramatically versus the depreciating dollar.

Gold is valuable, very valuable when governments and central banks are profligate.  But what of bonds?  Those are the opposite.  They are valuable when governments get more serious about their finances, or when people are scared about the future, and buy long bonds because they want certainty of cash flows in the future.

Also, be for real, Warren.  The dominant asset class inside BRK is bonds.  You hold a lot of them in your insurance companies.

Do I believe in stocks?  Yes, if they are my stocks — the value premium of buying beaten-down companies is dependable.  It doesn’t work every year, but it works most years.

My main point is this: stocks are great, but they are not a panacea.  Gold and things like it are needed for inflation.  Bonds are needed for deflation.  Cash offers flexibility.  These are all useful to investors at the right times.

And, Warren, you have done better than most.  Your stock portfolio has beaten others over the last 40 years.  Most stock portfolios have not beaten bond portfolios, though admittedly by a smidge.

So, is this the time to buy stocks?  I am more bullish than bearish, so yes, but edge in, and be ready to adjust.

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.

I thought that I had a really good proposal for dealing with money market fund problems.  And it is good, far better than what the SEC is proposing.  My proposal is better because it treats money market funds like ETFs — they are pass-through vehicles, and as such, do not need capital buffers.

And, my proposal is better, because it recognizes that credit events should be rare but acceptable aspects of how money market funds work.  Think about it: particularly when short term interest rates are so low, there is no way for interest to cover even the slightest discrepancies versus NAV.

Under my way of doing things, let there be stable net asset values, freedom in investment guidelines, but the possibility of credit events.  The present set of restrictions in investing does no one any good, because the problem is not length of maturity or credit quality, but issuer concentration.

But let money market fundholders analyze the tradeoff between yield and risk.  Guess what?  Short-term bond fund holders have to do the same thing.

Though I would not do it for individuals, in the Stable Value world, there have been “in kind” distributions where when a fund winds up, it distributes assets pro-rata to clients.  With individuals, I would create a second fund that absorbs liquidity from the first fund as assets mature, where fundholders could withdraw assets, if desired.

But why are we going after money market funds?  When they fail, the cost is pennies on the dollar, and it rarely happens.  Why not go after banks?  They fail far more frequently, with much larger losses.  I say let money market funds fail, and do not increase regulations on them.  Rather, let them be like ETFs, and let them be constrained by the prudence of the free markets.  What? You can have investment without the possibility of loss?  Ridiculous.

Regulate the banks tightly, but let money market funds go free, but advertise that losses are more than possible.

One final note: in certain fixed income businesses, if there is an involuntary wind-up, two solutions for ending equitably are a pro-rata distribution of assets, or letting the portfolio mature, and sending cash with each maturity. With institutional money market funds the first option is possible: in a crisis, just divide the assets and let everyone work it out.  But with retail clients, the second option is also possible: send assets as the portfolio matures, with the complicating factor of what to do with a genuine default.  In such a case, collective action is usually preferable for winding up, so that might be the last few percent of liquidity that does not get distributed for some time.

Again, I will say, let money markets have the possibility of failure, rather than have extensive schemes to maintain them at par.  Unlike banks, money market failure are small and contained.  Tell the SEC and the banking regulators to focus on a real problem — bank insolvency.

Here are two articles to read on risk parity:

Pro: Pick Your Poison

Con: The Hidden Risks of Risk Parity Portfolios

I’m on the “con” side of this argument, because I am a risk manager, and have traded a large portfolio of complex bonds.  For additional support consider my article Risks, Not Risk.  Or read the second half of my article, “The Education of a Corporate Bond Manager, Part X.” There is no generic risk in the markets.  There are many risks.  Interest rate risk and credit risk are different topics.   There are bonds that have interest rate risk but not credit risk — long Treasuries.  There are bonds that have credit risk but not interest rate risk — corporate floating rate notes, my favorite example being floating rate bank trust preferred securities.

It is not raw price volatility that drives investment results as much as the underlying drivers of the volatility.  For fixed income, I described those in the two articles linked in the last paragraph.  During non-credit-stressed times, a bank’s 30-year floating rate trust preferred security is roughly as volatile as a five-year noncallable bond that it issues.  But during times of credit stress, the first security becomes volatile, whereas the second one doesn’t.  The first moves in line with 30-year swap yields, LIBOR, and long junior bank spreads.  The second moves in line with 5-year Treasury yields, and short senior bank spreads.  The underlying drivers have little in common, and when things are calm, their volatilities are similar, because the drivers aren’t moving.  But when the drivers move, which in this case is one correlated driver, credit stress (30-year swap & junior bank spreads go a lot higher), the volatilities are very different, the first one being high and the second one low.

Thus equating volatilities across a bunch of asset subclasses, investing less in the volatile, and levering up the non-volatile, is hard to do.  History embeds all the curiosities of the study period, and calls them normal, and that past is prologue.

From the Pick Your Poison article above, what I think is the (lose) money quote:

Gundlach insists most money managers misunderstand junk bonds, comparing them to 5-year Treasurys to determine how rich their yields are, when the correct comparison should be to 30-year Treasurys.

How can Gundlach compare junk bonds, which do better when the economy heats up, with long-term Treasurys, which get killed when the economy revs up and the Fed raises interest rates?

That’s irrelevant, he responds. The thing to look at is volatility, because that tells you the odds you will have to sell at a loss when you need to raise cash in an emergency. On that basis, junk bonds that were trading at a seemingly reasonable spread of 5 percentage points, or 500 basis points, to 5-year Treasurys in mid-2011 were actually trading at an intolerably low 250-basis-point spread to the proper bond. (By then DoubleLine had cut its junk bond allocation from 10% to 1%.) Sure enough, junk fell 12% as the year went on, and the spread to 30-year Treasurys has doubled since mid-2011.

“It’s called risk parity,” Gundlach says. “There’s only two investors who seem to understand it—me and Ray Dalio,” the highly successful manager of $122 billion (assets) Bridgewater Associates.

Personally, I don’t think Gundlach makes his money that way for his funds, but in case he does, how should a good bond manager view junk bonds?

First, ignore Treasuries — they aren’t relevant to the price performance of junk bonds.  I’ve run the regression of Treasuries vs junk bond index yields many times.  It’s barely significant for BBs, and insignificant thereafter.  Second, look at stock market indexes of industries that lever up and issue junk debt.  Junk corporate debt is a milder version of junk stocks, i.e., the stocks that issue junk debt.

Third, a corollary of my first reason, realize that risks with junk aren’t driven by spreads, but yields.  With highly levered, or very junior debt, it does not trade on a spread basis, but on a price basis.  Anyone looking at spreads will see too much volatility versus yields and prices.

But mere volatility won’t tell you the riskiness.  Indeed, when economic times are good, junk will do well, and long Treasuries do poorly.  Now, maybe that makes for a very noisy hedge, but I wouldn’t rely on it.

And, volatility is a symmetric measure, which as bond yields get closer to zero, the symmetry disappears.  Most asset classes display negative skew and fat tails, which also makes volatility problematic as a risk measure.

Going back to my first piece on the topic, if I were applying risk parity to a bond portfolio, it would mean that I would have to buy considerably more of shorter and higher quality instruments, and lever them up to my target volatility level, somehow with spreads large enough that they overcome my financing costs.  Now, maybe I could do that with mispriced mortgage securities, but with the problem that those aren’t the most liquid beasties, particularly not in a crisis if real estate is weak.

I guess my main misgiving is that levered portfolios are path-dependent, as pointed out in the GMO piece above.  You can’t be certain that you will be able to ride through the storm.  The ability to finance short-term disappears at the time it is most needed.

Now, if you can get leverage after the bust, and invest in beaten-up asset classes, you can be a hero.  But that’s a time when only the most solvent can get leverage, so plan ahead, if that’s the strategy.  If an investor could consistently time the liquidity/credit cycle, he could make a lot of money.

As the GMO piece concludes, the only benchmark that everyone could hold would be a proportionate slice of all of the assets in the world, which implicitly, would strip out all of the leverage, because one would own both the shares of the company, and the debt it owes, and in the right proportion.

So I don’t see risk parity as a silver bullet for asset allocation.  I think it will become more problematic, as all strategies do, as more people show up and use it, which is happening now.   First in the hands of the master, last in the hands of a sorcerer’s apprentice.  Be careful.

PS — I have respect for the skills of Gundlach and Dalio.  I’m just skeptical about what happens to risk parity when too many use it, and use it without understanding its limitations.  And, here is a nice little piece about Bridgewater and its strategies.