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Archive for October, 2012

Yield is the Last Refuge of Scoundrels

Wednesday, October 31st, 2012

Governments involved in financial repression (keeping savings rates below the inflation rate) encourage their citizens to do stupid things by reaching for yield.  Remember, most people think of yield as a magic chicken that lays eggs on schedule, and never gets sick or dies.  Those who truly understand markets know that yield is an allocation of free cash flow, and that many businesses can’t control their free cash flow, so dividends are less than fully certain.

And so, I’m skeptical of the focus on income investing.  With bonds, I am not as skeptical, because there is a promised, though not guaranteed return of principal.  That doesn’t mean there aren’t problems there.  We are having a record year for issuance of corporate bonds.  Abbott Labs is offering a huge deal.  My experience with huge deals is to avoid them, unless there is some special reason to play, kind of like the last bond deal from Household International in 2002, where I bought and then traded them away for the 3o-year non-deal protected bonds bigtime.

That said, I get concerned over:

China has low interest rates for savers, so many Chinese turn to Wealth Management Products in order to earn something decent on their money.  Many of them may be little different than a Ponzi scheme.  When governments do not allow savers to earn rates exceeding inflation, savers turn to all manner of products that could harm them, both legitimate and illegitimate.

The same thing goes on in Malaysia with their Gold Plans, and suchlike.  But let’s keep things simple: let’s invest in the best corporate bond investment out there: long Baa bonds.

What’s that I see?  We’re at a 50-year low for yields on low investment-grade-rated bonds.  Surely the economy should be booming.

What, like the Great Depression, we are in a liquidity trap?  Seems that way.  Additional capital finds rare incremental productive uses, and often the best use is shrinking the company by buying back stock.

Part of that stems from the folly of the Federal Reserve using its balance sheet to buy up all manner of high quality debts by expanding its balance sheet — its cost of finance is 0% (maybe, wait till the losses come, they came to Fannie and Freddie).  By doing so, they distort pricing in the debt markets, favoring issuers over lenders, favoring the government over the private sector.

It leads to nothing good, because increasingly marginal projects get financed.  As in Japan, the marginal efficiency of capital fell dramatically, and has not risen for two decades plus.  Though it would have been painful it would have been better to have more failures and longer recessions 1986-2007.  The Fed should have kept rates higher for longer.  We would have normal markets today if they had.

As I have said before, investors don’t do well when they don’t have a place to park excess money for a small real return.  I’m not looking for the ’80s, when the return was often huge, but something above inflation, fairly estimated.  Until then, the misguided plans of the Fed will continue to do little, as businesses look at the low marginal efficiency of capital, and shrink their operations.  Remember, when businessmen see economic policies that can’t persist, they don’t take advantage of the situation — they pull in their horns and become defensive.  Thus the budget deficits, QE, and the ZIRP lead to a slower economy in the intermediate-term.

Dealing in Fractions of Sense

Saturday, October 27th, 2012

So the SEC wants to take on some of the market distortions caused by decimal (and sub-decimal) pricing.  Well, there are the things that can’t be argued about and the things that can.

Starting with what can’t be argued about: liquidity is not a free good.  In a trading market, it exists because market makers or specialists are willing to offer markets of a certain size and bid-ask spread given the usual price volatility.  Most of the time they  will make money, because there is enough informationless volume trading back and forth, that they can take a few losses when information hits the market, and informed traders temporarily make money against intermediaries until a new equilibrium is reached.

The same is true when things become more uncertain — either bid-ask spreads get wider, or sizes get smaller, or both.  I remember back in 2002 as a corporate bond manager/trader — bonds were trading in “onesies” and “twosies,” though bid-ask yield spreads hadn’t widened much.  (I.e. $1-2 million of face amount would trade at a given bid-ask context… if they got too much interest in one side or the other, the bid-ask spread would move, and fast.

So when the SEC made its move to change the tick size (minimum bid-ask difference) from fractions of dollars — eighths & sixteenths, to pennies, there was a tendency for the amount offered by intermediaries to decline.

Now if you are a small trader, you don’t care that much about this.  You were able to get your work done, and at thinner bid-ask spreads.  Life is good.

But if you are a large manager of assets, it’s not so easy.  You have a big buy or sell that you have to do, and the market gate is thin.  Give away too much of the size you want to do, and the market runs away from you, costing you money.  You might actually like markets with bigger offerings and wider spreads better.

And so you seek other trading venues out away from the NYSE and NASDAQ, and occasionally you find you can get large trades done there when there is another large trader willing to take the opposite side of your trade.

And in the process the other trading venues sometimes create fleeting trading opportunities between them and NYSE or NASDAQ, or within them.  That’s high-frequency trading [HFT].  Now, NYSE and NASDAQ profit from this because they sometimes receive payment for order flow.  They seek orders, and are willing to pay a tiny amount to get them, knowing they can make a profit on the other side of the transaction.

Given all of the above, the SEC is now reviewing a proposal to change back to fractions.  My first reaction is this favors the big over the small.  My second reaction is why not regulate/legislate and create one central order book that all orders go through for each security, and publicly display the bids and asks.

My third reaction is why not end payment for order flow.  High frequency trading would end without easy access to the deepest markets.

My penultimate reaction is, why not restructure markets so they transact once a second, or once a minute. It would not impede markets much at all in my opinion.

But my last reaction is, why not charge a teensy fee for every order placed in any venue, whether it executes or not?  It might be as small as a penny on a thousand dollar order.  Or even a penny on a ten-thousand dollar order.  Just enough that there is a disincentive to place a lot of orders where there is little intention of having them fulfilled except at advantage to the order placer.

These are better ideas than moving back to eighths and sixteenths once again — leave that alone, the existing market structure favors small traders, and that is not all bad.  Many large traders disguise themselves as small traders, and get trades done more cheaply than if they were trading in fractions.

Every trading system has its weaknesses — the challenge is to create the system that is the best for the most.  In that case, a good system will:

  • Have a central order book, or,
  • End payment for order flow, or,
  • Change markets to an auction format, or,
  • Add a fee that eliminates most non-completed high-frequency trades.

Personally, I like simplicity.  One central order book and no alternative venues, but allowing for a wide amount of order types that accommodate large orders and small orders.

So don’t go back to fractions.  They weren’t the solution to the current problem.  Better to restrict the market structure so that placing an order costs something.  Being able to place an order is a good, so there should be some cost, whether it executes or not.

What I propose here is more minimalist than other proposals, and would solve most problems from high frequency trading.  Add a small fee to each order — what could be easier?

Sorted Weekly Tweets

Friday, October 26th, 2012

Insurance

 

  • Insurers Must Boost Reserves for Residential Mortgage Bonds http://t.co/z1Plcc9z Pretty trivial; change small, not worth making $$ Oct 26, 2012
  • The Randian and the Bailout http://t.co/45wGJSo2 Without a tax gift from the US Tsy, $AIG couldn’t pay off the bailout http://t.co/2O4k7vpA Oct 25, 2012
  • For that last tweet, full disclosure, long $AIZ for clients and me Oct 24, 2012
  • Assurant Reports 3rd Quarter 2012 Financial Results http://t.co/pTbHUunV Over 8.75 yrs $AIZ has shrunk its share count from 142M to 78M $$ Oct 24, 2012
  • Weschler Rise From Grace Leads to Role Advising Buffett http://t.co/uUlYUPVK Interesting tale of a guy who can deal4 & value companies $$ Oct 22, 2012
  • Goldman Sachs Creates a Dividend+Buybacks Measure, & 4 Insurer Stocks Shine http://t.co/myQ8Ga1e I own 2 of them 4 clients. Which 2? $$ Oct 22, 2012

 

Central Banking

 

  • Here Comes the Dollar Wave Again http://t.co/5EO5Ejve Defend exports, import inflation, asset bubbles “Our currency, but your problem.” Oct 25, 2012
  • Approach risks “distorting” decisions & “it might be economically inefficient 2try2 push prices up so much,” Shiller http://t.co/Bs5GJPGX Oct 24, 2012
  • Redacted Version of the October 2012 FOMC Statement http://t.co/2jOMkLje Note: CPI inflation is at 2%, also inflation expectations rising $$ Oct 24, 2012
  • FOMC Statement: http://t.co/E2BOFdrr Oct 24, 2012
  • “We fail 2c the direct link, or even an indirect link, btw the size of the Fed’s balance sheet & the unemp rate” http://t.co/bM149U5Z $$ Oct 24, 2012
  • Buffett: ‘”I get a little worried about continuously expanding” the Fed’s balance sheet, he said on CNBC.’ http://t.co/KWIVYBIS $$ Oct 24, 2012
  • Traders Calling Singer’s Bluff on Intervention as Koruna Gains http://t.co/Y1ml4EZ4 Czech National Bank playing with fire, will burn $$ Oct 22, 2012
  • Would mean that the external effect of loose monetary policy have been played out, & the next big move is coming (but from where)? $$ Oct 22, 2012
  • Worst Carry Trades Show Central Banks at Stimulus Limit http://t.co/IDxi6uVq Interesting thought: if carrytraders can’t make money… $$ Oct 22, 2012

 

Fiscal Cliff

 

  • Firms Hit Brakes Before Fiscal Cliff http://t.co/z1Plcc9z Tap brakes is more like it. Most think we won’t go over the cliff #gridlock $$ Oct 26, 2012
  • Aha! Here’s The REAL Reason Corporate Executives Are Freaking Out About The Fiscal Cliff http://t.co/oS8VZpsi Favors initiatives of Dems $$ Oct 22, 2012

 

Other

 

  • How Supap Kirtsaeng’s Textbooks Idea Led to Supreme Court http://t.co/h1CDWk1q What rights exist to re-sell something that you bought? $$ Oct 26, 2012
  • The Plot to Destroy America’s Beer http://t.co/3ElPpvvx A tale of cost-cutting, quality reductions. Light beers ascendant. $$ Oct 26, 2012
  • Sandy Nears Jamaica, Forecasters Weigh New England Threat http://t.co/R1HNSDm8 High Incidence, Low Power 4 Tropical Storms in 2012 $$ Oct 24, 2012
  • Calling All Germs http://t.co/BkfuReQq Cellphones Are Great for Sharing Photos—and Bacteria; Cleaning May Harm Screens $$ Oct 23, 2012
  • Romney’s Air Force Comparison Misses U.S. Edge in Jets http://t.co/3lFkg4KL There r some situations where more lower tech jets would help Oct 24, 2012
  • Dean, Marathon Split-Offs on Tap http://t.co/m5OLbAuI Post-split $DF looks interesting, if boring. More room 2 focus $$ Oct 22, 2012

 

Energy

 

  • Shale Glut Becomes $2 Diesel Using Gas-to-Liquids Plants http://t.co/sjUDsrVK This is the Holy Grail, because gasoline is tough2produce $$ Oct 26, 2012
  • The internal combustion engine is far from dead http://t.co/Ewa60lrw Most real improvements in energy efficiency deal w/fossil fuels $$ Oct 22, 2012
  • Americans Buying Fewer New Cars in Lifetime http://t.co/viB6dIlU long-term probably not a good sign; autos drive a lot of the economy $$ Oct 22, 2012
  • The Myth of Affordable Energy – Interview with Ed Dolan http://t.co/8jWI1faC Energy efficiency is increasing. Full cost pricing desirable $$ Oct 20, 2012

 

Demographics

 

  • Russian Funds Band Together to Repel Government Cash Grab http://t.co/72KWo3Bg Gotta b careful on pension funds cuz govts like 2 raid them Oct 26, 2012
  • More Americans delaying retirement until their 80s http://t.co/dZM4Tmqm This is the way it should be. Retirement s/b 4-5 years at most Oct 25, 2012
  • Can Japan’s Elderly Become Its Growth Engine? http://t.co/eqhsu54i This seems like wishful thinking to me. Spending from savings <> wages $$ Oct 24, 2012

 

Financials

 

  • U.S. securities regulator questions need for new broker standard http://t.co/iNUVJKIp Extending fiduciary standards 2 brokers in question Oct 24, 2012
  • Forcing frequent failures http://t.co/OL6WSfOM @interfluidity hits a home run in dealing with bank failures, & how to regulate Oct 24, 2012
  • Low Rates Pummel Banks http://t.co/577Fsc1i Borrowers Benefit, but Industry Lending Profits Hit Lowest Level in Three Years $$ Oct 23, 2012
  • Marsico: When Going Private Goes Wrong http://t.co/Vxyc40u7 June 2007 was the wrong time 2 LBO, then performance lags $$ My sympathies2them Oct 23, 2012
  • 3 key money topics Romney-Obama debates ignored http://t.co/7j79IQ4V Housing prices, Investor protections & Retirement Savings $$ Oct 23, 2012
  • The end of stock market crashes? http://t.co/VjIALNEm I’m sorry, but the conclusion is bogus. Even if its works, only some could escape $$ Oct 23, 2012
  • Mortgage risks underestimated, economists conclude http://t.co/TFDpqz70 FHA uses a model that leads it to underestimate delinquency risk $$ Oct 22, 2012
  • Annaly Says Michael Farrell Dies After Cancer Diagnosed http://t.co/n5VNgi8m He was kind2me ~2000; willing2share ideas w/little me $$ $NLY Oct 22, 2012
  • Mortgage REITs: Not Just Yet http://t.co/20kPVBs2 I would be careful here & reduce exposure… they are always unstable vehicles $$ Oct 21, 2012
  • The Winner for Investors Is… http://t.co/eBQM5Ws4 @jasonzweigwsj points out the connection between returns & politics is tenuous $$ Oct 21, 2012

 

Economy

 

  • Firings Highest Since 2010 as Ford to Dow Face Slump http://t.co/9q87q63I This is the US economy. We can’t support workers relative2profit Oct 26, 2012
  • Weak Tea at Unilever Persists Amid Innovation at Rivals http://t.co/ryqjkEof Did not even know that Lipton was a Unilever brand $$ $UL $UN Oct 24, 2012
  • Doom Heralded at Hayman by Widening Trade Deficit: Japan Credit http://t.co/CZS09whs Japan’s debt is the “cleanest dirty shirt.” Not. $$ Oct 23, 2012
  • Hunger Stalks My Father’s India Long After Starvation End http://t.co/dkVTXxaO Long article, makes me grateful that I can feed my kids $$ Oct 23, 2012
  • Electrolux, Philips Warn Of US Slowdown http://t.co/6k5hxTe2 Another soggy data point; less demand 4 bigger-ticket consumer items $$ Oct 22, 2012

 

Retweets

 

  • Ya, true RT @glenntyrpa: @barnejek @AlephBlog @sikorskiradek Yea. When did Japan invade China? Was that 1930? :-) we Americans forget. Oct 26, 2012
  • RT @PragCapitalist: Today’s financial tip: don’t ever buy a boat. Instead, find a friend with a boat. If necessary, buy the friend. … Oct 24, 2012
  • Clever RT @BradErvin1: @AlephBlog @PragCapitalist This is Buffett, courtesy legacy @kevindepew articles @Minyanville http://t.co/dGTNG9kl $$ Oct 24, 2012
  • Stinks, just stinks RT @ritholtz: THE SELLSIDE: SAME AS IT EVER WAS Courthouse News Service http://t.co/K9LDmj5m via @CourthouseNews $$ Oct 24, 2012
  • RT @KathrynTully: The last of Sarah Thornton’s top reasons for quitting art market surely belongs in top 10 reasons not to be a journo. … Oct 24, 2012
  • RT @emckean: LOVE THIS RT @aniajakubek: There’s a Polish saying that means “Not my problem” & literally translates to “Not my circus … Oct 24, 2012
  • SIFMA gets an infamous big name to speak to them RT @LaurenLaCapra: #greenspan http://t.co/rjVlCfV5 Oct 23, 2012
  • At my house too RT @retheauditors: Halloween is dead to me. Oct 22, 2012

 

Replies

 

  • #FF @NickTimiraos @carney @grossdm @annsaphir @ritholtz @ToddSullivan @PlanMaestro @RolfeWinkler @LaurenLaCapra @davidgaffen @jennablan $$ Oct 27, 2012
  • @TraderNewsFeed No, I don’t think that. I think we should enjoy our work, and enjoy it for as long as we can, until we can no longer work $$ Oct 26, 2012
  • @rjwile True, but that’s the price of not saving enough. There is no right to a retirement. Someone send the EU the memo. $$ Oct 26, 2012
  • @OVVOFinancial I largely agree. Reducing the real value of debts would help. My only fear is that nominal incomes might not grow much $$ Oct 25, 2012
  • @OVVOFinancial Missed that, thanks. Still, the Chain-weighted PCE deflator is 1.5% yoy at present. Oct 25, 2012
  • @barnejek oops Oct 24, 2012
  • @PragCapitalist A boat is a hole in the water into which you pour money $$ That said, the recession created a lot of used boats 4 sale Oct 24, 2012
  • @tebaho I am not a Romney backer Oct 24, 2012
  • @EddyElfenbein lifted the stake above 50% by 1995. Oct 24, 2012
  • @EddyElfenbein In 1977, GEICO was ~6% of his public investments, before $BRK.B acquired 33% of the company by 1980, and buybacks + Oct 24, 2012
  • @EddyElfenbein In 1981, GEICO was ~30% of his public investments — no data on how big his private investments were then $BRK.B $$ Oct 24, 2012
  • @EddyElfenbein 1996-7 around 16% of pretax income. Prior to that, it was not wholly owned, and so Buffett acctd 4 it as an investment $$ Oct 24, 2012
  • @EddyElfenbein $BRK.B would not want to live without GEICO, but in my opinion, it could live without it Oct 24, 2012
  • @EddyElfenbein It’s about 5% of BRK’s pretax profits. The float it generates is very short and is only 5% of liabilities. Oct 24, 2012
  • @PragCapitalist It’s a conglomerate fueled by a set of huge insurance companies, where assets r sourced privately & publicly $$ $BRK.B Oct 24, 2012
  • @PlanMaestro @aarontask @TheStalwart I think it is spurious correlation b/c I c many other variable that r weak. US economy is flat. $$ Oct 24, 2012
  • @felixsalmon In the NT Greek, there r2 words for God’s will, &1 tells u God ordains everything, the other, he doesn’t approve everything Oct 24, 2012
  • @CflGator I would ask the question, how is $TGT going to deploy the capital? The answer probably lies there. Oct 24, 2012
  • @LDrogen America’s politicians have always made appeals based on religion, & then abandoned the religious voters that support them (not new) Oct 24, 2012
  • @joshuademasi I realize with Japan, it is unlikely 4 there 2b an external default, until the external debt gets big enough Oct 24, 2012
  • @aarontask This is a stock versus flow issue. The banks reap capital gains now, but it will reduce their future interest margins/income $$ Oct 24, 2012
  • @CflGator Think they are trying to free up capital for alternative uses. Oct 24, 2012
  • @LDrogen But all people have unprovable a priori opinions, and many will affect their views on public policy, whether “religious” or not Oct 24, 2012
  • @LDrogen It becomes the same paradox that philosophers go through with respect to the concept of free will vs determinism Oct 24, 2012
  • @LDrogen Even 2a Christian like me, God’s will is a highly nuanced, b/c there r 2 words in NT Greek 4 “will” & they mean different things Oct 24, 2012
  • @LDrogen One of my close friends came into existence as a result of a rape. Two good people adopted him; biological mother was courageous Oct 24, 2012
  • . @aarontask will look for it — if anyone has a link 2 it, pass it 2 me Oct 24, 2012
  • @joshuademasi Nations with their own currencies don’t have to default on debts. I think some will choose to default for political reasons $$ Oct 23, 2012
  • “This brings up something @ritholtz would say ~ blog traffic goes up during a crisis…” — David_Merkel http://t.co/9U0OxjLe $$ Oct 23, 2012
  • @joshuademasi Not sure he will lose; he has a decent chance of being correct. Japan has preceded the global economy for past 20 years $$ Oct 23, 2012
  • “5. Tadas, as you have said before, investment/finance blogging is hard. And many of the best of us…” $$ David_Merkel http://t.co/EuaE0hmB Oct 23, 2012
  • @StephenShiflett I distrust polls generally. I am not a Romney supporter. Most statistical comments in the media r not well-founded $$ Oct 23, 2012
  • @StephenShiflett Stratification matters more. The size was smaller than most polls I c, & instant senses of who 1r often not correct Oct 23, 2012
  • @DUNNER2 @CBSNews Now there was a poll that no one asked for, the sample size was far too small, but actually had a real impact. Sad. Oct 23, 2012
  • @Shwaver should be more like 5% if the poll is well stratified, and most polls aren’t Oct 23, 2012
  • @thejudge1082 @cbsnews I would criticize that as well. Most polls are too small and not well stratified Oct 23, 2012
  • @nmariecrumbie @DJDougMadrid @cbsnews I am *not* a backer of Romney. I am voting for the Constitution Party. I am a statistician, are you? Oct 23, 2012
  • @Justsaying1104 @CBSNews size *always* matters. I am a statisticiam by training. The hyper-short news cycle forced out a poll Oct 23, 2012
  • @Justsaying1104 @cbsnews of course size matters — what I object to is trying to get instant answers to what people are thinking $$ Oct 23, 2012
  • @ituzzip On a 500 person poll the error bounds are wider +/- 5%. But Rs answer polls less often than Ds. Oct 23, 2012
  • @JW28 Sorry, I am not a Romney backer Oct 23, 2012
  • @DJDougMadrid I don’t believe in instant, & I am voting 3rd party. Oct 23, 2012
  • @StephenShiflett Most polls I see are double that, it was still small, given the short time after the debate. Oct 23, 2012
  • @CBSNews Small sample size Oct 23, 2012
  • @TheStalwart I think you are fair and balanced, because A third of the time I agree, a third I disagree, and a third I an in-between. $$ Oct 23, 2012
  • @wallstCS FD: long $SFG — You do realize that revenue is not a useful valuation metric for insurers, right? Earnings & Book r relevant $$ Oct 22, 2012
  • @groditi @GaelicTorus it drives a lot of technology development, materials science, design (or lack thereof), advertising, energy efficiency Oct 22, 2012
  • @BradErvin1 No, the point is that corrupt governments tend to spawn corruption in society Oct 20, 2012

On the Virtue of Hard Questions for Young Analysts

Friday, October 26th, 2012

Yesterday I represented the Baltimore CFA Society at the kickoff meeting for the 2013 CFA Institute Research Challenge.  As is the norm, the Washington, DC CFA Society (which is 2.5x larger than us) and Baltimore choose a local company for the students to analyze.  Last year, it was Under Armour [UA].  This year, it is Marriott [MAR].

One quick aside.  Last year, the more bearish you were on Under Armour, the better a team scored.  But guess what?  Under Armour rose 15% in the last 7+ months — the team that finished last had the result that was the best, and the winner did the worst.  I know many of my readers don’t like Jim Cramer, but one thing that he said shines through here: “The bear case always sounds more intelligent.”  The same is true in academic competitions.  That’s one reason it is good to have a mix of temperaments in an investment firm.  Personally, I believe that bulls and bears do better together than separately — they need to round each other out.

Personally, I would prefer to analyze a growth stock like Under Armour, to the “asset light” hotelier Marriott.  That said, Marriott’s  Investor Relations team was out in force for the six (maybe seven) colleges who showed up, and gave what I thought were credible answers to the students who asked them questions.  Near the end of the presentation, the senior Investor Relations person walked them through each line of the income statement — I thought that was a nice touch, but wondered what Marriott used as an internal measure of profitability.

(Note to any students reading me: take a look at what Moody’s, S&P, and Fitch use as their metrics on Marriott.  The rating agencies are not dumb, and they get more data than stock analysts do. They are inside the wall.  They get material nonpublic information, and disclose the portion of it that is relevant to bond investors.  At the presentation, the Marriott IR folks stressed repeatedly that they want to maintain an investment grade credit rating.  That is a large constraint on what Marriott does, and should be considered in any good analysis.)

This will be an interesting competition, and five months from now, it will be fun to be a judge in the local version of the Investment Challenge.

-=-=-=-=-=-=-=-=-=-

Two weeks ago, I was a judge in a competition among finance students for four colleges that met a McDaniel College.  I was the only judge that did not graduate from McDaniel, which was formerly Western Maryland College, named after the Western Maryland Railroad which funded the school in its early years.

The question at hand was whether the Texas Rangers should have acquired A-Rod in 2000.  This is a tough question, because it is a binary decision, and it faces the winner’s curse.  So, you hired A-Rod.  How badly did you overpay to get him?

I don’t think I am overstating the problem.  Anytime there are multiple bidders for a unique asset, the winning buyer tends to overpay.

The case study (from Harvard) had its own issues.  It overestimated how fast average player salaries would grow, and the econometrics behind the estimation of wins as a function of player salaries was decidedly poor.  More than the Harvard Business School case study would admit, it was a lousy decision to hire A-Rod.  Add in the social effect on other players when A-Rod is paid a huge amount relative to them, and even if he is a nice guy, you wonder if you are truly valuable to the franchise.

But when you are a judge in such a competition, your mind works this way: the first team sets the tone, and has an advantage until a team eclipses them.  Then that team sets the tone.

The judges were pretty neutral on whether A-Rod should be hired or not.  The vote depended more on the process they undertook.  How much research did they do?  How do they back up their assertions?  Did they believe the data in the case study blindly?

–==-=–==-=-=-=-=-=-=–==-=-=-=-

Face it, the business world is unclear/dirty, and those that analyze it have to take account of what they don’t know, and make the best decision that they can.  This is the virtue of hard questions for young security analysts, and why we hold such competitions.

Toss them a hard problem.  Make them think outside the box.  Life is tough, and investment decisions are often unclear.  This is life.

Investment competitions are a far better way to train students than the raw academics.  Modern Portfolio Theory is garbage.  Most academic approaches to investing don’t work.  But try to understand a business like Marriott.  They make money off of selling their name.  They make money managing hotels.  How can they be sure to make money as they do so?  Those are the tough questions to analyze.

It’s a good thing to make young analysts face a hard question.  Whether they win or lose, they had to work hard, plan, compromise with team members, and come to a decision that would face criticism.  When we invest money, we don’t get criticism vocally, but we do see the gains and losses.  Thus the investment competitions are a very good way to prepare students for the eventual gains and losses they will face when they are making business decisions on their own.

 

 

Higher Taxes, Inflation, Default (Choose One)

Thursday, October 25th, 2012

I am a mix of analysis and intuition. Few argue with my analysis, a decent number argue with my intuition.  But I am not the only one concerned about monetary policy.  Listen to Warren Buffett (pages 12-16, but he comments elsewhere on the cost of capital and the inability to compete on an unlevered basis because of low rates.  Buffett is uncomfortable with the idea that the Fed can expand its balance sheet indefinitely.  He doesn’t know why it won’t work, but he knows that there are no free lunches, and wonders what might happen as a result.

Or, read this piece that disses quantitative easing.  Truth, there is no easy transmission mechanism between quantitative easing and employment.  It is a fools game, and when I say that, I say that neoclassical economists are sophomores, that is, “wise fools.”

Are they bright? Yes.  Have they imbibed dumb ideas that have a patina of intelligence? Yes.  Too much private debt leads to banking crises.  Too much public debt leads to worries over higher taxes, inflation and default, which inhibits private action, leading to a slower economy.

The Federal Reserve has discovered that they have a real balance sheet.  They not only have a liability policy, as in the old days, but they have an asset policy, allowing them to take on pseudo-fiscal stimulus.  Sadly, the idea that a central bank should not take asset risks is out the window.

Just as the referendum process makes legislators lazy, in the same way delegating economic policy to a central bank makes legislatures lazy — they can do nothing, and let the central bank react.

Part of the problem here is that we are relying on the models of the economists who argued that debt is neutral, and could not see the crisis coming.  Debt is the problem.  Debt-based systems are inherently inflexible and lead to crises when they are too big.  All significant economic crises are debt crises.

We need to get the neoclassical economists out of the Fed.  They can’t think broadly enough to see the problems we are in.  We need people who can think long-term, like actuaries and value investors.  (Please tell the SOA, CAS, and CFA Institute to rid their curricula of neoclassical economics.)  There is enough intelligence in those two groups that a new theory of what to do could emerge, perhaps realizing that optimizing the short-term ruins the long-term, and vice-versa — sometimes you have to take a depression to realign your economy.

In general, the US Government has not displayed any real talent in managing the economy.  If I could rewrite the Constitution, I would limit the Federal role in matters economic, and eliminate the possibility of a central bank.  Even when it did work well under Martin and Volcker, it does not make up for Greenspan, Bernanke, Burns, Miller, Harding, Crissinger, and Young.

I would also require balanced budgets on an accrual basis, ending the problems of non-funding Social Security and Medicare.  The problem of promises now, performance later will bite us hard, and most of the rest of the world also, because changing old age security from a personal issue to a collective issue has this problem: there is no reason for any husband and wife to have more children.  This is hitting the rest of the world harder than the US, because the (mostly dead) Protestant optimism of the US leads people to have more have more children. (Please remember that the group in history that had the largest completed family size was not the Catholics or the Mormons, but the New England Puritans, who averaged 9.5 children in families where the wife survived.)  Also note that Puritan husbands cared for their wives deeply.

As for me, my wife and I bore 3 children, but not for lack of trying for more.  We never used birth control.  We also adopted 5, sending us through the social work system 5 times.  It is challenging to raise a large family, but it was worth it.  We are on the receding side of it, with our youngest now aged 10.  The challenge of raising older children is significant.

Um, I got off-track.  The grand scheme is that many think that they can borrow big in the present, and it won’t have any significant consequences in the future.  That idea will fail in some way in the future, but how it fails is an open issue.

Redacted Version of the October 2012 FOMC Statement

Wednesday, October 24th, 2012
September 2012October 2012Comments
Information received since the Federal Open Market Committee met in August suggests that economic activity has continued to expand at a moderate pace in recent months.Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to expand at a moderate pace in recent months.No change.
Growth in employment has been slow, and the unemployment rate remains elevated.Growth in employment has been slow, and the unemployment rate remains elevated.No change.
Household spending has continued to advance, but growth in business fixed investment appears to have slowed.  The housing sector has shown some further signs of improvement, albeit from a depressed level.Household spending has advanced a bit more quickly, but growth in business fixed investment has slowed.  The housing sector has shown some further signs of improvement, albeit from a depressed level.Shades up household spending.  Shades down business investment.
Inflation has been subdued, although the prices of some key commodities have increased recently. Longer-term inflation expectations have remained stable.Inflation recently picked up somewhat, reflecting higher energy prices.  Longer-term inflation expectations have remained stable.Shades up their view of inflation, blaming energy prices. TIPS are showing rising inflation expectations since the last meeting. (5y forward 5y inflation implied from TIPS.)
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.Emphasizes that the FOMC will keep doing the same thing and expect a different result than before. Monetary policy is omnipotent on the asset side.
Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.No change.
The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.No change. CPI is at 2.0% now, yoy, so that is quite a statement.
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of Treasury securities, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.No real change.

Does not mention how the twist will affect those that have to fund long-dated liabilities.

Wonder how long it will take them to saturate agency RMBS market?

 

The Committee will closely monitor incoming information on economic and financial developments in coming months.The Committee will closely monitor incoming information on economic and financial developments in coming months.No change. Useless comment.
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.No change.
In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.The FOMC promises what it cannot know or deliver.
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.No change.

Promises that they won’t change until the economy strengthens.  Good luck with that.

In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.No change
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Jerome H. Powell; Sarah Bloom Raskin; Jeremy C. Stein; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Jerome H. Powell; Sarah Bloom Raskin; Jeremy C. Stein; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen.No change
Voting against the action was Jeffrey M. Lacker, who opposed additional asset purchases and preferred to omit the description of the time period over which exceptionally low levels for the federal funds rate are likely to be warranted.Voting against the action was Jeffrey M. Lacker, who opposed additional asset purchases and disagreed with the description of the time period over which a highly accommodative stance of monetary policy will remain appropriate and exceptionally low levels for the federal funds rate are likely to be warranted.Lacker sharpens his hopeless dissent against a flock of doves.

 

Comments

  • No big changes.  The FOMC’s views on household spending and inflation have risen.  Note that the CPI is at their 2.0% line in the sand.
  • In my opinion, I don’t think holding down longer-term rates on the highest-quality debt will have any impact on lower quality debts, which is where most of the economy finances itself. When this policy doesn’t work, what will they do?
  • Also, the investment in Agency MBS should have limited impact because so many owners are inverted, or ineligible for financing backed by the GSEs, and implicitly the government, even with the recently announced refinancing changes.
  • 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.
  • GDP growth is not improving much if at all, and the unemployment rate improvement comes more from discouraged workers.

A Statement to Dr. Bernanke:

More debt will not get us out of this crisis.  The Great Depression ended when enough debts were compromised, paid off, or cancelled, which from my study is 1941, before World War two started.

Your policies further aid the growth of the budget deficit, and encourage malinvestment in housing and banking, two things in a high degree of oversupply.  The investments in MBS only help solvent borrowers on the low end of housing, who don’t really need the help.  Holding down longer-term rates on the highest-quality debt does not have any impact on lower quality debts, which is where most of the economy finances itself.

The problems with unemployment are structural, not cyclical.  Labor force participation rates continue to decline.  There is greater labor competition around the world, forcing down wages on the low end.  There is nothing that monetary policy can do to change this.  You can create stagflation through your policies, but not prosperity.

When inflation does arrive, the FOMC is going to find it very hard to raise Fed Funds or shrink its balance sheet.  The banks will not react well as you try to shrink, and the long rates that you have held down will react violently.

You haven’t thought through all of the “second order” effects of your policy.  Even the “first order” effects, which favor the rich over the poor, seem to elude you.  Assets rise, helping the rich.  Interest rates fall, helping the rich who can borrow.  Commodity prices rise, harming the poor.

Insanity is doing the same thing over and over, and expecting a different result.  When will you realize that the policies of the Fed aren’t helping, and need to be abandoned?

Why I LOVE Blogging

Wednesday, October 24th, 2012

Abnormal Returns (one, two), The Reformed Broker, and Felix Salmon all opined on the health of the Financial Blogosphere today.  It’s dying.  It’s not dying.

As an actuary, I don’t have to be so strident.  Death is a normal thing for fallen men and their creations.  The only question is how rapidly they die.  A good experiment would be to list all of the economics & finance bloggers publishing in 2007 that are still publishing in 2012, at least once a month.

If you are a blogger on economic, financial or investment topics, you have to have something burning within you in order to post regularly.  If you don’t have some reason to speak, you won’t post much.  After all, no one makes much money off of pure blogging.  My blogging buys food for my family for two months of the year, no more.

Think of forks in the road.  Many stop blogging because:

  • Life goals change
  • There are few rewards, and many annoying commenters
  • Regulatory standards stop them
  • They don’t gain traction and give up
  • They get lots of negative feedback, and give up
  • They go professional
  • The markets shift — they blogged during the crisis, and don’t know how to blog in normalcy, or vice versa.  I have my share of detractors from both eras.
  • They run out of things to say.

I was once part of the RealMoney Columnist Conversation, and unlike most, I would dispense post-long comments, which the editors would occasionally republish as posts, which they never did for anyone else that i know.  If you have something that is valuable to say, people will listen to you.

As for Felix’s take on blogging, I am somewhat sympathetic, but my sense is that things are not the same but are on average the same.  I don’t see a lot of new stars.

All that said, though I like some corporate bloggers, like Felix, for the most part I still like those who are independent and express their own views by nature, because they aren’t getting paid by someone else.

The Rules, Part XXXIV

Monday, October 22nd, 2012

“Once something is used for hedging purposes, it becomes useless for predictive purposes.”

I know this is kind of a trivial insight now, but when I originally wrote it, it was more cutting-edge.  That said, it is still not fundamentally understood by most.  Most still look at a fragment of the puzzle.  Few look at the whole.

My poster-child for fragmentary thinking is this article: The end of stock market crashes? Do I disagree that correlations begin rising among risky assets toward the end of a bull market?  Not at all.  I have even written about it on occasion.

But if few understand this, then only a few will take shelter when correlations get high.  The rest will continue the disorderly party until the “market cops” show up in the bear market.

If it becomes a widespread idea, a market rule, etc., it may constrain behavior for some time, leading to no large crashes, but after a long while with no crashes some will assume that such crashes are not possible, and the rule is out-of-date.  Four  examples:

  • Stocks should yield more than Treasury bonds.
  • Stocks should yield more than 3%.
  • Q-ratio
  • CAPE10

Many items that have intermediate-term wisdom, and are known to have that wisdom, eventually get ignored.  The first two I listed were common market nostrums in their day.  The second seem to have more long-term validity, but get ignored by many who say, “It’s different this time!”

But even if everyone agrees that a certain risk measure is a correct risk measure, and it becomes a part of the market’s furniture, that doesn’t mean risk ceases.  It does mean risk takes a different form.  I think of all of the people decided not to take equity risk during 2000-2007, and decided to invest in residential real estate, or take risk through CDOs, subprime RMBS, etc.

Yes, they avoided risk in the stock market.  They ran into something far more fundamental.  The risk from all risky assets, public, private, leveraged, unleveraged, is everywhere, and it is very difficult to hide while taking risk.

The markets incorporate a lot of rules that have partial validity.  They are known variably, and apply variably.  At some points these rules seem sharp and prescient.  At other times they seem weak and outmoded.

This brings me back to my view that the market is an ecosystem where no strategy has permanent validity.  Strategies ebb and flow as many parties search for scarce returns.  There are well-known limits to markets, like the Q-ratio and CAPE10.  If the markets come up with another one, like risky asset correlations, it will have validity, restraining speculative behavior, until people overwhelm it, and a new bust happens.

The boom-bust cycle cannot be repealed.  But it takes many forms.

 

On PB-ROE

Saturday, October 20th, 2012

Here is an e-mail from a reader:

I’m curious about the intercept of the PB-ROE line. In your examples (http://alephblog.com/2012/02/25/thinking-about-the-insurance-industry/), only life had a negative intercept; the others were all positive. Here’s the implication:

 PB = a + b ROE (where a and b are the intercept and slope).

If I divide both sides by ROE I get:

PE = a / ROE + b

Taking the differential:

dPE = – (a / ROE^2) dROE

So if the intercept is positive, an increase in ROE results in a lower PE and vice versa.

So here are two questions:

1) Why would the relationship be negative? Is it because the higher ROE is achieved via leverage, is therefore riskier, and requires a lower PE? 

2) Why is the intercept negative for life insurers but positive for the others?

First, you have to understand PB-ROE.  The idea is that there is a limiting factor to earnings with financial companies.  The earnings of financial companies is limited by its book capital.  I think this is correct to a first approximation.  But different financial companies experience different financial results; they have different ROEs.  How sustainable are those different ROEs?  ROEs tend to revert to mean; competition drives that.  How fast ROEs revert to mean derives from the length of the businsess written.  Long tail exposures found in life companies mean that a higher ROE usually gives more kick to the P/B multiple.

As an aside, with industrials and utilities =, I often think that sales are the limiting factor, and so my equation becomes:

P/S = a + b * E /S + e  (E/S = profit margin)

Now to your math.  You have the first equation wrong, it should be:

PB = a + b * ROE + e , where e is a normally distributed error term, so if you did the division by ROE, it would be:

PE = a / ROE + b + e / ROE, which means my error term could no longer be normally distributed.  So, you can’t divide through by ROE.  Not legitimate.

Let’s try a different approach.  What if we modeled P/E as a function of B/E?

First, to me that doesn’t make sense, because the idea of capital as a limiting resource goes out the window.

Second, if you did that the a and b would be different, because regression minimizes the squared differences of the dependent variable (actual versus expected).

So, with respect to what I said above, I would not do the math your way. Dividing and differentiating by ROE neglects the meaning of the original equation.  All models are just that, models.  But we can’t go neglecting what they internally assume, and expect to get good results.

So, I can answer your second question, but not your first question.  When we estimate PB-ROE, often the equations with the highest slopes have the lowest intercepts.  What that describes are situations where the ROEs, if they are high, are expected to remain high, and thus produce much higher P/Bs.  Such would be true with long duration coverages like in the life industry.

The reason the life industry is different is that the companies with high ROEs are expected to maintain those high ROEs for a longer period of time, because coverages are long, and pricing adjusts slowly.  With other insurance coverages, pricing adjusts annually or nearly so.

For a short-tail P&C company with an ROE of zero, I would expect a P/B multiple that is positive, because pricing adjustments and mean-reversion are coming soon.  For a life company with a low ROE, the adjustment will happen slowly, or it may never happen.  Perverse dynamics kick in when a company with long-tail coverages finds itself earning very little to nothing.  There is the tendency to mis-estimate reserves, “because we can’t be making so little.”  The length of accruals allows a greater degree of subjectivity to be injected into the estimates.  Short accruals get validated every year.  Long accruals don’t get that validation, at least not in a way that a public investor can see.

If you were an actuary inside the long-tailed life insurer, you would get some data telling you that your assumptions were optimistic, right, or pessimistic.  But it takes a while to figure out whether the last few years are a deviation or a trend.  Good actuaries dig in, and look at the causes for claims, trying to see if the reasons for policyholders making claims matches up with the original estimate of what the subject population would be likely to die (or have disability or LTC claims) from.  Too many abnormal claims may imply that the business has been underwritten wrong, and needs to be adjusted.

That analysis takes some doing, because long-tail life coverages are low-frequency and high-severity.  That’s why the qualitative data may help, by giving clues long ahead of the flood of claims that you did not expect.

To summarize: Life is different because the coverages are long duration in nature, and ROEs don’t change so rapidly.

 

Book Review: Investing in the High Yield Municipal Market

Friday, October 19th, 2012

This is a very good book.  It is also a hard book, so I don’t think many of my readers will benefit from it.

Score yourself:

  • How well you do understand bonds?
  • How well do you understand muni bonds?
  • How much do you understand about credit analysis?
  • Do you understand how municipal credit is different from corporate credit, including how the bankruptcy code works in each case?

If you are positive on three or four of those questions, this book will help you.  If positive on two, it might help you.  If less, forget it.  This is a book for those that have some knowledge of bonds generally and municipal bonds in particular.

I learned a lot from this book, but I have a lot of experience with bonds.  This book is a hybrid.  It is written mostly by the author, who recruited experts to write specialty chapters.

Here is my main misgiving on the book: in order to invest in high yield municipals, you really need an adviser next to you to guide you.  Even though the book says a lot of true things, there is no replacement for the person sitting next to you, who correct you in “real time.”

Aside from what is written in this book, if you are willing to put in a lot of time to understand the high yield muni market, you could do quite well.  But this is not adequate for average investors — I don’t think any book could be for high yield munis.

But the book is a really good introduction to the high yield muni market.  If you understand that it is only an introduction, the book will be valuable to you as you search for more knowledge.  This book is great, but it is not enough.  I don’t think any book could be enough, because there are a lot of complexities in these markets, and who would pay for a 2,000 page book?

Quibbles

Already expressed.

Who would benefit from this book:   If you want to get an introduction the the high yield municipal bond market, you will benefit from this book.  If you want to, you can buy it here: Investing in the High Yield Municipal Market: How to Profit from the Current Municipal Credit Crisis and Earn Attractive Tax-Exempt Interest Income (Bloomberg Financial Series).

Full disclosure: I asked the publisher for the book, and he sent it.

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.

 

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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