I have noted recently a number of advertisements offering risk-free investing.  When I dig into them, they are selling life insurance and annuities.  They claim high rates of return with virtually no risk.  Here are the problems:

  • Life insurers have come off of 3+ decades of falling interest rates, portfolio yields are high relative to what you can get in the market today.  Some insurers may show above average rates, but if enough take advantage of them, the rates will fall to market levels.
  • Commissions to agents are relatively high, which has two effects: 1) less investment performance goes to the insured, and more to the agent, and 2) High surrender charges.  If you ever need your money in full, you will never get it back from an insurance contract.
  • People have forgotten the 1970s, with rising interest rates, where many insurers were near bankruptcy, and on a market value basis, many were technically bankrupt.
  • Life insurers that have written a lot of variable business or a lot of indexed business have taken on a lot of hidden equity risk.  Imagine a Great Depression scenario, where equities fall 90% over 3 years, and it takes 20 years more for values to recover.  Guess what?  Virtually all of the life insurance industry dies, whereas most survived the Great Depression.
  • From Mutual Insurers, life insurance dividends are not guaranteed.  In a real crisis, dividend scales could drop to zero.  The insurance you thought was free regains a price.
  • Equity indexed products rarely return well.  When I analyzed them back in the early 2000s, T-bill yields were the result of my models.  Today, T-bill yields are so low that the returns must be better.  That said, you will have to accept low returns versus a long surrender charge.

Insurance is meant for protection, not savings.  It is also meant for scamming the tax man, especially with respect to estate taxes.

Just be wary here, I’m not naming names, because many of these parties are litigious, another sign of weakness.  But there is no “one size fits all” method for Wealth Management.  One of my clients recently complimented me because I don’t try to get all of the assets of a client.  Indeed, I want my clients to feel that they have chosen me for their purposes.  I do not want them to allocate more to me than they are comfortable allocating.

So, be aware of the limitations inherent in life insurance products.  And when you hear that something is virtually risk-free, take a step back and hold onto your wallet.  Nothing is risk-free.  Even with the guaranty funds backing the insurers, the full value of large policies is not guaranteed, much like large depositors in the banks.

The regulation of the solvency of life insurers has been better than that of banks for the last 30 years, but it hasn’t been perfect.  I was on the takeover team that tried to have AIG to take over the Equitable.  AXA overbid, and bought a bad situation just as it was about to turn.

As for AIG, some of those promoting insurance products say that AIG’s life insurance subsidiaries did not need a bailout in the crisis.  That was false, because of the securities lending agreements, and a few other things.  Most of the domestic life companies of AIG received bailout money.

The good record of life insurance lack of default over the last 30 years is the result of three things:

  • Falling interest rates
  • Better solvency regulation than banks
  • AIG’s life insurance subsidiaries were bailed out.

Be diversified, and don’t use just one set of entities to fund your retirement.  Using only insurers runs a lot of regulatory and taxation risk.  A future government may find clever ways to undo the clever tax avoidance that has been achieved there so far.  Spread your regulatory risk.  If you are wealthy enough, spread out your country risk, but be wary as you do so.  Who will support the rule of law better than the US?  Where will governments not tap assets under custody in a crisis?  Remember Cyprus.  It will not be the last place where assets are expropriated for the good of locals, even if locals got hurt as well.


From one of my longtime readers:

I just wanted to toss this suggestion your way and the motivation is partly selfish, but given the decline in gold the last 3-4 days (I actually exited all my long positions around 1500-1505 last Friday based on the breach of the technical support level at 1525-1535 and am now short in my trading account from that same level) I’d be interested to get your qualitative thoughts and maybe an update on your refined quantitative model with negative real interest rates and where it says gold should be trading.

If it turns out substantially above the current price of 1360, I’d be curious if you think that model isn’t valid or if gold is a bargain here.  This article here got my wheels turning that bases on a gold price model on ratio to CPI:


But to come up with an estimate of gold’s fair value, they calculate a ratio of gold to inflation going back as far as they were able to obtain data. They report that this ratio, when expressed in terms of the U.S. Consumer Price Index, has averaged about 3.2-to-1. Even at $1,400 an ounce, this ratio stands at 6.03-to-1, or nearly double this average. 

From a qualitative standpoint, the negative interest rate model made the most sense to me simply from a critical thinking standpoint.  The relationship to CPI seems less reasonable to me if one starts with premise that gold is an alternative currency.

Anyways, thanks for any response or addressing this on your blog.

Links: The Gold Medal Gold Model, Gold does Nothing.

I updated my gold model.  This is what it looks like without re-estimating the parameters:

Eddy's Gold Model_16809_image001

And this is what it looks like after re-estimating the parameters:

Eddy's Gold Model_11787_image001

The real cost of carry in holding gold is negative, and it has been consistently negative for the last five years. and mostly so for the last ten years.  Thus the run-up in the price of gold over the last 10 years.

Now models are just that, models.  I can make three seemingly contradictory statements about this model:

  • The old models did not predict the path of the gold prices well.
  • The re-estimated models fit the data better than the old models.
  • If the model is accurate, there is economic pressure to make the price of gold rise.

My hypothesis at this point in time is that easily tradable products based on gold encouraged speculative pressure, leading the price of gold to overshoot, and now it is correcting.  That said, when the real cost of carry is so negative, gold should appreciate.

Alternatively, we could try to develop a supply-driven model of gold, where we estimate the marginal costs of mining an additional ounce of gold.  Ore depletion is significant, but the effect is relatively constant compared to demand for gold.  It also helps to explain why the stocks of most gold miners have not done well, even with a rising gold price.

We often like to think that if a commodity price is rising, the stock of the producer must do even better.  Not always true, if the prices of extraction/production rise faster than the commodity price, as it has been with gold producers, the stocks will be a bad investment.

My final opinion is this: if you have a 5-year time horizon, I think you will do well with physical gold, where you take delivery, and store it yourself.  With easily tradable paper versions of gold, it is less clear, because you would need to analyze the actual assets.  There might be some credit risk involved.

I don’t think the currency devaluation competition is going away anytime soon, so gold will likely do well against paper.  The real question is when will some major country decide to give up and raise taxes dramatically, inflate, or default.  Aside from the raising taxes scenario, gold should do pretty well.  I might get less optimistic if the gold miners began making significant money,producing much more gold, but producing gold remains a hard business.

Market Impact

  • Gold Buyers Throng Indian Stores for Second Week on Rally http://t.co/ilkuosl43D Physical gold is receiving much attention, futures not $$ Apr 26, 2013
  • Renaissance Funds Take a Tumble http://t.co/U3x0uboqPA Hedge Funds in aggregate r2 large &2 similar. They r an inferior way 2 invest. $$ Apr 26, 2013
  • Investors Say No to Sallie Mae Bond Deal http://t.co/ZOmyJpDWJL Another sign of bad credit building up $$ Apr 26, 2013
  • Silver — The Poor Man’s Gold Crossing Wall Street http://t.co/CTWhiJTXNX @eddyelfenbein retells the attempted corner on silver story $$ Apr 25, 2013
  • Cleveland Fed leads in measuring stress http://t.co/sdL7KsNSax Aggregate financial stress gauge measures current risks daily $$ #kicksthevix Apr 24, 2013
  • Emerging-Market Returns Unhinge From Developed http://t.co/Ml8iBjGkPy Perhaps a sign that the risk trade is getting past the peak $$ Apr 24, 2013
  • TradeBots, Social Media Form Volatile Combination http://t.co/QTiRnL6ZKt U mean u can’t trust everything u read on Twitter? $$ #scandal Apr 24, 2013
  • Watchdog: Banks R Still Too Intertwined http://t.co/8hkaUWCJyg TBTF not solved, mortgage assistance may have harmed more ppl than helped $$ Apr 24, 2013
  • Pimco’s Rising Stars Pull in Money for Future After Gross http://t.co/Xda08qQ8U4 Pimco is a quant bond shop; not reliant on 1 person $$ Apr 24, 2013
  • Hulbert on Investing: How to Time the Market http://t.co/QfH1yd8J70 Value Line’s Median Appreciation Potential is 50%; yellow/red light $$ Apr 22, 2013
  • Hedge funds: Launch bad http://t.co/tLk5swElr7 Breaking into the hedge-fund world is harder than before, fees coming down, game 2 tough $$ Apr 22, 2013
  • Apollo-to-Goldman Embracing Insurers Spurs State Concerns http://t.co/uMylWdF9pE Newcomers to life insurance invest more aggressively $$ Apr 22, 2013
  • Reminds me of bad old days of life insurance investing, thinking the old rules don’t apply, using novel capital structures & investments $$ Apr 22, 2013
  • BTW, the bad old days were 1982-2002. Other similarities r the use of too much leverage & scrimping on actuarial/other specialty talent $$ Apr 22, 2013
  • Why Does Financial Innovation Sometimes Make System Riskier? http://t.co/WbEHfNyiUc something new to wager on, can amplify bets elsewhere $$ Apr 22, 2013
  • Other reasons — regulatory arbitrage, relief frm accounting rules, tax advantages, agency problems (heads I win, tails the company loses) $$ Apr 22, 2013
  • JPMorgan Said to Plan CMBS Deal With Sales at Post-Crisis Peak http://t.co/elhMy69Q2O If u could borrow @ ~4%, u might buy commercial RE2 $$ Apr 22, 2013
  • Lurching Gold ETF Veers From Metal Most in Year Amid Selloff http://t.co/8CyKR7Ptsr Less of a factor now, as $GLD is trading near NAV $$ Apr 21, 2013
  • Gold slide flashes warning signs for global economy http://t.co/x5w7HWaZ1s Significant but just one sign, Long US Tsys have also rallied $$ Apr 21, 2013


Rest of the World

  • Japan’s Investment Banks Once Ugly Sisters Turn Into Cinderellas http://t.co/GuRw6T3LLG When finance is expanding, it is not prosperity $$ Apr 26, 2013
  • The Poverty Lie: How Europe’s Crisis Countries Hide their Wealth http://t.co/F3OikdTHs6 Germany getting restive over requests 4 bailouts $$ Apr 24, 2013
  • After the Flash Crash http://t.co/elcHKBo6hX Andy Xie bullish on Agriculture & Gold, bearish on Japanese monetary policy $$ Apr 24, 2013
  • Xinhua: Overcapacity troubles Chinese economy, reform needed http://t.co/UU2Guow1M5 2 much investment in heavy industries 4 export $$ #Japan Apr 24, 2013
  • Bernanke Peer Quits in Sweden as Inflation Targeting Tested http://t.co/uM6zq4Gjw0 Apostle of salvation via inflation finally quits $$ Apr 24, 2013
  • Spain’s population falls as immigrants flee crisis http://t.co/aNHDMURxqq Foreigners came in good times, now leave in hard times $$ #byebye Apr 24, 2013
  • China alert to debt risk fears http://t.co/BjyjB1rEXw Local governments keep borrowing $$ & selling land; how will it get paid back? Apr 24, 2013
  • Greece’s great fire sale http://t.co/X6LXA5Wbhd Selling pristine beaches to palaces, entire islands & its London embassy $$ #regretitlater Apr 24, 2013
  • Inside Merkel’s Bet http://t.co/uNdfdGUR0U Merkel pushes dirty work to the Troika, stays popular in Germany resisting bailouts 4 fringe $$ Apr 24, 2013
  • Japan’s population suffers biggest fall in history http://t.co/I48upsEBQM Japan, Germany, China, Russia lose vitality as populations drop $$ Apr 24, 2013
  • Why the US is looking to Germany http://t.co/OtxDy8W5g0 With their labor market, the US is suffering from a rising case of ‘German envy’ $$ Apr 22, 2013
  • China’s cooldown: Charting a new path for commodities http://t.co/L5aFpZ8jml Feels like the global economy is slowing, debt-heavy $$ #soggy Apr 22, 2013



  • Jim Grant on the Most Undervalued Stocks http://t.co/xz9K18lKbo Someone must have given him a double-shot of espresso b4 this lively chat $$ Apr 25, 2013
  • Few $1-Salary CEOs Make a Buck as Ellison Gets $96MM http://t.co/9HisNA97zH Avg comp 4 S&P500 CEO is $1.1MM, which sounds low $$ #avoidenvy Apr 25, 2013
  • Verizon-Vodafone Chatter Picks Up Again – Corporate Intelligence http://t.co/cFu4NsKLYI $VZ should buy $VOD , &sell off what it doesn’t want Apr 25, 2013
  • Last tweet full disclosure: long $VOD Apr 25, 2013
  • Apple, the Fed and the financial fallacy http://t.co/FdjDLxLoEt @jamessaft compares the Fed’s & $AAPL ‘s willingness2dabble in fin’l mkts $$ Apr 24, 2013
  • Illinois Tool Works’ Plan Faces Major Test http://t.co/aF3lEsa1x5 Probably being done 2 meet management ROE incentives $$ $ITW #wouldnotdoit Apr 24, 2013
  • Netflix Shows It Pays to Buy Index Flotsam – Focus on Funds http://t.co/3aRurKK4bw Index departees often rally hard after forced selling $$ Apr 24, 2013
  • He’s Not Short: Dude Likely Cheered On IBM Plunge http://t.co/CQLhwgusLn Warren the wonderful has $$ 2 reinvest, likely buying more $IBM Apr 24, 2013
  • U.S. Aid Drove Fisker to Overreach http://t.co/X4hrc1quB9 It would b cheaper 4 the Govt 2 finance alt energy research, no companies $$ #duds Apr 24, 2013
  • Hewlett-Packard and Its Obstinate Director http://t.co/WCqgabIayk Easier 2 toss out a sitting congressman than a public company director $$ Apr 22, 2013
  • More than 90 pct of NY, NJ Sandy claims settled -trade group http://t.co/cvnVlJLEwo 3rd largest loss event in real $$ terms v Katrina,Andrew Apr 22, 2013



  • Wrong: Health Insurance Actuaries In the Hot Seat On ‘Rate Shock’ http://t.co/HQDkLjzfF4 Actuaries r generally honest, unlike politicians $$ Apr 25, 2013
  • Wrong: Boston and the Un-Bush http://t.co/AuUBsA1zTH Obama is Bush-plus. That doesn’t make it right. Free societies take losses $$ Apr 25, 2013


US Politics & Economics

  • It’s A Bit Early To Declare A Winner In The Economic Debate http://t.co/5NAAQJbI8F High debt levels do slow growth; they create uncertainty Apr 26, 2013
  • Bombing Victims Get Millions as Internet Redefines Giving http://t.co/mgy3peyEmA It works 4 now, b/c it’s new. Donor fatigue will set in $$ Apr 25, 2013
  • Americans Paying Up Wherever They Reside Beseech Congress http://t.co/h9QPtCgpw5 Congress forgets expatriates, IRS remembers $$ #youlose Apr 24, 2013
  • Rand Paul Tries to Transform a Moment Into a Movement http://t.co/PbAV8wu4JK Libertarianism rarely wins in the US; here goes another try $$ Apr 24, 2013
  • Deflation – A Three Act Play http://t.co/0VvU2Qi8E1 Fed’s lengthy battle w/deflation 2 weaken the $$ & rejuvenate inflation expectations Apr 24, 2013




  • If u want 2learn best tonality 4 your voice, sing the highest note u can clearly, then the lowest note, best tone is 25% from low 2 high $$ Apr 24, 2013
  • Changing the Sound of Your Voice http://t.co/xh2ABsnKfw The quality of your voice affects how people perceive u; retraining can help $$ Apr 24, 2013
  • Chili Peppers Seen Helping 36 Million Migraine Sufferers http://t.co/RSg5Zk0iHU This is the next hot idea in pharmaceuticals $$ #sorryihadto Apr 22, 2013


Replies, Retweets & Comments

  • Thx 4 realspeak $$ RT @jckhewitt: but you don’t understand man. They made a spreadsheet error. Infinite debt is infinity plusgood now. Apr 26, 2013
  • Not surprising, almost all fail for lack of volume $$ $MKTX RT @Alea_: BlackRock Crossing Bond Platform KAPUT http://t.co/U7Thmd1API Apr 25, 2013
  • @AppFlyer Capital needed to escape one’s country during times of panic to obtain a safe life in the US Apr 25, 2013
  • @VCEO_Vision I am a life actuary by training. Living benefits r not adequately reserved, & r improperly priced; regulators should ban them Apr 25, 2013
  • “Not only was it short, it was small.” — David_Merkel http://t.co/rI3NOhOD2w Regarding the twitter “Flash crash” Apr 25, 2013
  • ‘ @timmelvin @TimABRussell MD searches 4 $$ , then 4 a justification; more imperial overreach in the People’s Republic of MD #raintax Apr 24, 2013
  • ‘@dpinsen @EddyElfenbein Here’s my article on the topic: http://t.co/HkHilkN5rV At the end I conclude that 1.5x growth is the outer limit $$ Apr 23, 2013
  • Owners of bank common stocks RT @MattGoldstein26: This CSFI, Cleveland financial stress index, is fascinating stuff. So who is shorting it? Apr 23, 2013
  • @kyith I would never buy a dread disease policy; typically the claim pmt/premiums ratio is low. People overestimate incidence Apr 22, 2013
  • @fundmyfund My wife says @theEconomist always tries to save money on pictures by using funny captions $$ “Plan B for finding seed capital” Apr 22, 2013
  • RT @Galrahn: One terrorist had over 1,000,000+ Americans across 100+ square miles hiding in houses for safety. Boston is how not to do Home… Apr 22, 2013



  • My week on twitter: 22 retweets received, 4 new listings, 67 new followers, 25 mentions. Via: http://t.co/cPSEMLXpb8 Apr 25, 2013



 My name is XXX and I am a senior at Trinity Christian School. A couple weeks ago my teacher and senior project adviser, Dr. YYY, suggested that I contact you for professional insight and opinion. I am reaching the end of my paper but I have a few questions:

  1. What actions would you suggest to European Leaders? (I know you addressed this in your article, “Winding Down the Eurozone“, but if there is anything you would like to add it would be greatly appreciated)
  2. What would a restructured Eurozone look like? 
  3. What does the Bible say about our finances? What advice does the Bible offer to officials? 

We can correspond either through email or telephone, whatever you prefer. 

You wrote a good question, compliments to your teacher, so I respond by blog post.

I have a saying, “Cultures are large than Economies, which are larger than Governments.”  The Eurozone is a big mistake, which came into existence trying to prevent another European war.  One might ask what threat there is of such a war, and we should be skeptical of anything more than a shrug.  Please ignore my last name, but Germany is no military threat to Europe.  There is no logical reason for the Eurozone.

A free trade zone is a good thing, and better we should have one across the whole world.

As for a restructured Eurozone there are three models:

  1. Germany and Finland leave, and the remaining Eurozone has a weak currency, which allows their industries to be competitive.
  2. Greece, Italy, Spain, Portugal, and maybe Ireland and France leave.  Those remaining have a hard currency, and a much smaller Eurozone.  The problems are not totally solved, though, because there are still significant productivity differentials across the diminished Eurozone.
  3. The entire Eurozone unwinds, and good riddance.  Most large economic errors occur because governments assume they have more power than they really have.

Now, as for what the Bible has to say about finances, and what officials should hear from the Bible is a big topic, and I will cover that in a few days.  But for now, that is all.

The following was published by RealMoney on 4/26/2006.  As with all of these “classic” articles, I republish them because they aren’t available at RealMoney any more.  They changed their system for links, and so articles and comments that I put a lot of work into have disappeared.



If you believe in the trend but prices are high, take a half position.

Despite U.S. automakers’ woes, cars will be built by someone; this makes stronger parts suppliers a good play.

Global economic development means more demand for chicken.


One of the most important things to understand with investment ideas is what time period they are for. Sometimes a given asset can take different directions over the short, intermediate and long terms.

Imagine for a moment that you buy the thesis that a large portion of the world is joining the capitalist economy, and that this will lead many more people and businesses in developing countries to demand more goods consistent with what we view as a middle-class lifestyle. That’s a secular trend that will play out over many years. It can be a guiding theme that can help organize investment ideas over the long term.

Now, say that your interpretation of that secular trend implies higher worldwide demand for foodstuffs, metals, timber and energy. However, when you look at the valuations of some of the companies affected by the trend, they appear to be too high, and profit margins are above historical norms. (Valuations are in fact reasonable for many companies in these sectors, but play along with me for a moment.)

You are faced with a problem, then. You think the secular trend is valid, but that much of the story is presently anticipated by current valuations. What to do? One technique that I have used in situations like this is to buy half of what I would if valuations were reasonable (which occasionally aggravates my boss, who is an all-or-nothing kind of guy).

If the stocks go down, I would come up to a full position. If the market gets crazier and valuations rise, I would punt out the smaller position for a gain. If the market muddles somewhat trendlessly, I would buy and sell using my rebalancing discipline, which will clip a couple of extra percentage points over time.

There are alternatives, though. You could buy a full position, but then you are committing to the stock for the long run on the idea that the secular trend will dominate over valuations. You’d better be right, because with higher valuations than normal, being wrong has a greater cost.

You also could do nothing. After all, valuations are extended, and you won’t just pay anything for a stock. This strategy presumes an interruption in the general trend will be coming. That may or may not happen; high valuations often get higher for stocks in a winning thesis. Paying up for a good idea is often a good strategy, but the tradeoff between valuation and the secular trend is a difficult balancing act.

Part of working that tradeoff comes with experience, but I would argue that it also requires humility — the market always finds a new way to make a fool out of you. Always consider what could go wrong. Conservatism means that you will always stay in the game, and staying in the game for a long time is the secret to compounding returns.

The Internet Bubble

Let me give you a few real-world examples. Think of the Internet bubble. The long-term prognosis that the Internet would be big was correct (in hindsight), but valuations were screaming “Don’t play here,” and many concepts were quite marginal from a cash-flow standpoint. That said, the technicals were screaming, “Momentum, baby! Time to play!”

My solution was to sit it out. I figured that, eventually, the cheap financing would run out and the market trend would shift. The problem was, it lasted two years longer than I anticipated.

Maybe I left something on the table. I could have played with smaller position sizes, or played with a mental “stop order” in the back of my mind. That said, it didn’t fit my personality, and I didn’t feel that I could evaluate who the survivors would be, so my optimal decision was to sit it out. (I didn’t short it because the momentum was too great. Never argue with a liquidity wave.)

Industries in Secular Decline

What if you are looking at an industry in secular decline, such as the photo film business (think of how Kodak (EK:NYSE) has fumbled, or, worse, Polaroid), fixed-wire phone service companies, or the newspapers? All of these are being displaced by new technologies.

Verizon (VZ:NYSE) looks cheap and has a nice dividend. Is it a candidate to buy?

This is an example of Warren Buffett’s concept of “cigar butt” investing: Someone may have tossed it on the ground, but you can still get a few good puffs out of it. The company has limited growth potential unless a radical new strategy gets introduced, and that could be costly, or even fail. I had better get this company extremely cheap to compensate for potentially falling earnings at some point in the future. Even a wasting trust has a proper price, so if I can get it at a level that reflects a 15% annualized return, that could be a great investment.  One nice thing about declining industries is that there usually isn’t a lot of direct competition.

Here’s one more example: auto parts. I own Johnson Controls (JCI:NYSE) and Magna International (MGA:NYSE) , two companies with strong balance sheets that are picking up market share against weaker competitors. Automobiles are going to be built, even if GM and Ford aren’t going to be building as many of them.

This is one part of the auto sector where you can have moderate growth, and the stronger suppliers can do far better than the average. I still want to buy them cheap, but I can afford to pay a little more for quality in markets where quality is scarce. In this case, lower-quality companies could be cheaper, but they aren’t the ones to buy when an industry is under stress.

Playing Chicken

As the developing world grows, so will demand for animal protein. To me, that means chicken.

Valuations are favorable here, because many investors are scared about avian flu. Whole flocks of birds might have to be culled if even a few get sick. That said, large North American poultry producers isolate their birds from wild birds, and even from humans who have the flu.

The risk is overstated, and once the pandemic is over, valuations will rise. (Some people are mistakenly avoiding chicken, even though there is no chance of getting avian flu if the chicken is properly cooked.) I own Gold Kist (GKIS:Nasdaq) and Industrias Bachoco SA (IBA:NYSE) , but am considering whether I shouldn’t increase my exposure and add Pilgrim’s Pride (PPC:NYSE) , or Sanderson Farms (SAFM:Nasdaq). Tyson (TSN:NYSE) is too diversified, and I’m not crazy about the management.


Full disclosure in 2013: I am still long Industrias Bachoco SA [IBA] — what a great unknown company.

Note: this was published at RealMoney on 7/2/2004.  This was part four of a  four part series. Part One is lost but was given the lousy title: Managing Liability Affects Stocks, Pt. 1.  If you have a copy, send it to me.

Fortunately, these were the best three of the four articles.


Investing Strategies

Some groups can reinforce their own behavior in the market, causing booms and busts.

Balance sheet players tend to be strong holders.

Liquidity can change the market landscape.


In Part 1 of this column, I began describing the various classes of investors and their investment behavior. In Part 2, I’ll continue that description, and will follow it up by explaining how some classes of investors can temporarily reinforce their own behavior, causing booms and busts. Finally, I will offer practical ways you can benefit from understanding the behaviors of different investor classes.


8. Leveraged Private Investors

The use of leverage gives the investor the ability to make more out of his bets than his equity capital would otherwise allow, but eliminates some of the advantages that the unleveraged possess. Investors that are leveraged do not entirely control their trade; if their assets decline enough in value, either they or the margin desk will reduce their position.

Leveraged investors are in the same position as the European banks that I discussed in Part 1. Worry sets in as one gets near a margin call, not when the margin call happens. As worry sets in, mental pressures to change the asset positions materialize. The challenge to the investor is to decide whether to liquidate, or take chances. Being forced to make a decision leads to a higher probability, in my opinion, of making the wrong decision.

In addition, leveraged longs have to pay for the privilege of financing additional assets. With overnight rates low today, that might not seem like much of a cost. But when the market is in the tank and interest rates are sky-high, as they were from 1979 to 1982, the cost of leveraged speculation is a deterrent and helps keep a lid on the market.

9. Short-Sellers

Being short is not the opposite of being long. It is closer to the opposite of being a leveraged long. Shorts do not entirely control their trade; if their shorts rise enough in value, either they or the margin desk will reduce their position. This is the opposite of leveraged longs. Remember, unleveraged longs can stay put as long as they like, and almost no one can force them to change. Shorts can be forced to cover through a squeeze, whether through rising prices threatening their solvency or a decrease in borrowable shares from longs moving their shares from margin to cash.

Stocks with a large short interest relative to the float, like Taser (TASR:Nasdaq) , can behave erratically with little regard to anything more than the short-term technicals of trading. (If fundamental investing is akin to a chess game, trading Taser is more akin to a street brawl.)

Short-sellers also have costs that unleveraged longs don’t face. When it is difficult to borrow shares (i.e., the borrow is tight), you might have to pay for the privilege of borrowing. As an example, when I was short Mony Group, I had a 2% annualized rate to pay on the last block of shares that I shorted. The rest came free, but that was before the trade got crowded. (When the borrow is not tight and if you are big enough, it is possible to get a credit, but that’s another story.)

Another cost is paying any dividend that the company might pay. Granted, the stock is likely to drop by the amount of the dividend, but cash going out the door to support a trade makes a trade more difficult to hold on to.


10. Options Traders

Buyers of options fully control their trade and pay a premium for the privilege. Sellers of options give up some control of their trade and receive a premium for their trouble. Being short an option is like being short a stock; theoretically, the risk is unlimited. If the short options of an investor rise enough in value, either they or the margin desk will reduce their position. Long option investors face no such constraints, but they do face the continual decay of the time premium of their options.

When there are company-issued options outstanding, such as warrants, convertible preferreds and convertible bonds, another trading dynamic can develop. Because the company has offered the call options on its stock, unlike other investors, it can issue stock to satisfy calls. The dilution from share issuance can put a ceiling over the price of the stock near the strike price for the call options until enough demand exists for the stock that it overcomes the dilution.

One more example of embedded options shows up in the residential mortgage bond market. Residential mortgages contain an option that allows the mortgage to be prepaid. Mortgage bond managers, who often manage to a constant duration (interest-rate sensitivity), run into the problem that their portfolios lengthen when rates rise, and shorten when rates fall. This can make them buyers of duration (longer mortgages or noncallable Treasuries) when rates fall, and sellers when rates rise.

In either case, with enough mortgage managers (and mortgage originators, who are in the same boat) doing this, it can become self-reinforcing because many market players buy into a rising market and sell into a falling market. This has an indirect effect on the Treasury and swap markets because mortgage hedgers use them to adjust their overall interest-rate sensitivity. In general, mortgage hedgers are weak holders of Treasuries, which they sell off as rates rise.


Balance Sheet Players vs. Total Return Players

I find it useful to divide the players in the investment universe into two camps: balance sheet players and total return players. Balance sheet players can lose it all and then some. Total return players can lose only what they have invested and include mutual funds (including index funds), unleveraged private investors, defined benefit plans, option buyers and endowments. Balance sheet players include banks, insurance companies, leveraged private investors and option sellers.

Total return players tend to resist — or at least are capable of resisting — market trends, which provide stability in the market. At the edges of negative price movements, balance sheet players find that they have to sell risky assets in order to preserve themselves. In severe market conditions, balance sheet players can make market movements more extreme.

I think it helps to view the behavior of balance sheet players through the lens of self-reinforcement. When there are too many of them crowding into a trade, there is the potential for instability. If the price of the asset has been bid up to the point to where a buy-and-hold investor would feel that he could not obtain a free cash flow yield adequate to compensate him for the risk of the purchase, then the asset is unsustainably high, which does not mean that it can’t go higher. When you see long-term investors exiting, it’s usually time to leave.

Fueled by leverage, some players will increase their bets as the price of the asset rises because they have more buying power with a more expensive asset. Finally, a few smart players start to sell and the process works in reverse as leverage levels increase for balance sheet players with a large concentration in the stock and a self-reinforcing cycle of selling begins. The same boom-bust cycle can happen with total return players, but it would be more muted because of the lack of leverage.

At the end of the bust, the buyers typically are unleveraged buy-and-hold investors. For example, I remember picking over tech and telecom stocks in 2001-02 that had been trashed after the bubble burst. This is a sector of the market that I don’t play in often, because I don’t know it so well; that said, it became 30% of my portfolio. Many of those stocks were trading for less than their net cash and a few were even earning money. My thought at the time was that if I tucked a few of these stocks away and held them for five years or so, I’d have something better at the end. With the bull market of 2003, my exit came sooner than I expected; other market players saw the potential of the cheap, conservative tech companies that I held and liked them more than I did.

This brings me back to weak and strong hands. In general, total return players have stronger hands than balance sheet players, at least when market values are out of whack with long-term fundamentals.


Illiquidity and LTCM

An asset is illiquid when the bid-ask spread is wide, or even worse, when there is no bid or ask for a given asset in the short run. This can happen with large orders in small-cap stocks and in “off the run” corporate bonds. Often an illiquid asset offers a higher potential return than a more liquid asset; given the disadvantage of illiquidity, in a normal market it would have to. Even a liquid asset can act illiquid if you hold a large amount of it relative to the total float. Trying to sell rapidly would drive down its price.

To hold illiquid assets, you either have to hold them with equity or a low degree of leverage with a funding structure for the leverage that can’t run away. One example is the type of portfolio I ran in the mid-1990s: unleveraged micro-cap value stocks. Another example is Warren Buffett’s portfolio. He buys whole companies and large positions in other companies, and funds those purchases with a modest amount of leverage from his insurance reserves.

My counterexample is more interesting (failure always is). Long Term Capital Management for the most part bought illiquid bonds and shorted liquid bonds that were otherwise similar to the illiquid bonds. When LTCM was small relative to the markets that it played in, it could move in and out of positions reasonably well, and given the nature of bonds, absent a default, there was a natural tendency for the bonds to converge in value as they got close to maturity.

As LTCM became better known, it received more capital to invest. Assets grew from profits as well. Wall Street trading desks began to figure out some of the trades that LTCM was making and started to mimic the firm. This made LTCM’s position more illiquid. It was fundamentally short liquidity, leveraged up using financing that could disappear in a crisis and had LTCM wannabes swarming around its positions.

At the beginning of 1998, it had earned huge returns and its managers were considered geniuses. The only problem was that they were running out of places to put money. The yield spreads between their favored illiquid and liquid bonds had narrowed considerably. “The juice had been squeezed out of the trade,” but they still had a lot of money to manage.

By mid-1998, with the Asian crisis brewing and Russia defaulting, there came a huge premium for liquidity. Everyone wanted to get liquid all at once. Liquid bonds rose in price, while illiquid bonds fell. The LTCM imitators on Wall Street got calls from their risk control desks telling them that they had to liquidate the trades that mimicked LTCM; the trades were losing too much money. In at least one case, it imperiled the solvency of one investment bank. But at least the investment banks had risk-control desks to force them to take action. LTCM did not, and the unwinding of all the trades by the investment banks worsened its position.

When the severity of the situation finally dawned on the investment banks, with the aid of the Federal Reserve, the investment banks realized that there was no way to easily solve the situation. LTCM couldn’t be liquidated; its positions were so large that a “fire sale” meant that the investment banks that lent it money would have to take a haircut. LTCM needed time and a bigger balance sheet, if the investment banks were to be repaid. The investment banks eventually agreed to recapitalize LTCM funds and unwind the trades at a measured pace. Even the equity investors got something back when the liquidation of LTCM was complete. LTCM’s ideas weren’t all bad, but it was definitely misfinanced.


Final Advice

Keep these basic rules in mind as you consider how to apply these concepts to your own trading. They aren’t commandments, but paying attention to them will help you make more informed investment decisions.

  1. All good investment relies at least implicitly on sound asset-liability management. Assets should be matched to the type of investor and funding structure that can best support them.
  2. Understand the advantages that you have as an investor, particularly how your own cash flow and funding structure affect your investing.
  3. Try to understand who else is in a trade with you, what their motivations are, their ability to carry the trade, etc.
  4. Don’t overleverage your positions. Always leave enough room to be able to recover from a bad scenario.
  5. Be aware of the effects that changing demographics may have on pension plans and individual investors.
  6. Always play defense. Consider what can go wrong before you act on what can go right.
  7. Be contrarian. Maximize your flexibility when the market pays you to do so. Be willing to sell into manias and buy after crashes.

Two of my 35 stocks have short interest ratios over 10 days.  [Short interest ratio = amount of shares shorted / average daily volume]

I look at this statistic, and force myself to re-examine companies where the ratio is over 10.  Maybe there is something that I don’t know.

The two stocks in question are Stancorp Financial and National Western Life Insurance.  The short cases for both are based on a naive view of how insurance companies work.

Stancorp is a disability insurer.  Disability insurers often do badly in a recession because disability claims increase — people who are unemployed claim they are disabled.

There are two models for disability insurance: 1) Underwrite carefully, and pay all legitimate claims. 2) Accept all business, but when claims come in litigate with vigor.

Stancorp follows the first model.  I would never own an insurer that followed the second model, it is dishonest, and it is bad business.

Because Stancorp does its risk management up front, it does not get the same degree of unemployment masquerading as disability claims.  But the shorts don’t get this.  Thus the short interest ratio near 20.

Doesn’t bother me.  This is a undervalued company with a quality management team.  Low debt.  Sustainable competitive advantages in its niches.  One nice thing about being a knowledgeable insurance investor is that you can get a firm grip on the nature of the management teams, and invest in the good ones when they are out of favor.

With National Western, the short interest ratio is near 11.  Admittedly, it is an unusual company.  No analysts. Large controlling shareholder.  Hasn’t lost money in over 10 years.  Trades at less than 40% of adjusted book value.  Sells insurance policies to foreigners who want flight capital.

With interest rates falling, some shorts think some insurers will have difficulty meeting policy interest guarantees.  From my view, that is not the case with National Western, they have a large amount of long bonds to protect the guarantees.

Thus I say to the shorts: short all you want.  You will be buyers at higher levels.

Full disclosure: long NWLI and SFG for my clients and me

Note: this was published at RealMoney on 7/1/2004.  This was part three of a  four part series. Part One is lost but was given the lousy title: Managing Liability Affects Stocks, Pt. 1.  If you have a copy, send it to me.

Fortunately, these were the best three of the four articles.


Investing Strategies

Different investor groups in the market have different patterns of funding and disbursement.

Understand those patterns to read market action more clearly and see what trends might emerge.


Recently, the firm I work for held a large amount of the common stock of Phoenix (PNX:NYSE). As the stock rallied, I kept moving out my sell target, because the technicals on the stock were so compelling. There were no analysts saying buy, there were a few saying sell and the short interest was high. The company was doing all the right things and the stock had great price momentum, but the valuation was just too high. I wanted to sell, but I couldn’t figure out when.

Finally, on Feb. 21, the stock price began to rally on no news. Going to the message boards, I discovered that there was a momentum investor with a radio show who was making one of his occasional television appearances, and was touting Phoenix. I went to our trader and said that we had our chance. There was a group of valuation-insensitive buyers buying the stock with abandon. I said, “Ride the ask [offer stock at the asking price], and if you get any thick bids near the ask, hit them.” (Read: If there are aggressive large bidders, sell to them at their level.) We sold our position in two weeks, without disturbing the market; we were able to get an average price of about $14.25. (Our trader is top-notch.) Today the price of Phoenix is about 15% lower. The momentum investors choked on the stock that we (and others) fed them.

Why did this work for us? We understood two aspects of how Phoenix traded very well: the fundamentals and technicals. The fundamentals taught us what fair value should be, but the technicals taught us how investors would react to movements in the stock price.

Every investor has a mode of funding and a mode of disbursement. The funding and disbursement modes affect how long and under what conditions an investor wants to, or is able to, hold his position. Some examples will illustrate general principles of these modes. I will describe the ways that various classes of investors fund their investments, how their investments are held, how they are liquidated and how all of this affects what kinds of investments they can use from both an asset class and liquidity standpoint. I also will attempt to explain how the behavior of some classes of investors can become temporarily self-reinforcing, leading to booms and busts.  Finally, I will try to give some practical advice along the way as to how you can benefit from the behaviors of different classes of investors.


1. Banks and Other Depositary Institutions

Banks make promises to depositors. Some of these promises are absolute; some are contingent on external events. Bank regulations exist to make the keeping of the promises more certain (or, in modern times, keep the guarantee funds solvent). Banks have to keep adequate capital on hand to provide a margin of safety against insolvency. The amount of capital varies on the immediacy with which deposits may be withdrawn, the degree of equity/credit risk of the assets and how well the asset cash flows are matched to the liability cash flows.

Liquid assets must be set aside to meet the amount of funds that may be withdrawn immediately with little or no penalty. The more that is set aside, the lower the risk and the lower the profit. If the assets are materially longer or contain more equity risk than a money-market-like investment, there may be a loss when the assets are liquidated to pay off depositors. In general, the cash flows of assets must be matched to the liabilities that fund them, at least in aggregate.

This biases banks to hold primarily short- to intermediate-term, high-quality fixed-income assets: bonds, loans, mortgages and mortgage-backed securities. These are generally safe investments, but banks are fairly leveraged institutions. If the market moves against their investments and their capital cushion gets eroded to the point where their ability to operate becomes questionable to regulators (or customers), the banks might be forced to sell investments into a falling market in order to preserve solvency.

The first motive of a financial institution is to survive; the second is to profit. When the first motive is threatened, even if there is a good possibility that the institution will survive and make more money if it retains the assets that now are perceived as risky, in general, the risky assets will get sold to assure survival at the cost of current profitability.

To return to a concept I discussed in the first column I wrote for RealMoney, Valuing Financial Slack in the Steel Sector, banks with a high degree of leverage relative to the overall riskiness of their assets and liabilities possess little in the way of financial slack. Volatility in the markets that cuts against their position harms such companies. They end up becoming forced sellers and buyers.

Banks with financial slack can enjoy volatility. When the markets are dislocated, they can make room on their balance sheets to wave in securities that are distressed and temporarily trading below intrinsic value. During times of volatility, the strong benefit at the expense of the weak, whereas weak firms outperform during periods of stability. As an example, after the real estate crisis in 1989-1992, the banks that did the best over the whole cycle were those that did not become overleveraged, did not over-lend to marginal credits and had diversified operations. During the crisis, they had the flexibility to lend in situations of their choosing at favorable yields.


2. Insurance Companies

Insurance companies are like banks but generally have longer funding bases and typically run at a higher ratio of surplus to assets. Insurance companies typically have more ways to lose money than banks, and potential cash flow mismatches in the longer liability structure require more capital to fund potential losses. In principle, the higher surplus levels and the longer liabilities should allow for investment in longer-duration assets like equities, but the regulations make that difficult. Surplus is limited; what gets used for equities can’t be used for underwriting.

As a counterexample, consider what happened to the European insurance industry in 2002. European insurers are allowed to invest much more in equities than their U.S. counterparts can. (Berkshire Hathaway (BRK.A:NYSE) is an interesting exception here.) As the bull market of the 1990s came to an end, European insurers found themselves flush with surplus from years of excellent stock-market returns, and adequate, if declining, underwriting performance. The fat years had led to sloppiness in underwriting from 1997 to 2001.

During the bull market, many of the European insurers let their bets ride and did not significantly rebalance away from equities. Running asset policies that were, in hindsight, very aggressive, they came into a period from 2000 to 2002 that would qualify as the perfect storm: large underwriting losses, losses in the equity and corporate bond markets and rating agencies on the warpath, downgrading newly weak companies at a time when higher ratings would have helped cash flow. In mid-2002, their regulators delivered the coup de grace, ordering the European insurers to sell their now-depressed stocks and bonds into a falling market. Sell they did, buying safer bonds with the proceeds. Their forced selling put in the bottom of the stock and corporate bond markets in September and October of 2002. Investors with sufficient financial slack, like Warren Buffett, were able to wave in assets at bargain prices.

This principle may be articulated more broadly as, “The tightest constraint dominates investment policy.” As an example, an insurer that already was at a full allocation on junk bonds could not take advantage of the depressed levels in the junk bond markets; such investors were biting their nails, wondering if they would make it through alive. Another example occurred in 1994, when the most volatile residential mortgage bonds were blowing up. Insurance companies that had a full allocation to that class could not buy more when prices were at their most attractive. Companies and investors that rarely bought the “toxic waste” of the residential mortgage bond market began scooping up bonds at discounts unimaginable previously. A number of flexible investors, including St. Paul (now St. Paul Travelers) and Marty Whitman both ventured outside their ordinary investment habitats to benefit from the crisis.


3. Defined Benefit Pension Plan

Defined benefit plans need cash to fund payments to beneficiaries. The amount and timing of the benefit payments vary with plan demographics (sex, age and income), physical roughness of the industry and the specific plan provisions (e.g., late retirement, early retirement, etc.). Inflows to DB plans depend on funding levels and the financial health of the company sponsoring the plan. For an individual DB plan, the cash inflow and outflow characteristics will help determine the plan’s asset allocation, together with the risk tolerance of the plan sponsor.  The more risk-averse a plan is, the less capable it is of funding inflows, and the older the plan’s participant population, the larger the proportion of assets that will go into bonds and other safer investments.

For all DB plans in aggregate, though, the cash flow and demographic characteristics mirror those of the Old Economy. DB plans were created back in the days when the relationships between employer and employed were more fixed than they are now. In the current era of more short-lived employment relationships and with the average age of participants in DB plans rising, these plans face several challenges:

  1. Net cash outflows are getting closer.
  2. There are fewer cash inflows.
  3. Plans are being terminated (or converted to cash balance plans) due to cost, economic weakness and inflexibility.

DB plans are major holders of equity and debt in the U.S., but they are not as great a force as they once were.  Defined contribution plans (i.e. 401(k)s, 403(b)s, etc.) are bigger now. The relative decline and aging of DB plans has had, and will continue to have, two effects in the market. First, because of aging, there will be a greater relative demand for bonds. Second, DB plans have always had a long investment time horizon. That is shrinking now. DB plans tend to resist trends in the market; they tend to rebalance to a fixed asset allocation, which leads them to buy low and sell high. DB plans were the ones selling equities in March 2000 and buying in October 2002; their rebalancing strategies insured that. As DB plans become a smaller fraction of the investor base, markets will become more volatile due to the reduction in long-horizon capital in the market.


4. Endowments

Endowments plan to survive forever. Forever is a tough mandate.

Inflows to endowments are uncertain, and outflows are fairly constant. They have spending formulas, the most common of which has the charity spending a constant percentage each year, usually 4% to 6% of the endowment. (In the old days, say 10 years ago, most formulas allowed charities to spend income, which was defined as dividends plus net capital gains.) Within these constraints, endowments behave like defined benefit plans.


5. Mutual Funds

Mutual funds do not face any fixed funding or disbursement. Their flows come from retail money chasing past performance. Managers that do well face the blessing of attracting more funds, which they hope will not dilute their returns. Managers that do poorly have funds withdrawn from them, forcing them to liquidate investments that they otherwise think are promising. If a manager is a big enough investor in a given company’s stock (think of Janus’ concentrated portfolios), this can have the effect of worsening performance as liquidation goes on, or boosting the already good performance of managers that are receiving cash inflows to a concentrated fund.

These tendencies become more pronounced the better or worse that performance gets. When performance is near the median level, say, within the second and third quartiles, performance-driven fund flows are small. For many mutual fund managers, this gives them the incentive to never drift too far away from the benchmark, whether that is an equity index or an average portfolio of peers. There is safety in the pack, even if there might be more grass to eat further from the herd. It is rare for a mutual fund manager to be fired for being mediocre.


6. Index Funds

What is true of regular mutual funds is also true of index funds, but the difference between the two helps illuminate a basic idea on demographics. Aside from taking market share away from active managers, when do index funds receive and disburse funds? The answer lies mainly in the demographics of investors.

When investors are younger, they invest surplus cash. When they are older, particularly after retirement, they liquidate investments to generate cash. Given the demographics in the U.S., the excess return for merely belonging to the S&P 500 has been roughly 4% per year over the past 15 years; index funds have received disproportionate large inflows relative to the market as a whole. Aside from that, in aggregate, active equity managers benchmark to something that approximates the S&P 500. Belonging to the S&P 500 ensures a continuing flow of capital.

Or does it? What will happen near 2020, when aggregate investment behavior changes from saving to liquidation?  Belonging to major indices may not have the same cachet as investors liquidate their holdings to fund present needs. What was 4% positive in the 1990s could become 4% negative in the 2020s, absent a continuing move toward passive investing.

I don’t have a firm answer here, but I do have suspicions. I would be cautious of too much index exposure 15 years from now, to the extent it can be avoided. (And of course, this will be anticipated several years before the flows turn negative.)


7. Unleveraged Private Investors

Sometimes private investors feel disadvantaged vs. larger institutional players, but there are advantages that unleveraged private investors have that institutional players often don’t: the abilities to invest for the long term, concentrate and do nothing.

Institutional investors are subject to the tyranny of constant measurement because they manage money for others. As I have noted before, measurement affects how a manager invests, particularly when it might affect the amount of assets under management, or the receipt of incentive fees. This encourages managers to be both short-term in their orientation and more like an index. It also encourages hyperactivity; clients often expect a manager to make changes to the portfolio even when doing nothing could be the most prudent policy.

Unleveraged private investors can make aggressive investment decisions. They can concentrate their portfolios or consider more esoteric areas of the market. They also can back away from the market if they feel that opportunities are absent. Finally, they can buy and hold, which is not always an option for institutions. They can’t always ride out long but temporary dips in the price of an asset.

That an unleveraged private investor can do these things doesn’t mean he should. Using these advantages presumes a level of expertise in the market well in excess of the average investor. Most investors are average and should index. Those with skill should use it to their maximum advantage, realizing that they are taking their own financial life in their hands; the risks to such an approach are significant, but the same is true of the rewards.

Unleveraged private investors have needs for cash. Some will need it for college, retirement, a second home, etc.  The sooner that an investor will need to liquidate a significant portion of his portfolio, the more conservative the portfolio must be to achieve those spending goals. Looking at private investors in aggregate, this would mean that as the baby boomers approach and enter retirement, there might be a tendency for the overall willingness to take risk in the markets to decline. Also, once the baby boomers are in retirement, assets will have to be liquidated to support them, which will be a drag on the markets at that time.


In the second part of this column, I will describe how the funding and disbursement modes of three more key groups of investors affect the market, \and how balance sheet players and total return players further mix up the market forces. I’ll also use the Long Term Capital Management crisis to illustrate how illiquidity can shape and shake the market.

Note: this was published at RealMoney on 3/23/2004.  This was part two of a  four part series. Part One is lost but was given the lousy title: Managing Liability Affects Stocks, Pt. 1.  If you have a copy, send it to me.

Fortunately, these were the best three of the four articles.  The copy I received has no links, so sorry for the lack of links.  I hope you enjoy the article.


Stock Analysis

Watch how the stock reacts to news.

Examine the short side.

Pay attention to what insiders are doing.


A little more than a month ago, I wrote a column to help explain some of the differences between the market’s strong and weak hands, and I received quite a response.

It’s been a while since the story appeared, so here’s a chart to clarify some of the ideas I put forth in it.

 Table of Actions for Investors With Long Positions

Consider four classes of investors and how they behave with respect to market action

Market Action

Investor ActionStock price goes downStock price goes up
More likely to holdValuation-sensitive and strong holdersMomentum investors and strong holders
More likely to sellMomentum  investors and weak holdersValuation-sensitive and weak holders

To put it another way:

  • Weak holders play for small gains and losses.
  • Strong holders play for big gains, will ride out big losses and sometimes get killed with the firm.
  • Momentum investors require liquidity from the market and exacerbate price moves.
  • Valuation-sensitive (or mean-reverting) investors provide liquidity to the market. They hold or buy more when prices decline, and they sell when prices rise enough to hit their valuation targets. This category describes my normal posture in the market.

These four descriptions here are ideal investor types. Some investors and institutions fit only one of them, but many use a mix in their investing activity.

After Part 1 of this piece appeared, the most common reader question was, “How do you identify whether a stock’s holders are weak or strong?” There’s no simple answer, but I can offer a bevy of techniques and tools that I use for this purpose. Some require a good deal of experience and judgment; beginners can use others easily. Here are some tips to get you started:

Assess how the stock reacts to news

Good news should make a stock go up, and bad news should make it go down. But we learn the most when the price reaction is different from what we expect. For example, if a stock refuses to go down much — or even rises — on significant bad news, then it has many strong holders. If it doesn’t go up much — or even falls — on significant good news, then it has many weak holders.

Examine the short side.

Short-sellers are typically weak antiholders of a stock. The percentage of the float that is shorted will tell you how much of the stock is subject to buyback if the price rises significantly.

Now, short-selling is a double-edged sword. Although short-sellers have an impulse to buy back into strength, high short interest usually indicates problems at the company. If you encounter a heavily shorted stock, take a close look to see whether it’s strictly a valuation issue or if something is fundamentally broken at the company on an accounting or operational basis. Short interest is available on Yahoo! Finance; here’s an example of a heavily shorted stock, Phoenix (PNX:NYSE) .

Find out who the large holders are.

The higher the proportion of stock held by insiders and long-term investors, the more strongly a stock’s holder base is. I track this by reviewing proxy statements as well as 13D and 13G filings, which are freely available at the SEC Web site.

These data require some judgment to interpret. First, I find out who holds more than 5% of the stock, because some of those large holders tell a story about the stock.

Most institutional investors will not take stakes of more than 5% in a corporation’s shares, as getting into and out of such large positions requires careful trading. Once they are above the 5% limit, changes in position size must be disclosed via 13D filings, which give away information to other traders who may trade against the large holder.  Large holders by their very nature tend to be strong holders; the costs of exiting a position are significant.

Look at insider activity.

Insiders, if they hold large positions, tend to be strong holders of a company’s shares. Additionally, they often have a clearer perspective on the company’s prospects. Insider buying can be a great indicator of potential value, particularly if the insider pays for the shares from his or her own pocket. Small insider holdings and holdings acquired for compensation are more likely to be cashed in when insiders need the proceeds. Insider data are freely available at Yahoo!; here is an example.

One exception needs to be understood regarding large insider holdings. If the holdings are so large that a single investor has discretionary control over the company, then it pays to review how that “control investor” has treated outside passive minority investors (folks like you and me) in the past. If he or she acts on self-interest to the detriment of smaller investors, then it’s time to look elsewhere.

Review proxy statements.

After spending enough time looking at such data, you begin to see what kinds of investors are among the large holders. Most tend to be value investors or long-term growth investors. After this, a list of the remaining institutional investors can be instructive. A limited view of this is freely available on Yahoo!; here’s an example.

This particular example tells me that the major holders are value investors and index managers. These are relatively strong holders of the stock; they don’t run away after minor disappointments. In general, growth investors tend to be weaker holders than value investors.

Take note of turnover.

To the extent that you can obtain turnover rate data, for example, in mutual fund prospectuses, that’s a good proxy for how weakly a manager holds stocks. Quantitative managers tend to be weak holders of securities; many of them try to profit from short-term mispricings of securities, often trading at very high turnover rates. Qualitative managers who are tightly benchmarked to indices, including many institutional managers who are scrutinized by the consultant community, can find themselves in the same boat.

Glance at the message boards.

Although there are exceptions — and this is squishy — the amount and shrillness of postings on message boards seems proportional to the weakness of the holder base. The more reasoned and slow the message board, the less speculative the stock’s retail holder base.

Gauge the volatility of the price action.

If market prices are more volatile compared with the factors that drive the stock’s underlying value, there are relatively more weak holders. If market prices are less volatile compared with the factors that drive the underlying value, there are relatively more strong holders.

Valuation also affects the holder base: The higher the valuations, the lower the proportion of valuation-sensitive investors in the holder base, and that tends to increase price volatility. The lower the valuations are, the lower the proportion of momentum investors in the holder base, and that tends to decrease price volatility.

Review chart action.

I’m not a technician, so bear with me. One simple question to ask is whether buyers or sellers are more motivated.  A simple way to answer that for the immediate past is to look at a money flow graph. Here is an example of a noncumulative money flow graph from Yahoo! The top part of the graph is the price; the bottom part is money flow. When the money flow figure is over 50, more trades have been occurring on upticks than on downticks. The opposite is true when money flow is below 50. Momentum investors dominate the buy side of trading when the money flow indicator is persistently high. Valuation-sensitive investors dominate the buy side of trading when the money flow indicator is persistently low.

As I’m not a technician, I won’t explore levels of support and resistance. I use those techniques, but I’ll leave it to the expert technical analysts to describe them in detail. Levels of support and resistance often indicate where valuation-sensitive investors are accumulating and selling shares.

What I promised at the end of Part 1 will have to wait for Part 3 of this series. In response to the questions I received, I’ll also cover the effect of dividends and weak holders in the Treasury bond market. If you have any questions, please feel free to email me.

I left one small question for last; I gave a partial answer to this one at the conference.  I think I was the only one that said much on it.  Here it is:

Where does academic theory fail in finance and in economics?

Little questions, big answers.  How do you eat an elephant?  One bite at a time.  Let’s start with math in economics:

1) We have to reduce the complex math in economics — I think we are trying to apply math where it is not valid.  As such, the true strength of ability to explain what is going on decreases, while economic becomes an odd “inside game” for a funny group of mathematicians trying to make sense of an idealized world that bears little resemblance to our own world.

2) The next piece is on maximizing utility or profits.  Maximizing takes work, assuming one can even do it.  Work is a negative, so people conserve on that.  Most of us know this: we look for a solution that is “good enough,” and do it.  That means we don’t maximize utility, and the pretty equations don’t represent reality.

What’s worse is that men care more about relative results than absolute results.  We would rather be kings over an impoverished realm rather than middle class in a wealthy country.  We are worse than greedy; we are envious.

It’s even worse for firms.  There you have agency problems where the management often has its own goals that do not maximize profits, or their net present value, but maximize the benefits they receive.  Boards are frequently a cover for management, rather than advocates for the shareholders.

Regardless, since firms don’t maximize, the elegant math does not work. Putting it simply, if you want to understand economics better, don’t listen to economists — become a businessman.  An ordinary businessman knows more about how the world works than a neoclassical economist.

3) One of the beauties of a capitalist economy is its dynamism.  It adapts to changing needs and desires.  The variation is considerable; as an example, go through your supermarket and try to count the total number of different tomato products.  Or  look at the amazing degree of variety in a major tools catalog.  Or go to Costco, Walmart, Home Depot, Ikea, and look at the incredible variety that exists under one roof.

But that level of variety cannot be mathematically accommodated by economics.  They have to aggregate the complexity into categories, and a lot of the reality is lost in the process.  That is why I distrust  many economic aggregates, such as inflation, GDP, etc.  Politicians find “economists” to suit their political ends, and they come up with complex reasoning for why measured inflation is higher than it should be, inequality is rising, etc.  You can find an economic advocate for almost anything.


4) Because of the aggregation problem, the link between microeconomics and macroeconomics is made weak, especially since utility cannot be compared across any two people, and yet the economists mumble, and implicitly do it anyway.

5) At least with microeconomics, we can agree that demand falls as prices rise, and supply rises as prices rise.  But with macroeconomics, there is little agreement as to whether a given policy aids real growth or not.  Modern neoclassical economics is to me a bunch of sorcerer’s apprentices playing around with very large and crude tools that they think can affect the economy, only to find the results are not what they expect.  Somewhere, economists got the naive idea that they could eliminate the boom-bust cycle, only to find that by eliminating minor busts, they set up the conditions for growth in indebtedness, leading to a huge bust.  Far better to be McChesney Martin, or Volcker, who let recessions do their work, than slaves of the government who did not — Burns, Miller, Greenspan or Bernanke.

Take inflation as an example.  Does printing more money, or creating more credit boost asset prices, product & services prices, both, or neither?  The answer to this is not clear.  The Fed has taken many actions over the past 30 years, using a model that assumes tight relationships between short interest rates and inflation/ labor unemployment.  The evidence for these relationships are not evident, except at the extremes.

6) The idea that running deficits to “stimulate” the economy is questionable.  Debts have to be paid back, repudiated or inflated away, any one of which would make business and consumers less confident.  Further, the way the the money is spent makes a great deal of difference.  Much government spending inhibits or does not help economic growth; think of the complexity of the tax code — a recipe for wasted time, and unneeded social enginerring.  Some government spending does aid economic growth, where it lowers the costs of consumption or production — critical infrastructure projects, etc.  But those are rare.  If it were really needed, lower level governments or private industry would do it.

The thing is, most of the deficit spending has not been useful; there’s no economic reason to run such large deficits.  If we were rebuilding all of our aging infrastructure, that would be one thing, but the crazy quilt of tax breaks and subsidies affects behavior, but does not compound and aid growth.

7) We need to admit that culture is not a neutral matter.  Some cultures will have faster economic growth, and others will be slower.  There is no universal culture, no generic economic man.  Some cultures are more enterprising than others.  That has a big impact on growth quite apart from resources, population, education, etc.

8 ) Whether the money is tied to gold or fiat, banking must be tightly regulated.  Solvency of all financial institutions should be tightly regulated.  With financials risks arise when the is too much leverage, and too much leverage that is layered.  Things should be structured such that there is no possibility of dominoes knocking over other dominoes.

  • Limit leverage
  • Increase liquidity of assets vs liabilities
  • Forbid lending to/investing in other financials
  • Derivatives should be regulated as insurance, insurable interest must exist, which means that bona fide hedgers must initiate all transactions.

On Finance

9) The first thing to realize is that a mean-variance model for investments is loopy.  First, we can’t estimate the mean or the variance, much less the covariance terms.  There is also good evidence that variances are infinite, or close to it.  Thus the concept of an efficient frontier is bogus.  Far better to try to estimate crudely the likely forward returns on a cash flow basis, the way a businessman would, and weakly factor in the uncertainty of the forecasts.

10) Thus, beta is not risk, and volatility is not risk.  At least at present, until the low volatility funds get too big, there seems to be an anomaly where low volatility equity investing beats high volatility equity investing.  This is consistent with my theory that the relationship of risk and return is non-linear.  Taking no risk brings no return; taking moderate risk brings decent return; taking high risks brings low returns.  There is a sweet spot of prudent risk-taking that brings the best returns on average.

11) Multiple-player game theory indicates that to win, you assemble a coalition with more than 50% of all of the power, and you get disproportionate benefits.  Think about the poor buyer of a home in 2006, going into the closing with the deck staked against him.  Or think about forced arbitration of disputes on Wall Street, where the investors rarely win.

Complexity is not the friend of most ordinary economic actors.  Avoid it where you can.

12) Capital structure does matter; it is not irrelevant like Modigliani and Miller said.  Companies with low leverage tend to return more than companies with high leverage.  There are real costs to being in distress or near distress.

13) Markets can have non-linear feedback loops, like in October 1987, or the “Flash Crash.”  Markets are not inherently stable, and that is a good thing.  Instability shakes out weak players that are relying on a shaky funding base, leaving behind stronger players who understand risk.  It is not wise to try to eliminate the possibility of disasters occurring.  When you do that, pressures build up, and something worse occurs.  Better to let the market be free, and let stupid speculators get burned, so long as they aren’t regulated financial companies.

Ethics matters

14) Economics would be more valuable if it focused what is right, rather than what is “efficient.”  I know there will be differences of opinion here, but a discipline that focused on explicit and implicit fraud could be far more valuable than men who don’t have good models for:

  • Inflation
  • Asset Allocation
  • GDP
  • Unemployment
  • and more

Imagine applying all of that intelligence to fair dealing in economic relationships, rather than vainly trying to stimulate the economy, and accomplishing nothing good.  It would be like the CFA Institute applied to the economy as a whole.