Wrong

 

  • Wrong: A Hawkish Signal Bernanke Didn’t Send stks.co/sISp No, Fed misunderstood the markets, & what their “transparency” said $$
  • Slow-minded: Fed Presidents Say Dodd-Frank Failed to Dispel Too-Big-to-Fail stks.co/fbLA No, duh. U r only realizing this now? $$
  • Wrong: Pension funds may see the silver lining on the interest rate cloud stks.co/gbLA As interest rates rise, assets go down $$
  • Wrong: The Last Mystery of the Financial Crisis stks.co/aZl7 Shallow analysis that does not take account of regulatory needs $$
  • Wrong: Long Live Synthetic CDOs – Bloomberg stks.co/ianr Levering up risky debts exacerbates the credit cycle; should b ended $$

 

Market Dynamics

 

  • Traders Trapped in Scandinavia Discover No Easy Sell stks.co/tIUb Low-liquidity currencies, big moves when all rush 2the exit $$
  • Why ‘average’ returns aren’t good enough stks.co/fbLB Arithmetic avgs r less accurate than geometric averages & more $$
  • Royal Bank of Canada Gains by Putting the Brakes on Traders stks.co/qIXh Over the long haul they will prosper vs HFT $$
  • Billionaire Ron Baron: The Dow’s A Double stks.co/cZbY He’s delusional, and does not get how stretched prices are vs book/sales $$
  • Holding bonds today is a disaster in the making stks.co/iatP I think the economy will b weaker than Fed expects, could c rally $$
  • Closed-End Funds Bite Back stks.co/garg Leverage Juiced Returns When Rates Were Moored; Now It Is Magnifying Losses $$ #BlameDaFed
  • Apollo Fueled by $9.6 Billion Profit on Debt Beats Peers stks.co/pI7U Strength of investing across capital structure evident $$
  • State Street Temporarily Stops Cash Redemptions For Muni-Bond ETFs stks.co/pHnc Dealers can’t presently swap ETF shares 4 cash $$
  • Billionaire Fisher Says U.S. Still in Middle of Stock Rally stks.co/hanR He is stuck in a mindset of a low debt world $$
  • Housing Seen Shrugging Off Loan Rate Rise as Banks Loosen stks.co/jaQY Easier financing returns, tho Tsy yield rise undoes more $$
  • Treasury Yields Surge Most Since 2003 as Fed Previews Tapering stks.co/sHeT When cheap forward financing ends, prices go south $$

 

Metals

 

  • Gold-Price Decline Uncovers Mining Companies’ Debt Woes stks.co/tIUa Debt in cyclical industries is always a problem in a bust $$
  • Gold Drops to 34-Month Low as Precious Metals Slide on Fed View stks.co/cZdI All risk assets have been hit since Fed meeting $$
  • Gold Bear Market Hits Hardest in South Africa Mines stks.co/eZl1 Mines r high cost per ton, no surprise they r affected early $$
  • Bottom Falling Out of Copper Prices stks.co/jbDz When Dr. Copper speaks, we can sense the pulse of the economy, getting weaker $$
  • Gold Miner Writedowns at $17 Billion After Newcrest stks.co/aZDq Beginning of a process reconciling dud mining assets $$

 

Monetary Policy

 

  • Risk of 1937 relapse as Fed gives up fight against deflation stks.co/ibLa Deflation is inevitable given present policy $$
  • 2 Fed Presidents Emphasize Stimulus 2Persist After QE Taper stks.co/cZ7b & stks.co/aZHK Fisher & Kocherlakota obfusc8 $$
  • BIS fears fresh bank crisis from global bond spike stks.co/eZGv Banks r mismatched long; will have trouble in run on liquidity $$

 

China

 

  • Credit Warnings Offer World a Peek Into China’s Secretive Banks stks.co/cZdL & more extreme: stks.co/dZdV Bad future $$
  • China breaks silence on cash crunch stks.co/fasu Nation’s lenders approach crisis point as part of crackdown on shadow finance $$
  • China’s alarming credit crunch stks.co/sHxk This could have been exacerbated by a reversal of a popular yen-yuan carry trade $$
  • China Loses Control of Its Frankenstein Economy stks.co/faqF Things r likely 2b shaky in China’s short-tern lending markets $$
  • Financial reform cannot wait stks.co/jaiU But the Party, is it ready to give more freedom to its people & transparency 2 banks $$

 

Energy

 

  • How BP Got Screwed on Gulf Oil Spill Claims stks.co/tISo Free $$ brings out the worst in people | FD: +$BP
  • Frack Music Attracts Halliburton to Submarine Spy Tool stks.co/hb7I “The hills r alive, w/the sounds of fracking…” $$
  • In Moving US Oil, ‘Flexible’ Rail Bests Pipelines stks.co/pI7j Railroad tank cars:low fixed, high variable costs, more flexible $$
  • New Pipelines to Bring Landlocked Oil to Texas-Coast Refineries stks.co/jakj Pipelines: high fixed cost, low variable cost $$

 

Insurance

 

  • Berkshire’s Tracy Britt In, Lynn Swann Out at Heinz’s Board stks.co/bZh0 Whiz Kid gets 1st board seat $BRK.A M&A | FD:+ $BRK.B $$
  • Regulators put chill on US private-equity insurance deals stks.co/dZbX Those who might undo the conservatism should not buy $$
  • $HIG to Sell Unit to Berkshire stks.co/pIb8 I do not get how $BRK.B benefits from this; its worse than the $CI transaction $$
  • 7 Annuity Mistakes to Avoid stks.co/sHxj Illiquity, wrong payout type or guarantees, switching, w/d 2much, taking buyback, etc. $$
  • Misjudged Annuity Guarantees May Cost Life Insurers Billions stks.co/rI1Z Why I don’t invest life insurers w/much variable biz $$

 

Other

 

  • Working Poor Losing Obamacare as States Resist Medicaid stks.co/dZdW A rare case where states avoid Federal $$ | avoiding a trap
  • Four Reasons Non-GAAP Metrics Are Exploding stks.co/cZbX Non-GAAP measures r an attempt to make acctg reflect free cash flows $$
  • Another shameful day for Europe as EMU creditor states betray South stks.co/pIb9 Germany crams down on Greece & euro-fringe $$
  • Holder Says US Seeking More Disclosure on Surveillance stks.co/aZ10 U can disclose it now; U r a bigger threat than terrorism $$
  • Sorry, but Do You Speak English? stks.co/pHna Not surprising; cultural differences drive differences in English dialects $$

 

Full disclosure: long BP, BRK/B

Each of the situations I used as examples yesterday, I have personally run into, and I could write about more of them.  Good investment and risk control shops do their home work in advance.  They ask questions on what could go wrong with a given investment or product; they are willing to negatively but not unreasonably imaginative.  Buffett has said something to the effect of, “We’re paid to think about the things that can’t happen.”

What I said about life & commercial insurers goes double for the banks.  Those insurers have long liabilities, which gives them more time to bounce back from asset disappointments.  The short liability structures of the banks give them less time to deal with asset problems.

All of this implies having disciplines for buying assets, and re-evaluating assets in any portfolio.  My discipline evaluates these at mid-quarter, when few others are doing their evaluations.

The idea is to be ever and always forward-looking.  The past doesn’t matter, except to serve as grist for the mill, showing us what can happen.

Good investing does not care about entry prices.  Good investing is like the great Wayne Gretsky, who did not care about where the puck was, but where it would be.  This is why when I invest I am always comparing the assets in my portfolio versus alternatives.  I look for what will do well in the future.  I do not care about past gains and losses.

Good investing cares about trading what is good for what is better.  This is easy for bond managers.  A bond manager with skill, and freedom to execute can make many wise trades to improve a portfolio.  All he has to do is buy bonds with yields that compensate for the risks, and sell bonds that don’t compensate.

For equity investors the calculus is more vague, but it still exists.  Look to where you can earn returns on average.  Find enough of those areas so that diversification works.

I have never run an index-like portfolio, unless it was an accident.  I will occasionally throw a company in for diversification reasons, but my main goal is owning cheap assets that will earn far more than the index.

Good investing involves business knowledge.  That means you understand how money is made across the set of companies that you invest in.

Whether you are an investor or not, if you want to make greater progress in your career, you should try to learn the financial aspects of your company.  That will stand you in good stead for those that look for managers, because those who understand the profit model are far more valuable than those that don’t.

I stand with Buffett, “I am a better businessman because I am an investor, and I am a better investor because I am a businessman.”  Outside money and inside money can learn from each other, leading to a better investing result.

Summary

I offer to all investors this simple idea, trade what is less good for what is better. It will improve your returns.  Continually improve your portfolio, and do not be married to any ideas.  The idea of relative improvement of the portfolio has aided me greatly in portfolio management.  It is easy to swap bond for bond, and relatively easy to trade stock for stock.  Asset allocation decisions are more difficult.  Figuring when to trade stocks, bonds and cash between one another is far more difficult.

In my career as an asset manager, and as a manager of financial risk, I have learned that all good risk management is done upfront, before the first purchase is made or product is sold.  Secondarily, good risk management relies on the concept of feedback, i. e., are the results expected at inception happening?  If not, are they happening in a way that makes us doubt the margin of safety that we thought we had?

I’ll give you some examples:

1) There are two ways to offer disability insurance (this applies to high-end P&C products for the wealthy, and other financial products):

  • Rigorous underwriting that does not cover groups & individuals that could be high risk.
  • Underwrite freely, and then attempt to deny claims that happen with higher than expected frequency.

2) After designing a living benefit for an annuity, you notice that one option is being chosen by policyholders, and the rest not.  Do you:

  • Retest the option being chosen, to see that you are not giving away the store?
  • Do nothing.  After all, it’s the only product of its class selling, and marketing is off your back for now.  Why spoil the party?

3) You discover that you are the only company willing to offer a certain type of reinsurance, or a certain type of coverage.  Do you:

  • Try to analyze why  your competitors don’t do it.  If there’s no special and durable barrier to entry that you possess, make the pricing jump through harder hoops.
  • Congratulate yourself for your unique perspective, and willing to take risks that others won’t.

4) On your new insurance product, the claims area sends you early claims data, showing you reasons for the claims.  They reasons aren’t what you would have expected from the quality of the clientele that you thought you were marketing to.  Do you:

  • Begin analyzing marketing data, to see if the product is being offered more to those less intended.  Analyze what agencies are doing who sell a disproportionate amount of the product.
  • Attribute the claims to the “Law of Small Numbers.”  Hey, it’s a weird world, and odd stuff happens.

5) You’re part of a team of value investors.  A news event hits, showing that the company will be less profitable than expected by a wide margin.  Do you:

  • Analyze what the company is worth presently.  If it is no longer safe or cheap, sell.  If the market has over-reacted, buy.  Oh, and feed back the lessons from this episode into the process for evaluating new investments.
  • Automatically sell, because it has breached your loss limits.
  • Just hang on, because we have more than enough capital versus investable ideas.
  • Complain about the event, the potential dishonesty of management, and the analyst that recommended purchase.  Ask why we didn’t sell this last week.  Decide to go activist on the company, because it obviously the assets would be managed better in hands that you select.

6) The credit cycle has gotten long in the tooth, and securities that offer a decent yield versus risks undertaken have become few.  You manage money for income seeking investors.  Do you:

  • Edge away from risky bonds, slowly upgrade quality, and pare yields.  Communicate to clients why you are doing this, even if it means you might see assets walk.
  • Stay fully invested in the best quality bonds you can find, subject to a given yield hurdle.
  • Just facilitate the demands of clients, and invest as if you faced normal yield tradeoffs for risks undertaken.  After all, they want you to take risks.  If clients lose, that is their problem.

7) As a value manager, you have been underperforming for clients.  Though you have tested and re-tested your processes, you can’t  find anything wrong.  You think there is a speculative mania going on.  Several other managers that do things your way have been fired.  Do you:

  • Stick to your guns.  Safe and cheap will eventually win out.  Communicate that to clients.
  • Tweak your portfolios to make them more index-like.
  • Switch to growth or momentum investing.  If you can’t beat them, join them.

There will be a part 2 to this piece.  I will finish up and summarize there.

From a reader:

Hi David,

I’ve been a classic “bottom-up” investment advisor for a few years now, but I agree with your assessment that industries, in general, are under-analyzed by the masses.

What is the best way to learn about a particular industry? Are you aware of any comprehensive publication that sheds light on both the qualitative characteristics of an industry and the appropriate valuation methods?

Thanks!

There are several ways to learn industries.  I’ll try to explain:

1) You can choose a bunch of companies in an industry, email the investor relations area, and ask for packet equivalent to what they send buy-side analysts.  I’ve done that at various points in time for industries I wanted to learn.  Compare and contrast.  Who is doing well, badly and why?  In the mid-90s, I did this for the trucking industry, and learned a ton of information.  I also talked with some trucker friends of mine who gave me on the ground data.

2) You can read industry publications.  When I was a buy-side analyst for the insurance industry, I read those regularly.  They exist for almost every significant industry.

3) You can go to industry meetings.  Almost every industry has meetings where they discuss industry conditions.  Just don’t be too pushy in trying to get information.  Be interested in the industry as a whole, and don’t try to gain material nonpublic information.

4) Value Line & Morningstar both provide industry analyses.  So do most major investment banks.  You can review those and compare and contrast.

5) You can use the quality screen to look at what industries have a rising ratio of gross profits from operations, versus a falling ratio of gross profits from operations.  Here is a chart from the last seven years:

PRICINGPOWER_8574_image002

The colored field reading “Chg” is the difference between the average of years 1-3 and years 5-7.  Profits are noisy, that’s why I did an average.

Gross profits from operations as a fraction of assets [GP/A] is a good measure of the quality of an industry, and whether their sustainable competitive advantage is is improving or declining.

Now, when I look at a measure like that, I do one of two things:

  1. I buy cheap companies with strong balance sheets among those industries where GP/A has fallen hard, and buy them, knowing that they are survivors, and will rebound.
  2. I buy moderately strong companies in industries where GP/A has been improving, and after research, the trend is not well understood.  It helps if the industry is dull, and few people follow it.

That’s what I do.  Whatever you do, size it to your own abilities, or the abilities of your firm.  Beyond that, look at cheapness of a company relative to normalized earnings, i.e., average earnings over a full market cycle.

Bernanke press conference (reverse order)

  • It’s over!
  • FOMC Participants Central Tendency of PCE inflation @ Year-End 2013-5, LR 1.22% 1.68% 1.88% 2.00% change -0.33% -0.07% -0.05% 0.00%
  • Bernanke gives an odd answer to Nikkei reporter, particularly given the Fed’s adoption of failed Japanese economic & monetary policies $$
  • Yeah, weird answer. RT @Matthew_C_Klein: “Volatility is linked to the BOJ’s efforts. Seems logical.” Um…
  • BB shows his ignorance on the topic of money market funds, a floating NAV will destabilize, and lead to runs on funds
  • FOMC Participants Central Tendency Unemployment Rate @ Year-End 2013-5, LR 7.23% 6.60% 6.02% 5.57% Change -0.12% -0.17% -0.19% 0.00% $$
  • FOMC Participants Central Tendency Change in GDP @ Year-End 2013-5, LR 2.40% 3.14% 3.19% 2.43% Change -0.13% -0.03% -0.07% 0.00% $$
  • BB, markets do not care about the past, they care about the future. Stock levels of bonds r the past, future behavior affects markets now $$
  • FOMC Participants Target Federal Funds Rate at Year-End 2013-5, LR 0.26% 0.58% 1.78% 4.01% Change from prior -0.03% 0.03% 0.47% 0.00% $$
  • Overview of FOMC participants’ Appropriate Timing of Policy Firming central tendency shrinks by 2 months to 2.3 years
  • Bernanke questioned on MBS holdings, denies that the Fed is having a big effect on the market. If so, why buy there for policy reasons? $$
  • BB is confused think that holding securities will keep rates low; yields react to changes in expectations of future actions $$
  • Cutting off asset purchases at 7% unemployment further clouds the market view of Fed policy; the Fed is far more flexible than that. $$
  • BB also refuses to talk about his future at the FOMC, after being asked by a Washington Post reporter. $$
  • Bad question from Bloomberg reporter suggesting that the unemployment trigger should be lower. BB gives no much of an answer. $$
  • Good question on the rise in real rates from the FT reporter. BB says that he doesn’t get why that happened. $$
  • Question on long term interest rates — BB says that is is an improving economy. Points to housing again (the dead cat bounce) $$
  • Hilsenrath asks a decent question on punk economic growth. BB responds with housing and State govs & 2 small of a deficit (!) $$ #pleasego
 

Companies & Industries

 

  • Validus Plunges, Credit Suisse Cites Cat-Bond Threat stks.co/sHbj Cat bonds, ILTs r useful, but no threat 2 reinsurers FD:+ $VR $$
  • Warren Buffett Bought This Stock. Should You? stks.co/rHeV $YHOO has2 get a technical analyst 2find someone 2disagree w/Buffett $$
 

Market Impact

 

  • Credit market rout may force US IG issuers to do more legwork stks.co/jaNp This is normal for Wall Street; this is not news $$
  • Gold Trade Most Bearish Since ’10 as Fed Spurs Drop stks.co/rHeI The juice comes out of every risk asset w/end of QE hint $$
  • Nobody Is Paying Attention To Junk? stks.co/ia6G As I have argued before, yields r better indicators of risk than spreads. $$
  • Honeywell CEO: Boomer Retirement ‘Will Crush the System’ stks.co/sH90 Duh, it took you this long to figure it out? $$ #FTL
  • Risks of Too Much Oneness stks.co/dYNb If assets bundle into risky and riskless, it is usually time 2 reduce risk $$
  • stks.co/cYAf Bank Everbright defaulted on an interbank loan 10 days ago amid wild spikes in short-term “Shibor” borrowing rates $$
  • Income hunters: Bank on this dividend stock play stks.co/iZpo Feels like a tired bunch of large cap blend stocks $$ #noedge
  • With a Month to Go Before Dell’s Buyout Vote, Eyes on Proxy Firms stks.co/qGyq Q boils down2 what %age of $DELL is held by arbs $$
  • Missing the Target stks.co/rGpy Target date funds should b called asset allocation funds with varying levels of volatility $$
  • The Intelligent Investor: Why the Markets’ Latest Stumbles Are Good News @jasonzweigwsj stks.co/sGm7 Areas 2consider investment $$
Rest of the World

 

  • Brazilian Revolt Claims Second Life as Violence Erupts stks.co/pHkL Tensions spread partly due 2 easy $$ pushing EM inflation
  • Moody’s warns on China’s local govt debt stks.co/dYmW China’s debt crisis will be a national crisis b/c China won’t let cos die $$
  • PBOC Said to Inject Cash After China Money Rates Jump stks.co/iaQe Like the US in 2007, where insolvency hid behind illiquidity $$
  • Abe’s Arrows of Growth Dulled by Japan’s Three Principles stks.co/dYhU Flexible labor markets r an aid 2 growth in any economy $$
  • China Banking Stress May Come Faster on Cash Crunch, Fitch Says stks.co/pHI7 Interbank market failures plague Middle Kingdom $$
  • G8 three Ts: trade, tax and transparency stks.co/fa2Z Stem tax leakage from corporations & individuals, & maybe trade freely $$
  • Cracks Appearing on the Great Financial Wall of China – Remember 1997? stks.co/fZnQ Interbank lending market skittish over Fed $$
  • Chinese Consortium, $AIG Extend Deadline on Deal for Plane-Lease Unit stks.co/ha1q Makes 10% downpayment, financing rest shaky $$
  • In Japan, Reform Plan Faces Troubles With Mergers stks.co/sGm3 Some cultures r averse 2change, even if there r gains 2b made $$
  • Friendships Die Hard for Hezbollah Angering Gulf Over Syria stks.co/cYAq Increasingly a Shia-Sunni proxy war, raising tensions $$
  • Rohani Wins Iran Presidential Vote in First Round stks.co/dY2Z Now 2c what he can do vs the mullahs that hold economic power $$
  • The Cracks in China’s Shiny Buildings stks.co/fZgu Adjusted 4 quality, China is not the 2nd largest economy in the world $$ #GIGO
  • Ancient Roman Concrete Is About to Revolutionize Modern Architecture stks.co/jZaF Roman cement had lyme &volcanic ash: enduring $$
  • Obama Says Bernanke Has Been @ Fed ‘Longer Than He Wanted’ stks.co/cYOk Long than we wanted, rather, but who wants Yellen? $$ #yuk
 

Illegal Spying by the Government

 

  • Booz Allen, the World’s Most Profitable Spy Organization stks.co/faUn Almost nothing gets done in DC w/o a contractor $$
  • NSA Surveillance Leaks Startle Privacy Board Back to Life stks.co/haI3 Weak privacy board brought to attention by whistleblower $$
  • It’s OK For The NSA To Spy On Americans, But Don’t Monitor A Mosque stks.co/jZiD Profiling is controversial, but it saves $$
  • Phone Metadata Proves a Powerful Tool 4 NSA, Police stks.co/cY4A If fewer crimes get solved thru lack of metadata, that’s fine $$
 

Central Banking

 

  • Bernanke Makes Life Even More Difficult for the Euro stks.co/iaWC All risk assets r getting hit; the Euro has its own problems $$
  • Bullard’s Unusual Dissent stks.co/tHci Unworthy of the St. Louis Fed. Time to find a new president who believes in sound money $$
  •  Central Banking at a Crossroad stks.co/rHcO Agree w/Volcker on monetary policy, but not on all aspects of regulation. Good read $$
  • Tapering 101, Courtesy of Japan stks.co/qHbB Bernanke needs to learn from Japan; the biggest item is that QE did not work $$
  • Market Calls Fed’s Bluff stks.co/eYWn Fed is now tied into the markets; they have lost the freedom to jolt markets w/o cost $$
  • “This was really eye-opening for me”: Fed’s Raskin shocked@ low quality of work @ local job fair stks.co/aYWN Utter Lightweight $$
  • Obama Says Bernanke Has Been @ Fed ‘Longer Than He Wanted’ stks.co/cYOk Long than we wanted, rather, but who wants Yellen? $$ #yuk
 

US Politics

 

  • Case Closed? Far From It. stks.co/faTx Whatever Rep. Elijah Cummings says, the opposite is usually true. $$ #endtheMDgerrymander
  • IMF calls on government to reduce wage and firing costs even further stks.co/eYvg Deregulation is the only economic free lunch $$
  • Pension Fund Takes Neighborly Advice stks.co/tHWe Jack Bogle advises his county pension fund to index & they do so $$
  • Jefferson County Debt Plan Is Costly stks.co/cYOi Presence of capital appreciation bonds increases the debt load $$ cc: @munilass
 

Financial Companies

 

  • Reason: banks have short, callable liability structures and insurance companies generally don’t. Insurance is better regulated than banks $$
  • US Weighs Doubling Leverage Standard 4 Biggest Banks stks.co/faTm Insurance companies have ~10% capital, banks should have more $$
 

Other

 

  • Sodomy Hazing Leaves 13-Year-Old Victim Outcast in Colorado Town stks.co/qHbF Rape of any sort should be automatic expulsion $$
  • A Few Voices Warn of US Energy Revolution ‘Hype’ stks.co/sH8y Depletion is the issue here, $ fracked wells tend 2 deplete fast $$
  • Impossibly Efficient stks.co/sH8w Good note on EMH, points out how EMH needs people who don’t believe in it to make EMH work $$
  • The Curious Case of Doug Kass and the Twitter Haters stks.co/rHCF I don’t know; a man as stalwart as @DougKass will return $$
  • A Warning Shot on Management Buyouts stks.co/sH8v Basically a slap on the wrist that might expand 4 future violators $$ $REV #FTL
  • Wrong: Even Pessimists Feel Optimistic About American Economy stks.co/ha2y These r economists being interviewed, biased views $$
  • Nuclear Decommissioning Surge Is Investor Guessing Game stks.co/qH0U It pays 2 delay final cleanup, radiation levels fall $$
  • Meh: LinkedIn Builds Its Publishing Presence stks.co/iZqP I guess it works for some, but I rarely find their publishing useful $$
  • Rupert Murdoch Files 4Divorce From Pie-Deflecting Wife stks.co/tGox Who will protect him now? He doesn’t have 2 worry about her $$
  • Wrong: Detroit Looks to Pay Less to Bondholders stks.co/hZuv Bold words from a man whose city will lose in court vs creditors $$
  • Bloomberg Reporters’ Practices Become Crucial Issue for Company stks.co/rGpZ Q: Is this disclosed in the subscriber agreement? $$
 

Replies, Retweets, and Comments

  • @TheStalwart QE Increases debt. In a situation where there are too many debts, deflation comes b/c ppl think that debts will not b $$ good.
  • Join me in calling on the NSA and the US government to #stopwatchingus. Sign this now: stks.co/qGtB Stand up & b counted $$
  • @c_c_saunders I would prefer John Taylor, Lacker, Plosser, Warsh, Fisher, Hanke, James Grant, etc. I would even take the challenge, & win $$
  • “We’re down 4% since BB started talking. Markets are discounting mechanisms; you know that well…” — David_Merkel disq.us/8dow0x $$
  • @ReformedBroker Knew she was a lightweight; this just confirms it. I thought the Fed was exempt from diversity requirements…
  • Except through M&A, IPOs, etc., money doesn’t really enter or leave markets. That said, relative…” David_Merkel disq.us/8dmh20 $$

I’ve looked around for a transcript for Bernanke’s press conference, and I can’t find one.  Here’s my gripe, and I mentioned briefly at the end of last night’s article.

But if the tightening is two years away, why did the market react so badly?  Markets are discounting mechanisms, and react to expected future changes, not the mistaken view of Bernanke that stocks of debt still affect the markets.  No, it is changes in the stock of debt, and changes in the expected changes in the stock of debt that affect the markets.

Ben Bernanke either does not get markets, or is hiding what he knows from economic illiterates.  He insisted that maintaining the purchased assets in the monetary base would continue stimulus, even if they slowed down the rate of purchase.

Really, I should have made it simpler last night, and said, “Market prices change when new information changes the views of economic actors regarding the future.”  Markets are discounting mechanisms.  If you tell the market that you will suck $85 billion of the highest credit quality assets out of circulation for as long as it will take to get the economy moving again, and then later you say that you will reduce that flow within a year, you think that won’t change the views of market participants?  It certainly will, and with violence, as we have seen over the last two days.  The market’s forward path for cost of capital has risen, and stocks have fallen as a result.

Not that I will ever meet Bernanke, but if I did, I would point him to the Efficient Markets Hypothesis [EMH].  He probably believes it.  I view it as a limiting concept, that is, EMH is partly true, but only when lots of people who don’t believe in the EMH scour the markets looking for information advantages.  For a funny take on EMH, you can read this.

The short answer to Bernanke is that what has happened in the past should have no influence on current market prices.  That information has already been incorporated into the price.  Only changes of future expectations affect the current stock price.  The same applies to asset prices versus monetary policy; asset prices react to changes in expectations.

But maybe it’s not so bad, or maybe it’s even worse.  What if the Fed is wrong about improving economic prospects, and we see GDP disappoint over the next two quarters?  I think that is likely, as do Bill Gross and Jeff Gundlach:

Going forward, however, yields are likely to start falling. And that means the place to make money in the next few months is “everybody’s most hated asset class: long-term government bonds,” Gundlach said. “There’s really no inflation, no sign of inflation.”

Gundlach says he’s uncomfortable with the term “tapering” to describe the Fed’s expected approach to winding down its bond-buying program, saying it wrongly implies the central bank can achieve “perfection” in its effort to wind down quantitative easing. While the Fed will eventually look to slow the pace of bond purchases, it could subsequently speed them up as well if economic data weakens, he said.

The Fed is wrong about how much power they think they have.  The more aggressive the easing cycle is, the harder the tightening cycle is.  There has been no greater easing cycle than this one.  Thus even the slightest hint of reduction in accommodation hits like a ton of bricks.  Now to hear from Bill Gross:

Gross and his colleagues have been skeptical about the U.S. economy’s potential for growth since the financial crisis. Gross said last week the Fed won’t raise rates in a “meaningful way” for at least the next two years and investors should be cautious when it comes to all risk assets.

As interest rates have climbed over the past two months, Gross has recommended buying U.S. Treasuries. In a Twitter posting June 18, he recommended buying five-year Treasuries and earlier, on June 12, he called intermediate Treasuries with yields above 2 percent a “buy.” The “Fed’s not raising interest rates for years,” he said.

and

“We simply think the real economy won’t follow the path that the Fed thinks it will because the Fed is based on a cyclical model that’s inappropriate,” Gross said in a Bloomberg radio interview today with Tom Keene.

When there is too much debt, we tend to get deflation, because we slowly realize that all debt claims will not be honored.  That leads to uncertainty and slow growth, as people try to preserve the value of what they have, rather than take risks to grow their assets.  I’ll be writing more about this in a future book review.  Highly indebted societies tend not to grow rapidly.

I’ve been adding some long Treasuries to bond accounts, and I may add more.  Like Japan, I think we are in the midst of a “bad policy” trap that restrains growth and leaves the economy to muddle, until enough debt is paid down, and fiscal policy looks sustainable.  That may not happen for a long time, so that leaves me a bear at present.

I’m not a fan of the enhanced communications of the Federal Reserve.  In general, I think central banks should say nothing.  Nothing.  Just do your work through fed funds, and make sure you squeeze out bad debts before you stop tightening.  That was the way Martin and Volcker did it, arguably the best men ever to have been Fed Chairman.

The idea that more transparency is needed stems from the wrongheaded idea that giving people more data will make them do what the Fed wants.  Rather, they will more quickly react to the hints of policy change.  If you are a smart central banker, you should want people/firms to be confused.  Confusion is helpful because when people finally figure out what is going on, they react with more punch.

I am amazed that economists imagine things, and then they expect the world to act ideally, rather than the messy way that it normally does.  It is worse that we let them control policy with their bankrupt theories that may bankrupt many.

So to the Fed, I say “Be quiet.  Act in silence and your powers will be enhanced.”

But now, what of the Fed’s enhanced communications?  Let’s look at their expectations of GDP:

GDP

In general, FOMC participants have been optimists.  That is what they are paid to do.  GDP has consistently been lower than what they predicted.  They give us the “smiley face,” and then explain disappointment quarter after quarter.

Unemp

Again, optimism is the operative word, that is what they are paid to do — be optimistic shills for the US Government.  In this case, they have been more accurate, as the unemployment rate has come down.  Please ignore the discouraged workers, and all of the new people on disability.  I’m sure that last four years have injured far more people than the four years prior, not.

PCE

This graph is different.  Because we are listening to FOMC participants, we must get a dose of their religion.  Long-run future PCE Inflation will be 2%, they guarantee it.  But in the present, their expectations for inflation keep falling.  We are in a deflationary world where labor has no ability to improve wages, and thus stimulate inflation.

Fed Funds

Regarding predictions of the Fed funds rate, for the most part expectations for the rate have declined for 2012-2014.  Only today has 2015 expectations expanded, as the Fed hints at the end of QE.  As I have said before, at inflection points, markets often react in a wild fashion, because the received wisdom gets called into question.

tighten

When the Fed started their enhanced communications, they had no dream that they would be trapped in easing for so long.  As it is, it is only over the last half year that expectations for when policy would tighten have coalesced at September 2015.  I don’t know if that is the right time or not, but it is interesting to see the views of the FOMC converge here.

The last two graphs reinforce each other as they indicate tightening two years from now.  But if the tightening is two years away, why did the market react so badly?  Markets are discounting mechanisms, and react to expected future changes, not the mistaken view of Bernanke that stocks of debt still affect the markets.  No, it is changes in the stock of debt, and changes in the expected changes in the stock of debt that affect the markets.

Please be aware that the the Fed is not working off of established theory here, but only presumption.  They are imitating the failed policies of Japan, because the theories tell them it will work.  With economics, theories have a bad track record.  Maybe they should get out of the prediction business, and in the process, replace the Fed with a currency board based on gold, commodities, or limited fiat money that does not let the yield curve gat too steep or too flat/inverted.

May 2013June 2013Comments
Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace.Information received since the Federal Open Market Committee met in May suggests that economic activity has been expanding at a moderate pace.No real change
Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated.Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated.No change
Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth.Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth.No change.  I’m sorry, but balanced budgets promote growth, because economic actors don’t fear their taxes rising in the future.
Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.Partly reflecting transitory influences, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.No change.  TIPS are showing falling inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is down near 2.25%, down 0.4% from May.
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 expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate.No change

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, right?

The Committee continues to see downside risks to the economic outlook.The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.Shades up their view of the economy.
The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.No change. CPI is at 1.4% now, yoy.
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 decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee 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 and of rolling over maturing Treasury securities at auction.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 decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee 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 and of rolling over maturing Treasury securities at auction.No 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?

Operation Twist continues.  Additional absorption of long Treasuries commences.  Fed will make the empty “monetary base” move from $3 to 4 Trillion by the end of 2013.

 

Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.No change.
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.
The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change.
The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.No change. Vacuous.
In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.No change
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 asset purchase program ends and 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 asset purchase program ends and the economic recovery strengthens.No change.

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

In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.Not a time limit but economic limits from inflation and employment.

Just ran the calculation – TIPS implied forward inflation one year forward for one year – i.e., a rough forecast for 2014, is currently 2.20%, down 0.05% from May.  Here’s the graph.  The FOMC has only 0.30% of margin in their calculation.

 

In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.No change.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Charles L. Evans; Jerome H. Powell; Sarah Bloom Raskin; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Jerome H. Powell; Sarah Bloom Raskin; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen.No change
Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.Voting against the action was James Bullard, who believed that the Committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings, and Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.Bullard finally votes against, but the language is puzzling.  Defend the inflation goal which way? Should inflation be higher or lower?

 

Comments

  • This FOMC Statement was a nothing-burger.
  • I really think the FOMC lives in a fantasy world.  The economy is not improving materially, but they shade their view of the economy up.
  • Current proposed policy is an exercise in wishful thinking.  Monetary policy does not work in reducing unemployment, and I think we should end the charade.
  • 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 much of the unemployment rate improvement comes more from discouraged workers.

AIG

I am biased on AIG.  It was never as good as proponents of its past have said.  But it was not as bad as current detractors allege.

AIG went through several eras, some of which are barely covered by this book.  There was the secular growth era, which existed from the beginning until the late 1980s.  It was easy to continue to grow in P&C businesses in the US until then.  After that growth would have to come from other ideas:

  • Life insurance in the US and abroad.
  • Foreign P&C insurance
  • Aircraft leasing
  • Asset management

And so, AIG moved from being primarily a US P&C insurance company to being a behemoth, big in life and P&C everywhere, as well as aircraft leasing and asset management.

Other Books on AIG

If you are reading this book, you ought to also read Fallen Giant. and Fatal Risk.  Excellent books both, but they cover different aspects of AIG.  Fallen Giant focuses more on the development of AIG by the founder Cornelius Vander Starr.  It spends relatively little time on the fast growth era which was the start of Greenberg tenure as CEO.

Fatal Risk focuses on the diversification era under Greenberg’s era, when AIG was so big in US P&C insurance that they began diversifying into risks that had more capital markets exposure — Life, annuities, derivatives, airline leasing, commodities, and asset management.

All three of the books spend disproportionate time on the failure of AIG, which is kind of a shame, because the failure was the simplest part of the story.

  • No risk controls because Greenberg was ousted.  That said, risk control should be institutionalized, not personalized.  That was Greenberg’s fault.  No one man should be in charge of risk for a whole company.
  • Too much subprime and other mortgage risk spread through the whole organization. (Investments in the life companies, securities lending, derivatives, direct lending, mortgage insurance, etc.)
  • True leverage was understated on the GAAP financials.

Notable Information

One aspect of AIG that The AIG Story tells is how AIG became a single company.  There were many minority interests, and when Greenberg was a new CEO he bought all of them in.  That decision allowed the company to focus, and not be concerned with minority interests.

In two breezy pages (122-123) we get Greenberg’s take on how he built his life insurance business, buying SunAmerica (1998) and American General (2001).  An aggressive company buys two more aggressive companies, overpaying in the process.  There should be no surprise why AIG’s stock price was basically flat from 1999 to 2007.  Greenberg overpaid for life insurance companies he did not understand.  He was a P&C guy, and did not get how life insurance companies worked.  He saw two aggressive companies willing to sell at exorbitant prices, and paid up.  Culturally, they fit, but buying overpriced assets always takes its toll.

Not mentioned is the debacle that was the attempt to take over The Equitable in 1991.  AIG assumed that a New York company would have a distinct advantage versus AXA, a French company that was the eventual buyer.  AIG made the following errors:

  • Scared Equitable’s management team into the arms of AXA, who would treat them well.  Yes, Equitable’s management team was incompetent, and needed to be shown the door, but you didn’t have to tell them that directly.
  • Assumed that the Real Estate portfolio would not rebound.
  • AIG offered to buy The Equitable for very little, while AXA offered $1 billion of funny money, surplus notes and convertible debt.  Strange, but the funny money was worth more than almost nothing.

Unlike the purchases of SunAmerica and American General, the purchase of The Equitable would have been cheap.  Very cheap.  And AIG missed it, and also under-rated the abilities of AXA.  I was there; I know.

This brings me to a significant point over what was included, and what was excluded… this is the story as Greenberg wants it to be told.  He excludes his errors, and focuses on his achievements.  He was not as good of a CEO as often credited in the 1990s.

On page 127, Greenberg talks about leaving markets where AIG could not earn an underwriting profit, but by the 1990s, AIG was so big that that flexibility was gone.

Closed Culture

AIG’s culture bound employee  fortunes to the stock price of AIG.  Options, participation in C.V. Starr, and a number of other programs created significant incentives for people to stay, and trust in the continual increase in the price of AIG shares.  That created a culture of “lifers” if if survived long enough.

Also, in the 1980s and 1990s the board of AIG had more insiders than most, but when corporate governance rules changed, by 2005, the AIG board was populated by enough incompetent businesspeople, that there was no way that they could control the risks inside AIG.  They tossed out Greenberg at the behest of Spitzer, and then could not supply the moxie that Greenberg had.

The Financial Crisis

The post-2008 Greenberg understands the financial crisis.  Let me quote:

A financial crisis was brewing due to a combination a including: (1) U.S. policy overstimulated appetites for home ownership and kept interest rates low for too long, (2) regulation of institutions was poor, as commercial banks fed the appetite for home ownership with generous mortgages while investment banks demand with complex financial products and increasing leverage; (3) rating agencies failed to analyze many financial products adequately, and the lack of trading in such products on organized markets made them difficult to value; and (4) regulators at the SEC failed to monitor the leverage of many financial institutions, whose debt levels rose to as much as 30 to 40 times capital and, in AIG’s case, regulators at the  Office of Thrift Supervision, which had authority because AIG owned a savings and loan association, simply ignored any signs of trouble.

Hindsight is 20/20… there were many mortgages insured by AIG before Greenberg left, and many mortgage bonds purchased by his life subsidiaries as well.

Greenberg tries to make out the problems of AIG as a liquidity crisis, and not a solvency crisis.  I’m sorry, but in a panic, there is no difference.  If you can’t produce cash when needed, you are insolvent.  It’s that simple.  AIG had enough incremental demands for cash in the crisis, that it should have gone into chapter 11.  Maybe the Fed should have rescued the derivatives counterparty, and charged it back to AIG, but beyond that, it should not have acted.  Much as Greenberg complains, AIG was insolvent, and should have been reorganized.  He would have gotten far less as a result.

He also takes umbrage against Ed Liddy, a good man who attempted to do what the stupid government wanted — liquidate in a hurry, but Greenberg does not recognize that he set much of this process (though not all of it) in motion himself.

Greenberg won the suits against himself.  He personally did nothing materially wrong.  But the mismanagement of AIG in the Greenberg era and the time thereafter did deserve to be punished with chapter 11, not coddled with a bailout and tax incentives.

Quibbles

The book is worth reading, but what you are getting here is court history — the history as approved by the King.  It has elements of history in it, and it is mostly true, but you have to consider the source.  A lot of true history was purposely omitted.

Who would benefit from this book: If you are an AIG buff, you can’t get the full picture without knowing what Greenberg purports.  If you want to, you can buy it here: The AIG Story.

Full disclosure: The publisher sent me a copy of the book for free.

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