Month: December 2013

Classic: The Correlation Trade Gone Wrong

Classic: The Correlation Trade Gone Wrong

The following was published at RealMoney on May 23rd, 2005.? It’s a little obscure, but indicative of what can happen when too much money pursues an obscure arbitrage.? If nothing else, the piece tries to explain a complex concept to those with moderate market knowledge.

Because of the market dislocations last week, I want to give a primer on the class of derivatives that really jolted the markets this week: Indexed Synthetic CDOs.? First, some definitions:

1)????? CDO – Collateralized Debt Obligation.? A trust that owns bonds, loans, or credit default swaps.? The ownership in the trust is hierarchical.? There are several classes of certificates that have different interests in the trust, which get defined by which class receives losses from defaults first, second, third, etc.? The earlier that a class (or tranche) receives losses if they occur, the higher the yield a class of certificates receives.

2)????? Synthetic ? a term used in opposition to ?cash.?? One who transacts in corporate bonds participates in the cash market.? The synthetic market in corporate credit is composed of credit default swaps.? It is called ?synthetic? because it transacts in corporate credit risk without making loans to corporations.

3)????? Credit default swaps ? A market participant who buys default protection on a given corporation through the credit default swap market gains the right to deliver a certain amount of defaulted bonds in exchange for the par value of the bonds, when an event of default occurs for the class of bonds covered by the agreement.? In exchange for this privilege, the buyer of protection pays the seller a fixed fee for the term of the swap, which is usually five years, but can vary.

4)????? Spread ? That fixed fee is called the spread.? When the spread falls, the value of a credit default swap to someone who has previously sold protection becomes more valuable, in the same way that a bond price rises when its yield falls.

5)????? Indexed ? A third party puts together a seemingly diversified (or focused) list of companies so that investors can invest in a liquid pool of similar companies that they want exposure to, whether on a debt, synthetic, or equity basis.

Indexed Synthetic CDOs gather together the risk of debt default for a group of corporations, and parcel the risk of default out in a concentrated form to those who hold the ?first loss? certificates, in exchange for a high yield.? Those who hold other certificates in the loss priority get lesser yields commensurate to the risk of taking losses.

Setting the Stage

The Indexed Synthetic CDO market rallied until March 2005.? In most cases, the more risk an investor took, the better that investor did.? The indexes were rallying.? Those willing to offer protection against the default of a wide number of corporations were willing to do so at smaller and smaller spreads.? As I stated previously on RealMoney, those spreads were too small to compensate for the possibility and severity of losses.

Also, until March of 2005, the decline in spreads was fairly uniform.? There weren?t many credits within each index that were not moving in tune with the rally.? This was significant, because it meant that results were particularly good for the ?first loss? investors.? What hurts ?first loss? investors are credits going into default.? If the spread on the index as a whole improves (goes lower), but a small minority of credits diverge (get wider) and then default, the ?first loss? investor can get hurt, while investors with greater loss protection can still do well.

What Happened Last Week

Last week, not only did spreads rise in general, but some credits related to the auto and auto parts industries widened disproportionately.? This wouldn?t have been such a problem, except that a large number of hedge funds participated in the Indexed Synthetic CDO market doing an esoteric arbitrage trade, where the hedge funds when long the ?first loss? piece, and short 2.0-2.5x the ?second loss? piece.? This trade was sometimes called the ?correlation trade? for reasons I will talk about in a moment.

Why do such a trade?? The lure of free money is inexorable, and the trade had been free money for a while.? So long as movements in the spreads of credits in the index remained closely correlated, the hedge would hold between the ?first loss? and ?second loss? pieces, and the hedged investment would earn a high riskless yield, which to a hedge fund is the holy grail; a lot of hedge fund of funds will throw money at a strategy like that.

All arbitrages boil down to buying and selling two similar securities, and attempting to profit from the price or yield spread over the anticipated time horizon of the transaction.? Arbitrages can be intelligent or foolish depending on whether the anticipated total return is large enough to compensate for the negative results if the convergence anticipated in the arbitrage does not occur.

Last week, conditions for the hedge did not hold as the credit default swap spreads on automotive-related credits rose, leading the ?first loss? pieces to fall in value.? Surprisingly, the ?second loss? pieces actually rose in value, as a number of players moved to close out their hedges, which put downward pressure on the prices of the ?first loss? pieces, and upward pressure on the prices of the ?second loss pieces.? This became self-reinforcing for a while until the close on Tuesday.? On Wednesday, hedge funds and investment banks poured fresh capital into the trade, since the risk reward ratio on the hedged trade was now more attractive, bringing the market back to a more normal state.

Effects on the equity market

This put a damper on the equity market for several reasons: first, some players feared that some of the investment banks were caught on the wrong side of the trade, or had lent to those on the wrong side of the trade.? My guess is that?s not true, but if true, it could raise systemic risk issues, which lowers equity values, as it did in 1998 during the LTCM crisis.? The risk controls at the investment banks are far superior to those at most hedge funds now, and far superior to what they were at the investment banks during LTCM.? That doesn?t mean there can?t be crises, but the preparations for a crisis are better now.? The investment banks have laid off more risks to other market participants.? The other main effect on the equity market was that yields on riskier corporate bonds rose, which usually correlates with lower stock prices.

In closing, just be aware that there are other big markets such as the credit default swap market, both in its single-credit, and indexed forms, that can have a big effect on the equity markets.? There is a lot of leverage around, and ?bets gone wrong? can be big enough to knock some confidence out of the markets.? But I offer this hope: so long as the effects of the ?bets gone wrong? do not affect major institutions such as investment banks, commercial banks or insurance companies, the effects on the markets should be transitory, as they were after LTCM.

Give Them a Small Bank

Give Them a Small Bank

It takes a thief to catch a thief. ?Thus I have a modest proposal for bank regulation. ?This could be applied more broadly to other forms of financial regulation also.

Why not require that all regulators spend time managing banks before they are appointed to be regulators? ?I think this would be very instructive to those who would become regulators, because they would see how issues at banks appear from the other side.

I am not suggesting that potential regulators “go native” and become sympathetic to banks. ?Working inside a financial institution can do the very opposite, and inform a regulator on what to be careful about. ?I want regulators to have the smarts that an insider perspective gives.

Think of me for a moment. ?I am not a fan of the insurance industry; I also don’t hate it, but I know it well. ?I know where the warts are. ?If I were a regulator, I would be feared by the industry, because there is almost nothing that I don’t know about insurance in broad. ?(I.e., I am not trying to brag, but I think that I am competent in analyzing insurers.)

My point is that we want intelligent regulators that cannot be bamboozled. ?That only comes with significant industry experience.

But industry experience isn’t enough. ?You want people who are intelligent critics, who can look at the industry and say that certain practices are wrong from a solvency or market conduct standpoint.

And thus I say, “Give them a small bank.” ?Let the Federal Government set up a bunch of small banks for prospective regulators to help manage for a few years. ?Being part of a senior management team would cue them into a wide number of problems as they try to make money in a competitive market. ?Let them interact with their regulators as well.

I write this because when I read what most broad bank regulators at the highest levels say, I think, “All you can do is suggest things should be tighter, but you have no good reasoning for what or why. ?Would that you understood the industry you are regulating.”

In general, it is a bad idea to have academic economists in regulatory positions, because they do not understand what they are doing, but merely follow their ideology. ?Far better to have practitioners that are skeptics be regulators, because they really know what is going on, and will not spare the industry over abuses.

As a dear friend of mine once said, “To truly loathe the public schools, you have to be one of the teachers.” ?In the same way, I say make the regulators work for the banks before they regulate them, so that they can properly loathe them.

Movie Review: Money for Nothing

Movie Review: Money for Nothing

Movie Review: Money for Nothing

Why will you like this film?

You get to meet clever traders, investors, and business thinkers, policymakers, historians, and Fed Governors ? some who have doubts, and many that are still true believers.? The contrasts are considerable.

Here is the cast list, shamelessly copied from Wikipedia:

Federal Reserve Officials

  • Paul Volcker – Chairman of the Federal Reserve (1979?1987)
  • Janet Yellen – Vice Chair of the Federal Reserve (2010?Present), President, Federal Reserve Bank of San Francisco (2004?2010)
  • Alice Rivlin – Vice Chair of the Federal Reserve (1996?1999)
  • Alan Blinder – Vice Chairman of the Federal Reserve (1994?1996)
  • Peter Fisher – Undersecretary of the Treasury (2001?2003), Executive V.P. of the New York Fed (1994?2001)
  • Richard Fisher – President, Federal Reserve Bank of Dallas (2005?Present)
  • Thomas Hoenig – President, Federal Reserve Bank of Kansas City (1991?2011)
  • Jeffrey Lacker – President, Federal Reserve Bank of Richmond (2004?Present)
  • Charles Plosser – President, Federal Reserve Bank of Philadelphia (2006?Present)
  • William Poole – Economist, President, Federal Reserve Bank of St. Louis (1998?2008)
  • Laurence Meyer – Economist, Governor of the Federal Reserve Board (1996?2002)
  • Marvin Goodfriend – Senior V.P., Federal Reserve Bank of Richmond (1993?2005)

Economists and Financial Historians

  • Michael Bordo – Economist, Rutgers University Professor, Director, Center for Monetary and Financial History
  • David Colander – Economist, Middlebury College Professor
  • James Grant – Economist, Editor – Grant’s Interest Rate Observer
  • Martin Mayer – Scholar – The Brookings Institution, Author – The Fed
  • Allan Meltzer – Economist, Author of “A History of the Federal Reserve”, Carnegie-Mellon University Professor
  • Raghuram Rajan – Chief Economist – International Monetary Fund(2003 ? 2007), University of Chicago Professor
  • Richard Sylla – Economist, New York University Professor, Chairman – Museum of American Finance
  • Bill White – Chief Economist, Bank for International Settlements, (B.I.S.) (1995 ? 2008)

Traders and Investors

  • Peter Atwater – President and CEO – Financial Insyghts, LLC, Former Head of Asset Finance – J.P. Morgan
  • Tony Boeckh – Economist, Chairman – B.C.A. Research (1968?2002), Founder – The Boeckh Investment Letter
  • Jeremy Grantham – Investor, Financial Historian, Chairman – Grantham, Mayo Van Otterloo
  • Todd Harrison – Derivatives Trader, Hedge Fund Manager, Founder and CEO – Minyanville.com
  • John Mauldin – President – Millennium Wave Advisors, Author ? Endgame
  • Barry Ritholtz – Washington Post columnist, Author – Bailout Nation, CEO – Fusion IQ
  • Gary Shilling – Economist, Forbes columnist, Author, President – A. Gary Shilling & Co.
  • John Succo – Derivatives Expert, Hedge Fund Manager

A Rough Outline of the Film

Why is the Fed controversial?

It?s controversial because those who run it are appointed rather than elected, and so their actions are shielded from direct action by voters.? It is also a secretive institution, which does not reveal its actions/discussions rapidly.

Why was the Fed created?

The Panic of 1907 unnerved people, and led politicians to argue for a central bank.? It would have been smarter to tighten regulation of banks, but that is water under the bridge.? Most crises are due to misregulation of banks ? too much leverage, bad credit risks, and borrowing short to lend long.

What was the initial impact of the Fed?

Not much impact in WWI. When the Roaring ?20s came into existence, it was driven by loose monetary policy from the Fed, which led to?

The Great Depression

When debt grows rapidly, an eventual correction will come ? this one was sharp.? Like today, not sure the Fed could do anything to make things better, aside from not having been loose previously.

WWII to the End of the Gold Standard

The Bretton Woods conference linked the currencies of the developed world to the Dollar, which in turn was linked to gold.? Sadly, the Fed adopted a dual mandate, which said it must focus on consumer price inflation, and labor unemployment.? It didn?t work well then, and it works less well now ? the link between goods price and wage inflation is a weak one.

The link of the US Dollar to Gold worked will until the mid-?60s, when the pressures from fighting in Vietnam plus trying to create the Great Society stretched resources too thin.? William McChesney Martin caved when LBJ pushed him (perhaps beat him physically), and lowered rates in 1965, leading to inflation.

Over the ?60s and into the very early ?70s, as inflation in the US rose, foreign central banks, particularly the French, began to request gold rather than dollars.? Eventually in 1971 Nixon ended Bretton Woods, ceasing redemption of US Dollars for gold internationally.? And all of this led to?

The Great Inflation

Nixon leaned on the Fed to be loose, and Arthur Burns facilitated it.? William Miller continued it in the Carter Administration, leading to higher inflation.? Volcker was appointed by Carter, and as he pointed out in the movie, what he would do would be painful.? He resisted pressures to be easy and started inflation on a downward course by reducing growth of the money supply.? (Do you remember the news networks flashing the M-numbers on the screen each week, and the newspapers featuring them near the top of the business section?? You are old, like me.)? Volcker was not reappointed by Reagan in 1986 because he was viewed as an independent player (good), and not submissive to the administration.? Thus we got the toady Greenspan, who led to?

The Great Moderation

No one could have predicted that Greenspan would be such a political compromiser. But in 1987, after the crash, he assured liquidity to financial firms that might have been impaired from a 22% drop in the Dow.? This led to the concept of the Greenspan put.? Bad news?? Greenspan has your back, willing to inject liquidity when times are bad.

You can look at the pattern of interest rates over the period of his chairmanship.? Rates kept making lower lows, amid rapidly growing private debts.

Then we had a series of crises: Long Term Capital Management, where Lehman also almost went under.? The NASDAQ soared and fell hard 1998-2002.? Low interest/mortgage rates from 2002-2007 further encouraged a Debt/Housing Bubble.? ?The Fed was never a great regulator of the banks or mortgages.? They assumed the lesser regulators would do the job. But deregulation gutted the regulators, particularly because banks could choose their own regulators.? Hubris permeated the Fed, and Mortgage Equity Withdrawal fueled consumers, until there was nothing more to borrow against, leading to?

The Great Recession

Why did the Fed act as they did once the crisis broke?? Part of it was due to the dual mandate.? Another part was that Fed models were weak because they did not model the financial sector.? As James Grant would point out they were fixing prices via interest rates.? Once they started QE the Fed pushed the private sector to take risk because of a lack of safe assets with decent yield.? Other points:

  • Inflation is difficult to measure
  • Hubris
  • Insufficient skepticism, according to Hoenig

Hoenig comes off as an honest dealer versus the rest of the Fed, suggesting that many errors were made under pressure.

My Disagreements with the Movie

1) Bailouts were not needed in the way they were done

We could have rescued the operating subsidiaries that matter to average people, and let the holding companies fail.? Instead, we did the worst thing, and bought the equity of firms that were bankrupt.

2) Derivatives played no role in 1987

Unless you are willing to call futures derivatives, then derivatives played no role in the 1987 crash.

3) The net capital rule really wasn?t an issue.

4) Yes, the Fed has been monetizing the debt, and it will bite us eventually, when the demographics shift from saving to spending.? It will come in the next ten years.

Would you like the Movie?

I think most people would like the movie.? It gives the establishment sorts enough room to defend their actions, while offering wiser men the ability to say that the Fed was utterly wrong, and obviously so.

Twice before in our republic, we have eliminated a central bank.? Let us have the courage of our predecessors and eliminate the Fed.? It would be hard to do worse than the Fed did; they amplified economic shocks ? they did not mute them.

Redacted Version of the December 2013 FOMC Statement

Redacted Version of the December 2013 FOMC Statement

October 2013 December 2013 Comments
Information received since the Federal Open Market Committee met in September generally suggests that economic activity has continued to expand at a moderate pace. Information received since the Federal Open Market Committee met in October indicates that economic activity is expanding at a moderate pace. Shades their view up, but I don?t see much to support it.
Indicators of labor market conditions have shown some further improvement, but the unemployment rate remains elevated. Labor market conditions have shown further improvement; the unemployment rate has declined but remains elevated. Weasel words because the participation rate is falling, and wages are stagnant.
Available data suggest that household spending and business fixed investment advanced, while the recovery in the housing sector slowed somewhat in recent months. Household spending and business fixed investment advanced, while the recovery in the housing sector slowed somewhat in recent months. No real change.? Language clearer.
Fiscal policy is restraining economic growth. Fiscal policy is restraining economic growth, although the extent of restraint may be diminishing. Shades fiscal drag down, but the deficit is shrinking, so where do they get this?
Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable. Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable. Calls energy special, but it plays into all we do.? TIPS are showing slightly higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.65%, up 0.08% from September.
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 pick up from its recent 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 pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. No change. ?Monetary policy is omnipotent on the asset side, right?
The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall. The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced. Financial conditions are looser.? That?s largely due to the loose monetary policy globally.
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term. Shades their view on inflation down.? CPI is at 1.2% now, yoy.
Taking into account the extent of federal fiscal retrenchment over the past year, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program as consistent with growing underlying strength in the broader economy. Taking into account the extent of federal fiscal retrenchment since the inception of its current asset purchase program, the Committee sees the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy. No significant change, but switches the spotlight to the asset purchase program, suggesting that it has helped.
However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Worthless sentence eliminated.
Accordingly, 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. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month. Reduces the purchase rate by $5 billion each on Treasuries and MBS 
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. 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
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, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate. The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate. No real change.
The Committee will closely monitor incoming information on economic and financial developments in coming months and 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 closely monitor incoming information on economic and financial developments in coming months and 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. Useless paragraph.
In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. Says that purchases will likely continue to decline if the economy continues to improve.
Asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases. However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases. No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view 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 today reaffirmed its view 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. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent 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 2015, is currently 1.72%, down 6 bps since the last meeting.? Here?s the graph.? The FOMC has only ~1% 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.
The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal. New sentence.? Repetitive.
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; Charles L. Evans; Jerome H. Powell; 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; James Bullard; Charles L. Evans; Esther L. George; Jerome H. Powell; 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 Eric S. Rosengren, who believes that, with the unemployment rate still elevated and the inflation rate well below the target, changes in the purchase program are premature until incoming data more clearly indicate that economic growth is likely to be sustained above its potential rate. George in, Rosengren out.? Rosengren thinks any tapering is premature.

?

Comments

  • Small $10 B/month taper.? Equities rise, and long bonds fall.? Commodities do nothing.? The FOMC says that any future change to policy is contingent on almost everything.
  • Shades their views of GDP up and Inflation and fiscal drag down.
  • They think that if they use more words, they will be clearer.? Longer statements are harder to parse and understand.
  • 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 the past I have said, ?When [holding down longer-term rates on the highest-quality debt] doesn?t work, what will they do?? I have to imagine that they are wondering whether QE works at all, given the recent rise in long rates.? The Fed is playing with forces bigger than themselves, and it isn?t dawning on them yet.
  • 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, and part-time workers.
Risks, not Risk, Again

Risks, not Risk, Again

One of the most important things I am here to teach readers is that there is no such generic concept as risk. ?There are risks, and they must be handled separately. ?Generic measures of risk such as standard deviation of returns, beta, etc. are unstable. ?This was driven home to me when I heard a presentation from endowment investment advisors, where they talked about their models, and how the models translated current economic statistics into investment decisions.

I’m sorry, but the models can not be that good. ?The financial markets are only weakly related to the real economy in the short-run, though the tie gets strong in the long-run.

Economies are unstable; get used to it. ?The concept of equilibrium is also not useful, and it holds economics in thrall, because it makes the math work, even though equilibrium never occurs.

It is far better to look at your investment in an oil refiner and ask “What are the possibilities for where crack spreads will be a year from now,” than to look at the beta, correlations to anything, standard deviations, etc. ?The coefficients aren’t stable.

Many advisors would rather follow a false certainty, than have to think for themselves, and have to deal with the complexity of the markets.

I am a quantitative analyst, and a very good one. ?That is why I pay attention to the limitations of models, and the possibility that past data might be special, and not so relevant to the present. ?It is far better that you pick over your portfolios, and ask what risks they are subject to, than to look at standardized risk measurements that describe the past or present.

Be forward looking. ?What can go wrong? ?Analyze each company. ?Find the three most pertinent risks — read the 10-K if you are having a hard time. ?See if you think the risks are worth taking.

But be assured of this. ?Merely by looking at market price derived variables for stocks, you won’t learn anything valuable about the risks of what you own, or might own. ?You need to think like a businessman, a sole owner, and ask whether the risks can be ably faced.

To the Consultants

Your models are garbage. ?You need to review your managers at the holdings level, or you are doing no good at all. ?All of the aggregate statistics hide the instability. ?Far better to understand the qualitative methods of managers, and analyze whether they have a durable competitive advantage or not.

That may not seem so scientific, but science is put to bad ends in areas where there is no good science.

If I were hiring managers, I would spend a lot of time on process and people, and ignore a lot of other items.

Summary

Mathematics is of limited use in analyzing investments and investment managers. ?It is far better to look for those that have good business sense, and invest with them.

Book Review: Kentucky Fried Pensions

Book Review: Kentucky Fried Pensions

frontfinal This book takes you through the corruption in the Kentucky Retirement System. ?It has the dubious distinction of being the worst-funded municipal pension system in the US, leaving aside Puerto Rico.

This book is very well-researched for three?reasons:

1) The author served one four-year term on the board of the Kentucky Retirement System, so he has insider knowledge.

2) The author is an expert on pensions — he has worked in this area for over 25 years. ?He also holds a CFA Charter, which demonstrates his knowledge in investments, and his commitment to ethics in investing.

3) The author extensively cites his findings, giving nearly 600 endnotes in an otherwise 256-page book.

The Kentucky Retirement System is not a victim of incompetence alone, but of fraud, political favoritism, and structured neglect. ?The structured neglect is probably the most serious matter.

For years, Kentucky would not pay its full actuarially required contribution to the retirement system. ?Now, you can’t argue with the math, though you can argue with assumptions. ?Not making the full payment persistently will leave a pension plan weakly funded. ? As the author points out, it is a quiet means of borrowing against the future, and at a far higher rate than Kentucky could borrow in the municipal bond market.

This is the product of a broken political culture that only cared about the present:

1) Keeping current taxes low

2) Spending more than taxes

3) Politicians accepting bribes campaign contributions from those gaining pension business from the State of Kentucky.

4) Board members that would not enforce thorough audits.

5) Board members that would not seek out investment experts for their board.

6) Politicians that would appoint weak board members that were political cronies.

7) Awarding investment mandates to political cronies, where placement agents would earn disproportionate sums.

8 ) And more…

If you read this, you will wonder how a municipal pension plan could get screwed up so badly. ?My answer is this — the political culture of the state tolerates corruption, so it grows like a weed in obscure places like the Kentucky Retirement System.

On the Rating Agencies, Etc.

The book asks the question as to why the rating agencies were complicit on municipal pensions, waking up late to the problems. ?My answer is simple. ?The rating agencies have never hired many actuaries, and as such did not consider what is obvious to any actuary that I know. ?They came to the game late, and that is normal for the rating agencies — if there has not been a failure from a given factor, their models will not have that factor. ?That’s normal for most of us, because few of us can envision failures that have never happened before.

Few are like Buffett, who said, “We’re paid to think about things that can’t happen.” ?That is the sound of one hand clapping, and few can hear it.

Never allege conspiracy, when mere incompetence will do. ?Few saw the housing bubble, and many denied it, including the present and incoming Fed Chairmen. ?Incompetence is pervasive; we should be surprised when things go well.

On Pension Obligation Bonds, we should note that they are a dumb idea, and that every municipality that has tried it ended up regretting it. ?It is hard enough to fund pensions without borrowing money; it is much harder to do after borrowing money.

Quibbles

The main problem with the book is that it needed a better editor. ?It reads like a series of essays that are self-contained, because much material is repeated that could have been eliminated.

Secondarily, the book takes a position that pension benefits can’t be cut. ?That is not true. ?It may take constitutional changes to do so, but in a democracy, anything can be done. ?We could repeal the prohibition against ex post facto laws on a basis limited to pensions.

I say this because many municipal unions pressed for pensions far beyond what was warranted, in exchange for lower salary increases. ?It appealed to venal politicians, because increasing pensions usually had no current cash cost.

Eventually, municipalities will be forced to cut pensions, even for those that have retired. ?There will be no other choice.

Who would benefit from this book:?If you want to know the depths of depravity in municipal pensions, this is the book for you. ?If you want to, you can buy it here:?Kentucky Fried Pensions: Worse Than Detroit Edition.

Full disclosure: The author sent me the book after I asked for a review copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

The Prime Directive: Stay Out of the Bottom Quartile

The Prime Directive: Stay Out of the Bottom Quartile

If you are a money manager, you would like to be in the top quartile of managers all of the time, but you know that is virtually impossible. ?So you might set a more achievable goal, staying out of the bottom quartile. ?Now there are two ways to achieve that:

1) Make intelligent asset selections that outperform your competition.

2) Own an index-like portfolio that has low odds of slipping into the fourth quartile.

Now, which of those do you think is easier? ?Right, #2. ?Which do most money managers adopt? ?Right again, #2. ?Charge active management fees for a portfolio that will not perform much different from the index.

I take route #1 for several reasons.

1) If I am charging a fee for active management, I find it unethical to try to hug the index.

2) I am willing to look bad for a year or two, if I believe that my methods will outperform over time, reduce risk, etc.

3) My focus on “margin of safety” keeps me out of the fourth quartile anyway. ?I rarely take large losses on a given stock, even though I do not automatically sell stocks after ?a certain level of loss.

4) If you look hard enough, and are willing to try assets that have issues, but with adequate safety, you can do pretty well.

I would encourage you to look for managers that have a large active share — that is, those that are very different from the index, but with a record of doing well.

Understand the asymmetry of interests between managers and clients. ?You pay fees; they receive fees. ?Thus, look for managers that have a large proportion of their liquid net worth invested in the assets that they manage. ?That imposes a discipline that makes them fight for themselves as well as their clients. ?At present, I am still my firm’s largest client, with over 80% of my liquid net worth invested in my strategies.

If your active investments underperform over long periods of time, and you don’t know where to look, consider an ETF or index fund in the same area. ?My view is to look for managers that successfully take risk over time, and run portfolios that do not look index-like.

An Aside

As for me and my clients, increasingly the portfolio has become global. ?My portfolios don’t have a limit on non-US exposure. ?As I have selected assets the last few times, foreign assets have offered better opportunities than domestic. ?Maybe that implies something regarding US stock overvaluation, and maybe not.

From my angle, many foreign markets seem cheap, even if things don’t seem that great now. ?Regardless, I buy what seems to be best, and if I end up with an entirely foreign portfolio, so be it. ?I don’t aim for that, but if that is what is on sale, I will buy.

Sorted Weekly Tweets

Sorted Weekly Tweets

 

Rest of the World

 

  • US Drone Strike Hits Wedding Convoy in Yemen, Killing 13 http://t.co/6h2vhYPuw6 More bad PR 4 drone strikes, wonder how this will end… $$ Dec 13, 2013
  • 2.5-mile plunge into the world’s deepest gold mine in South Africa http://t.co/DQZA8Fkl9B &check out this graphic http://t.co/CvWrJlfbRu $$ Dec 13, 2013
  • A Journey Into the World’s Deepest Gold Mine http://t.co/mpb4pP658d The technology & the survivors @ the deepest gold mine in the world $$ Dec 13, 2013
  • How I Unintentionally Forced Pirate Bay From Its Latest Haven http://t.co/N3LReXRSJV Ascension Island boots Pirate Bay which runs to Peru $$ Dec 13, 2013
  • Irish Charm W/Germans Leads Nation Out of Bailout Wilderness http://t.co/4F0I3rGJz7 Fascinating piece on how Ireland survived austerity $$ Dec 13, 2013
  • SNB Gauges Bubble Risks as Euro Crisis Danger Recedes http://t.co/83gteiPvCZ Favoring exporters leads Sweden monetary policy to overheat $$ Dec 12, 2013
  • Merkel Embraces Coal as Rookie Lawmaker Makes Mark on Policy http://t.co/Qotu8cFsRm Fascinating how environmental policy isn’t considered $$ Dec 12, 2013
  • The Unstoppable Postal-Service Retreat Starts in Canada http://t.co/PSMW6FBLfy Is the future 4 USPS the elimination of local mailboxes? $$ Dec 12, 2013
  • Rat-Infested South Africa Schools Foil Mandela Education Dream http://t.co/TvJjENGqHG Graft & corruption eat up school $$ #culture $SPY $TLT Dec 12, 2013
  • Are we seeing the emergence of ‘dictator’ Xi? http://t.co/QsUU5184Xl His #2 is sidelined, & there is no obvious close helper. $$ Dec 12, 2013

 

Lobotomies

 

  • World War II Veterans’ Families Recall Lobotomy’s Scars http://t.co/SkutVXuhFH LONG article on how families coped after lobotomies $$ Dec 13, 2013
  • Neurologist Walter Freeman?s Lobotomy Legacy http://t.co/ilb2M1RO3c Ice-pick lobotomies r a horrifying legacy damaging minds of veterans $$ Dec 13, 2013
  • Lobotomy For WWII Veterans: Psychiatric Care by US Government http://t.co/rc5cLaxK80 LONG sad tale of lobotomies to cure mental illness $$ Dec 12, 2013

 

Volcker Rule

 

 

US Politics & Policy

 

  • Health Insurers Told to Ease Coverage Rules http://t.co/wpJOj8tWQw Exchanges r getting many more old than young http://t.co/b9YFdT5dPQ $$ Dec 13, 2013
  • Will Copper Pots Destroy Lake Superior? http://t.co/GqFmD4jPY6 Perhaps the tailings can be used 4 roadbed, or other types of construction $$ Dec 13, 2013
  • All-out war breaks out in GOP over budget pact http://t.co/vAZLPhm9D4 Will b interest 2c if House Dems pass the deal w/a subset of GOP $$ Dec 12, 2013
  • Obama Needs to Fire Some People http://t.co/AvOrlQgnxq Similarity of Obama & Reagan; they tend to stand behind their people, til it hurts $$ Dec 12, 2013
  • Republican-Tea Party Tiff Means 41% Don?t Like Candidates http://t.co/dw8UNAE9NF Divisions in the GOP weaken their political prospects $$ Dec 12, 2013
  • Republicans Get the Better End of the Budget Deal http://t.co/klP9uHuJGC @asymmetricinfo gives us a different take, but will GOP do it? $$ Dec 12, 2013
  • The Potholes Stay Where They Are http://t.co/ZZI56aYXmt VERY long article on the recovery of the US auto industry-what has changed $$ $GM $F Dec 12, 2013
  • Soothing Words on ‘Too Big to Fail,’ but With Little Meaning http://t.co/0h8COkjGIF! Short of breaking up big banks, no way to end TBTF $$ Dec 12, 2013
  • Ryan Lizza: Why Won?t Obama Rein in the N.S.A.? http://t.co/m8pc9jTgCu Long article on Obama’s hypocrisy on surveillance of US citizens $$ Dec 12, 2013
  • House, Senate Negotiators Announce Budget Deal http://t.co/9tQZ01iZGg The sequester would be better, at least that makes real cuts $$ $TLT Dec 12, 2013

 

Central Banking

 

  • The Fed Doesn’t Really Trust the Banks Either http://t.co/cNEyz5i6rw Structural rigidities in $$ mkts make Fed policy less effective $$ $TLT Dec 13, 2013
  • Hoenig Says Volcker May Spur Efforts to Split Biggest Banks http://t.co/f7AfDZY6yy Ending interstate branching would b more effective $$ Dec 13, 2013
  • A Fed Dissident on Policy and Transparency http://t.co/i3oQh6bjFS Plosser makes a courageous stand to protect the Fed from its excesses $$ Dec 12, 2013
  • Nicolas Copernicus Was Far More Than A Scientific Icon http://t.co/jX01ZEjEY7 Wrote “On the Minting of Money.” A hard money guy 4 his era $$ Dec 12, 2013
  • Stanford Economist Piazzesi Influences Fed Forecasts http://t.co/CgAAhituSv Now her theories affect policy w/every forward rate wiggle $$ Dec 12, 2013
  • Why do ivory tower academics get into policy positions, in this case assuming that forward rates forecast future economic activity? $$ Dec 12, 2013

 

Financial Sector

 

  • Six Investment Errors You Are Making Right Now http://t.co/vke2UmoRlS @ritholtz shows us errors that he has made that we r all prone 2 $$ Dec 13, 2013
  • Philadelphia Meets Manhattan at 10 Rittenhouse Square http://t.co/hOz6EXeiPb Worked w/Carl Dranoff once; bright guy, very creative $$ Dec 13, 2013
  • Five Accounting Red Flags the SEC is Watching http://t.co/wHktREd5Ci Revenue recognition & cost deferral r bigger issues; wasting time $$ Dec 13, 2013
  • Lawrence McCarthy, Who Saw Swaps Danger at Lehman, Dies at 49 http://t.co/PanZkbNbmH Bright guy; he will b missed $$ Dec 12, 2013
  • Wells Fargo Plans Ethics Review Amid Bank Scrutiny http://t.co/kgOfuKfoRn Give $WFC its due, they r trying to get ahead of their problems $$ Dec 12, 2013
  • Why Is Everybody Sitting on Huge Piles of Cash? http://t.co/N11xOheIHz Waiting 4 new IPOs absorb excess cash $$ HT: @ritholtz $SPY $TLT Dec 12, 2013
  • As stocks hit record highs, so do profit warnings http://t.co/PHLL8LiPMs Market rally is multiple expansion, pay more $$ 4 same stocks $SPY Dec 12, 2013

 

Companies

?

  • What Yahoo Didn?t Want Investors to Know http://t.co/Ec25tEMoor $YHOO relies on $MSFT 4 25% of its revenue in 2012 & 31% in 3Q2013 $$ $SPY Dec 12, 2013
  • BNSF CEO Rose shifts role, renewing Buffett succession talk http://t.co/0mHnRYYVAy Would b a good candidate2run industrial side of $BRK-B $$ Dec 12, 2013
  • Inside the Breakup of the Pritzker Empire http://t.co/5XcnNWHnZk How Tom Pritzker detangled the family business, giving freedom to heirs $$ Dec 12, 2013

?

Other

 

  • How to Hike the Entire Appalachian Trail, and What You’ll Get Out of It http://t.co/fP8yHH7rTQ Retired photojournalist makes way on trail $$ Dec 13, 2013
  • Secular stagnation and the bastardisation of Keynes http://t.co/r2JiJ5z885 Rising debt levels led GDP to overshoot & now revert down $$ Dec 12, 2013
  • How Isaac Newton Went Broke Chasing A Stock Bubble http://t.co/gIQcjyBpRv HT: @tomkeene | Ride a painted pony, let the spinnin wheel spin $$ Dec 12, 2013
  • Why Do Forecasters Keep Forecasting? http://t.co/2t4Az5ZiyI Predictors exist so that we have someone to blame other than ourselves. $$ $TLT Dec 12, 2013

 

Wrong, etc.

 

  • Overstated: The Texasization of America http://t.co/cj67aQcR1e Texas may b the fastest growing state, but not all states go4 lower taxes $$ Dec 12, 2013
  • Wrong:White House Works2Attract Younger Health-Plan Users http://t.co/rtrWhv4UIe Most people signing up r either poor or sick; won’t work $$ Dec 12, 2013
  • I.e., w/interest rates on investment grade debt so low, most of these defined benefit pension plans r still dramatically underfunded. $$ Dec 12, 2013
  • Wrong: Pension Funds Make the Most of Stocks’ Surge http://t.co/6FjCE7boAQ Unless u can defease your liability, u don’t have enuf assets $$ Dec 12, 2013
  • Wrong: Federal Reserve Eyes New Tool for Setting Interest Rates http://t.co/T2jWOrhFk8 This is wishful thinking; math is same as IOER/FF $$ Dec 12, 2013
  • Ridiculous: Was Mandela Right to Sell Out Black South Africans? http://t.co/qOcPQR3BkU South Africa has done better than rest of Africa $$ Dec 10, 2013

 

Comments

 

When to Worry — An Asset-Liability Management Perspective on Financial Macroeconomics

When to Worry — An Asset-Liability Management Perspective on Financial Macroeconomics

At the end of the day, the world is net flat.? Every asset is owned 100%; every liability is someone else’s asset.

If everything is 100% owned, why are there ever crises?? Financial companies owning illiquid assets financed by short, liquid liabilities.? Liquidity crises are credit crises; a company going through a liquidity crisis did not do sufficient stress testing to realize that they were weakly financed.

Crises are never accidents, aside from things like Hurricane Katrina and Superstorm Sandy.? And guess what?? How many insurers failed from those two events?? None.

Crises happen because things are inverted.? Under ordinary circumstances, prudence dictates that long-term assets be financed by equity or long-term debt.? Before a crisis, long-term assets are owned with short-term debt, and wealthy guys like Buffett and Klarman hold cash and shun long-term assets.? That’s inverted.? Those that should not be bearing risk are bearing risk, and those the could bear risk aren’t.? Why?? Because the prices on risk assets are high, and smart investors lighten the boat as the envious buy into momentum at the end of a doomed rally.? Ben Graham’s weighing machine takes over from the voting machine.

So what are reasons to worry?? Here are a dozen, not in any order:

  • The combined balance sheets of investment banks grow, and the complexity of their assets rises.
  • The repo market grows, as less liquid assets are financed by very liquid liabilities.
  • Poor-to-middle class people begin taking risk by buying homes, or speculating in stocks.? These people have weak liability structures, because they live paycheck to paycheck.
  • Mortgage finance moves to ARMs or even more exotic loans.
  • Downpayments on homes get low.
  • Rich hold more cash while the poor and middle-class borrow.? The rich can take losses — they have long time horizons.? When they play defense, it is a time to be concerned.
  • In a given sector there has been a large increase in debt, and there are concerns over ability to repay.
  • Shadow banking has increased dramatically.
  • Financial commercial paper issuance has increased dramatically.
  • People rely on certain large financial firms to not default, even if they have taken on too much credit risk relative to their capital.? (Think of Fannie and Freddie.)
  • Increased financial complexity makes everything opaque.? Bad things happen in the dark.
  • The credit cycle gets long in the tooth, and credit spreads/yields tighten to levels that are far too low for the risk taken on.

Now, I leave aside pure macroeconomic concerns like the possibility that the Fed might face a greater problem with stagflation than it did in the ’70s.? When long illiquid assets are financed by short liabilities, all sorts of bad things can happen.? Keep your eyes open.? Hey, aren’t Buffett and Klarman letting cash levels rise?

Classic: The Value of Financial Slack

Classic: The Value of Financial Slack

This was my first article published at RealMoney, in October 2003, I think on the 17th.

=-=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==–=-==-=-=-

As investors go, I am a ?singles hitter.?? I don?t get many investments where I more than double my money.? But I bat a high average when I invest.? One of the keys to this is insisting that the companies that I invest in possess ?financial slack.?? Financial slack means that a company can make a few mistakes, and not get killed.? This is the equivalent of Ben Graham?s margin of safety.

 

If you run a portfolio with a small number of stocks, it is important to avoid companies that destroy your capital.? It is difficult to recover when your capital has been impaired.? A good defense allows the offense to play aggressively, without losing sleep at night.

 

The market is a cyclical beast, with cycles inside cycles.? The market has a cycle of its own, but industries have their cycles within the cycle of the market.? This is where I find my advantage in the market ? analyzing industry cycles.? Industries go in and out of favor.? The time to buy a company in any industry is when it is out of favor; as a matter of risk control (and humility) the companies to buy when an industry is out of favor are those with financial slack.? If you are wrong about the industry, you won?t lose much; if you are right, the gains will be significant.

 

My example for today is the steel industry.? The steel industry is economically necessary for our world, but is in decline in the US.? The older integrated steel mills are inefficient compared to the mini-mills, and foreign competition.? The foreign firms have varying advantages ? cheaper labor, and governmental subsidies, both implicit and explicit.

 

Understanding Cyclicals

 

Steel is a cyclical business that follows the pricing of steel.? This may sound obvious, but the finance textbooks teach us to look at companies in a mode that assumes constant earnings growth.? This is a rare condition in the real world, and non-existent with cyclical companies.? With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance.? Longer-term, it comes down to:

 

  1. Buying industry leaders with impeccable balance sheets.
  2. Reasonable operating leverage ? they should be profitable at the cycle trough
  3. Buying them when the industry is hated.? Buy them cheap.
  4. Only buy firms that use free cash flow at cycle peak in a way that prepares for the trough.

 

Point 1 comes down to size and financial leverage.? Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.

 

Point 3 is the hardest point.? In growth industries, P/E ratios are a reasonable measure for valuation.? In cyclical industries, P/B [price-to-book] and P/S [price-to-sales] ratios are more reasonable, because earnings are less stable and reliable.? With cyclical companies, P/E ratios are typically lowest at the cycle peak, when companies have peak earnings, and high-to-nonexistent P/E ratios at the cycle trough.

 

Other issues around steel

 

There are a number of structural problems around the steel industry.? Tariffs to protect US production prevent inefficient capacity from exiting the industry.? The hint of removal or increase of tariffs can move steel stocks markedly.? Second, labor unions have not figured out how deeply uncompetitive the US steel industry is.? Between total compensation costs and work rules, the unions help make many US steel uncompetitive.? Finally, pension liabilities are often large relative to the total capitalization of many steel companies.? It is no surprise that one of the key issues regarding emergence from bankruptcy in the steel industry involves reduction of pension benefits.

 

Conservative investors investing in the steel industry will look for companies that do not have large pension deficits, and companies that are non-union, or where the unions have made peace with management.? They will also look for companies that can exist without tariff protection.? (Perhaps politicians will realize one day that more jobs hinge on the use of steel, rather than its production, and eliminate tariffs because it preserves more jobs, but I doubt it.)

 

Companies

 

In my investing, in the past, I have made money on AK Steel [AKS], Algoma Steel (insolvent), and Nucor [NUE].? When steel prices were higher, low cost producers (at that time) like AK and Algoma did well.? Their main problem was their debt loads; a company that is operationally efficient still has to service its debts.? EBITDA is all very good if you are a bondholder, but stockholders need free cash flow ? AK and Algoma had none of that as steel prices fell.

 

In this uncertain environment, I am invested in Nucor.? With little debt, a non-union workforce, and relatively low cost production, Nucor is an acceptable stock for conservative investors.? Nucor has been a consolidator of steel assets on the cheap amid the many bankruptcies that have plagued the sector.? When steel industry conditions normalize, they will earn a good return.? It has a strong focus on return on equity.? It should earn a about $1/share in the trough, and perhaps as much as $5/share at the peak.

 

But is it the right time to own Nucor?? Is it cheap enough?? I made my last purchase in the high 30s, and would purchase more there.? In the high 40s, I am a little more indifferent, because I would sell Nucor in the low 60s.? Given the normal level of profitability for Nucor, I view it as a buy below 1.3x book, and a sell at over 2x book.

 

An alternative

 

I do not have a position in POSCO [PKX], but am considering it for my portfolio at present.? POSCO, formerly Pohang Iron and Steel, is the third largest steel producer in the world.? It is based in South Korea, and is presently the lowest cost producer in the world.? Debt is low, and if you can trust Korean GAAP, it has earned consistent money for nine out of the last ten years.? It trades around its book value, and 7x 2004 earnings ? very cheap, unless we get a new war on the Korean peninsula.

 

As with any investment, the risks must be weighed against the likely returns.? I have one Korean company in my portfolio.? Do I want to double my risk?? That is my main question on POSCO.? Absent that, I would rate it a buy for those who can tolerate the risks involved.

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