Search Results for “Queasing”

Queasing over Quantitative Easing, Part VI

Posted on 9 October 20109 October 2010 by David Merkel

I am no fan of quantitative easing, as readers may know.? One aspect of the dislike comes from the one-sided view of how low interest rates benefit the economy.? They do not benefit the economy, at least not as far as the following are concerned:

Endowments spend less, as their spending rules lead to less spending when interest rates are low.
Pensions find that their liabilities are more expensive than they thought.
Virtually every long-term financial plan fails, because they assumed far higher return assumptions.

Does the Fed ask what entities they might be hurting through quantitative easing?? They hurt any entity that has to make payments over the long term.

Now, that might change should inflation return.? There is a huge psychological barrier to be overcome there.? Given the willingness of almost all of the central banks to inflate, inflation will probably return.? The question is when?

Aside from that, banks aren’t lending.? In order for inflation to return, bank lending has to recover.

Quantitative easing requires the central bank to buy longer-duration fixed-income assets than is prudent for a central bank to buy.? That crowds out other natural buyers, like endowments, pension plans, and life insurance companies.? Flattening the yield curve is not costless.? It affects those that need to fund long duration obligations.

Capitalism is complex.? There are many nooks and crannies that central bankers ignore.? They are focused on the short-term.? Do central bankers realize that they are making life tough for endowments and pension plans?? Do they care?

To the extent that central bankers lend long to the US government, I would tell them that they are in a long-term bad bargain, though the short run might be different.

I don’t know the future, but I favor ideas that favor effort over passivity.

Queasing over Quantitative Easing, Part V

Posted on 2 September 2010 by David Merkel

Does it matter who controls the businesses of the country?? Does it matter who regulates the businesses of the economy?? Should these people be smart or dumb?

One cost of the meddling that the Fed and Treasury have done through the bailouts is that dumb people are left in place.? People who mismanaged their firms still manage them, and regulators that misregulated are still in their jobs.? Both are rescued by taxpayer largess, but it reveals another hidden cost of bailouts — they make us less competitive/effective as a nation, because we do not let? firms fail, and we don’t fire regulators that were negligent, including the Fed.

The optimal outcome would be for bright managers to buy failed firms out of bankruptcy, and for failed regulators to be replaced with new ones that have a chance of doing things differently.? Aside from that, if you never fire regulators for failure, you will never motivate them to do what is right.

And this is true of most meddling by the Fed or the Treasury, picking favorites, not letting bad firms or regulators fail.? This extends to QE.? If you need lower rates in order to survive, you probably don’t deserve to.? All a lower rate structure does, if the government or Fed is forcing it, is encourage investment in lower yielding investments, because they can be financed cheaply for now.? This is an aspect of the liquidity trap, and the Fed is deepening it with their policies.

Remember, there is no evidence that QE works.? It has not helped Japan; it may have harmed Japan.

What I have found interesting over the last week are the number of discordant voices that are not in favor of QE or fiscal stimulus.? Here are some examples:

Consider what John Taylor and Richard Berner have to say in this article.
Listen to what Trichet has to say about government debt.? He says that the failure to cut debt has led to Japan’s malaise.
David Goldman questions QE here, suggesting that the US will fare worse with that strategy than Japan.
Or consider Raghuram Rajan, who in this article argues that low rates encourage speculation in risky assets, which may not result in growth in the long run, which is similar to the arguments of Fed dissenter Thomas Hoenig, who is also cited in the article, and me .? The difference that I have with Hoenig is that the economy is not strong here, and he thinks things are pretty good.? Hoenig thinks that low rates are hindering growth because banks sit back and make risk-free profits lending to the Treasury, and I agree with that.? It would be more stimulative of private sector lending to raise Fed funds to 1.5%, because then banks could not make money in Treasuries without taking a lot of interest rate risk.? They would have to go out and make real loans, or shrink their balance sheets.? Either would be good.
For an odd pro-QE view, Thomas Palley argues something complex, suggesting that Fed funds should be raised to promote saving and restrain speculation, while QE should be used to depress mortgage rates and state general obligation bonds.? I disagree, because we have too many houses, and state governments are too large now, having grown fat on the rising revenues generated by the credit bubble.? But do you see how when the QE genie is let out of the bottle, every special interest lines up to plead for the investment?? Bad enough that we have fiscal policy playing favorites for indebted homeowners at the expense of renters and those who own free and clear, but to make it a permanent part of monetary policy is foolish; it just creates a glut of homes, with marginal borrowers.

But consider Japan, which has not given up on QE, not because it works, but because they can’t think of an alternative.? It’s not as if there is a lot of demand for loans in Japan, but the Bank of Japan boosts a loan program anyway in the political season.

It makes me think that both Japan and the US have a comeuppance coming.? One cannot borrow forever without a bad result occurring, whether that be default, inflation, or high taxes.? But, in the short run, that game can go on with the politically connected disproportionately benefiting.? Though not on QE, this article from the Washington Post highlights the huge increase in Federal spending, and mentions in passing the huge benefits to DC, Virginia, and Maryland.? Yes, the benefits flow unequally, and it wasn’t as if the mid-Atlantic region was in bad shape.? Those near the capital benefit overmuch, and the hinterlands pay.

Summary

I stand by my thesis, which I hope to flesh out for stimulus spending in coming days.? QE does not benefit the US economy in the long run because it:

Creates dependency on the Federal Reserve to continue the financing.
Subsidizes governments and industries that need to shrink, and focus on core demand, not further expansion of mission.
Drives up the costs of funding long-term liabilities
Drives down the marginal efficiency of capital as the government and central bank does more of the investing, and invests in low ROE, or even negative ROE ventures.
Only looks at the present, and at politics, leading to decisions that benefit those connected
Tempts investors to take non-economic risks, where they will lose more than if they had stayed in cash.
Makes average people less certain about the future, which makes them more conservative in spending.
Undermines confidence in the fairness of government, and the value of a central bank.
It helps leave foolish men in charge of governments and bureaucracies that should have failed.

Queasing over Quantitative Easing, Part IV

Posted on 31 August 2010 by David Merkel

In my last post on this topic, I went over the orthodox and unorthodox monetary policy responses to the crisis in the US.? Here were the orthodox options:

Lower the Fed funds rate into lower positive territory.
Offer language that says that the Fed Funds rate will be low for a long time.
Buy more long-dated Treasury bonds.

And the unorthodox options:

Lend directly to classes of private borrowers.
Create negative interest rates for Fed funds.
Debase the currency by expiration dates, lotteries, etc.

On orthodox policy: I’m not sure there is that much difference between Fed funds at 0.25% and 0.10%, except that money market funds will find themselves in further trouble, as yields are too low to credit anything. That the Fed will be on hold for a long time seems to be the default view of the market already, so an explicit declaration would likely prove superfluous.? On buying long-dated Treasury bonds, that will benefit the US Government by pseudo-monetizing the debt, but won’t help the real economy much.

Yes, some high-quality corporate and mortgage bond rates will be pulled down with it, but so will discount rates for liabilities.? The same applies to spending rules for endowments, and how much retirees can get if they go to buy an annuity.? The effects of QE are mixed at best, and on balance, might be depressing, not stimulating.? But what practical proof, if any, do we have that QE has ever worked?

We need policymakers to understand the bankruptcy of the theories they are working with.? So many macroeconomic models work with one interest rate.? But in the real world there are many rates, and duration and quality of lending make a huge difference in what rate is charged.? I would urge that every person who would be on the FOMC work at a buyside firm managing bonds and money market instruments.? Let them see how the markets really work, and it might disabuse them of their false neoclassical views of how the lending markets work.? Better still, if their P&L is less than the cost of capital, revoke their appointment.? It’s time to kick out the academics, with their failed ideologies, and let those who have worked in the markets successfully manage the economy.

Direct Lending

But then there are the unorthodox methods.? When Social Security came into existence, they argued over where the money would be invested.? It was decided that the only fair investment was in government bonds, because it was neutral.? Investing in other assets, like the S&P 500 would be unfair, because they would be favoring a sector of the economy.

The same argument applies to direct lending by the Fed, because it would smack of favoritism.?? Going back to my last article, favoritism undermines confidence in the system, and makes people less willing to invest unless the government gives them an edge — cash for clunkers, $8,000 tax credit, etc.? We are Americans, after all.? Why buy from the retailer now, when you know that there will be another sale coming soon?? Economic policymakers should not rely on people to behave “as usual” when policy becomes unpredictable and unfair to the average person.

So I don’t see direct lending by the Fed, or buying high yield bonds, or offering protection on baskets of bonds as wise moves.? It may temporarily goose an area for a time, and make an area of the economy QE-dependent, or stimulus-dependent, but at best it is helping a few, while discouraging the rest.

Negative Fed Funds

I’ve been thinking about negative rates for Fed funds, and I think that they will have the following effects:

Banks will drop their excess reserves at the Fed to zero, and vault cash (or its short-term debt equivalents) will increase.
Banks will try to borrow from the Fed at negative interest rates, if they allow it, and just sit on the cash, park it in T-bills, Top-top CP — it’s free money, after all.? Of course, some point free money may be construed as valueless money, but that is another thing.

Required reserves are not a large percentage of liabilities.? Unless Fed funds goes deeply negative, it’s not going to affect bank profitability that much.? Banks may just view it as a cost of doing business, and pass it on to customers.

Destructive Creative Currency Debasement

With apologies to Schumpeter, who popularized the concept of creative destruction, I’ll try to define a new concept that is the opposite — destructive creativity.? Destructive creativity is when bureaucrats or regulators get too clever, and in an attempt to solve a lesser problem, end up creating a bigger problem.

I’ve heard proposals for further debasement of the currency via placing expiration dates on currency, or randomly canceling currency through lotteries based on the serial numbers on the bills.? The idea is that people will change their behavior: save less and spend more.

I can’t say that I can see every unintended consequence with these proposals, but according to Keynes, Lenin said, “The best way to destroy the capitalist system is to debauch the currency.”? These creative means of debasing the currency might do it.

Who gets to be the one holding the Old Maid card as expiry draws near.? How much time would be wasted scanning currency at registers as money is handed over and change is handed out?? Is the money cancelled or expired?? Close to expiration?? Quick, put it into the pile to give as change to the next customer.? There may be legal tender laws, but I can tell you that there would be fights over things like this.? Would all of the dollar bills used as a shadow currency overseas come trotting home?

If the Fed wanted to write its own death warrant, it should implement schemes like these.? The Fed is already viewed with enough skepticism by average people, that it wouldn’t take much to tip the scale from “Audit the Fed,” to “End the Fed,” where it gets replaced with the currency board tied to a commodity standard.

This leaves aside ideas like expiring/canceling a certain amount of monies in savings or checking accounts.? After all, why stop with the paper money?? Move onto the blips that we transfer day after day, silently, quietly choking the economic well-being of people, making them feel less safe, less secure, more paranoid.? Would we set up checking/savings accounts in other currencies to avoid this trouble?? Would that even work, such that we would have to set them up in foreign countries, and access funds that way?? What’s that you say?? Exchange controls?? Destructive creation indeed.? To “solve” a smaller problem, a dud economy, create a much larger problem…

Want to kill the economy/country?? Taxation is one thing, confiscation is another.? There are more than enough people who have question marks in their heads over what the government is doing with monetary policy and stimulus.? Aggressive actions to debase the currency can turn those question marks in to exclamation points.

This has gone longer than I thought.? Time to hit publish, and I will finish this tonight.

Queasing over Quantitative Easing, Part III

Posted on 28 August 2010 by David Merkel

I have a post on the futility of fiscal policy coming, but the hubbub over Jackson Hole has made me alter my publishing schedule.? I want to give one more shot on the idea that the Fed is out of ammunition, and that unorthodox moves are more likely to scare the public than result in increased real GDP.

I am better off than all of my friends, I think.? A common occurrence for me is a friend coming to me and saying, “How can the government borrow so much?? It doesn’t make sense.? Why do they spend money on this and not on me?”? I understand the paradox of thrift, but I don’t agree with it.? One reason is that because it is a paradox, ordinary people will react badly to actions of the government that they can’t do themselves.? Second, when the government or central bank does it, it seems like a form of theft, because no one should get something for nothing, and it degrades the ordinary person’s view of the honesty of the Government or Central Bank.? Third, what the money gets used for is viewed as a waste by some.

This consideration of the basic sense of fairness among average people should not be discounted by policymakers, nor the fear engendered when policymakers take such actions.? It is how average people think.? If you remember my review of the book Priceless, you might realize that people often act out of a sense of fairness, not out of economic interest.? When you think about the Paradox of Thrift through that prism, it is plain why government action doesn’t work — many people do nothing different when the government/central bank is making bold moves, because they are less certain about the future because the powers that be are dishonest in their view.

That said, the main reason I don’t agree with the solution to the paradox of thrift is that the government generally misspends money on cronies or projects of cronies.? It does not build the productive capacity of the economy, but only current consumption.? It does not aid growth.

Monetary Policy Now

Looking over a variety of articles on the options the Federal Reserve has, I would say that they are out of ammo that can do good.? They have plenty of ammo to destroy the economy, but little to build it.? What options does the Fed have left?

Lower the Fed funds rate into lower positive territory.
Offer language that says that the Fed Funds rate will be low for a long time.
Buy more long-dated Treasury bonds.

And the unorthodox options:

Lend directly to classes of private borrowers.
Create negative interest rates for Fed funds.
Debase the currency by expiration dates, lotteries, etc.

I will pick up on this tomorrow, and explain why the options that the Fed has are limited.

Queasing over Quantitative Easing, Redux

Posted on 21 August 201021 August 2010 by David Merkel

People are good about making binary comparisons for the most part, leaving aside come of the more complex choices highlighted in the book, “Priceless.”? Would you like coffee or tea?? Do you prefer this room painted blue or white?

Where things get complex is when there are a zillion choices, and your quest is to pick the best one, particularly when there are multiple attributes to each possible choice.? Consider the problems of trying to choose the one best stock for the next ten days, months, or years.? The best solution is to redefine the problem and try to choose an excellent bunch of stocks for each period.? Give up on the impossible game to play the possible game.

I follow this logic when I make stock trades.? It is not possible to get the best companies consistently, but it is possible to look at the companies that you are buying, and the companies that you are selling, and conclude that the new portfolio is superior to the old portfolio.? Three or four times a year, it pays to freshen the portfolio, selling the companies with the weakest potential, and buying those with more potential.

Now, binary comparisons underlie many aspects of financial accounting and management.? Think of doing a net present value [NPV] calculation.? We do them frequently, but how often do we ask what they really mean?? The NPV calculation compares the after-tax cash flows of a project to a hypothetical investment, which is to shrink the asset base of the company by buying back stock and retiring debt.

As a young actuary, I was fascinated by how much a small change in interest rates could change the present value of a policy.? I worked with two companies in the structured settlement business, both of which had the same philosophy on asset management — write short policies and long policies, and invest to the middle of them.? Though, with the second one, I took the opportunity to buy ultra-long bonds when they were attractive.

In an interest-spread management business like life insurance, the binary comparisons were in many ways more obvious, as I would swap bonds relatively worse for those relatively better.

Wait, how does this relate to quantitative easing?

The Fed can create liquidity in two ways — it can send the liquidity out to the general economy, raising prices.? Or, it can use the liquidity to buy assets, in most cases, government or high quality bonds, which lowers interest rates in that area, raising the prices of assets so bought.

Quantitative easing has a direct impact and an indirect impact.? The direct impact is that those that issue the bonds that have? been bought face lower yields and are inclined to issue more.? More Agency MBS, more Treasury issuance.? It is an obscure and indirect means of monetizing government debt and Agency MBS.? The government likes nothing better than to have a captive, non-economic buyer of its securities, particularly in a period of extreme deficit spending.

The indirect impact is that as Treasury yields fall, the yields on other debts fall to a lesser degree.? There are many investors out there who need yield, and as safe yields fall, they take more risk in order to achieve their desired income.? The conundrum of QE is that people get torn between income and losing capital by taking too much risk.

This helps to explain why stock valuations are low relative to high-quality bond yields.? The high-quality bond yields, affected by QE are not indicative of the true risks faced in the high quality lending.? Stocks and lower quality bonds are affected to a lesser extent — as it is harder get yield out of quality instruments, most will dip to lower quality instruments.

I learned as a corporate bond manager that every now and then I had to fly the “Jolly Roger,” but for different reasons.? When yield lust consumed the market, I would do painful up-in-credit lose-not-much-yield trades.? When there was panic, I would wave in yieldy bonds that were more than adequately protected.? In one sense, I was doing the market a favor, even though I was trying to make gains for my client.? I was always on the other side? of the money that was panicking.

So, what does QE do?? It lowers the cost of government debt (for now), and drags lower the cost of high quality debt, because there isn’t as much government debt available to buy because of QE.? As for high-yield bonds, and stocks, the effect is weak.

So, will QE improve economic prospects?? In my opinion, no.? Unless QE begins buying high yield debt and stocks (please don’t ever do this), it will not a have any impact on real businesses.? Government should be neutral, and beyond bias — buying the securities of a non-government enterprise should be forbidden — there should be no favorites to the government.? (What’s that you say, we have already had favorites via the rescues of 2008-2009?? Sad but true, but no reason to repeat the error!)

QE leaves investors in an awkward spot.? There are no safe places to place money with any yield.? So, you can earn zero, or take risks that seem uneconomic to gain yield.? Almost makes me want to be a trader, because there is little logic to where I invest. There is no obvious place for me to invest.

If the government thinks that QE will force investors to invest, I have news for them — yes, some will take more risks, but they will lose through their investing. Risky assets are only good at a fair or fear price, not at one where yields or risk margins are dragged low by QE.? Trying to tweak our psyche as a whole is ridiculous, and deserves only scorn by voters and investors.

Go, take your QE with you and destroy the economies of other nations.? Let interest rates rise here, and allow savings to grow, that will be deployed into the businesses of the future, not QE, that invests to protect the past.? We don’t need more homes, autos, and banks.? We don’t need AIG or the GSEs.? Just leave our economy alone, we can live with the booms and the busts, unamplified by central banks and federal governments.

Queasing over Quantitative Easing

Posted on 10 August 2010 by David Merkel

The world’s largest hedge fund, the Federal Reserve, is trying to decide whether it should expand its operations.? Unlike most hedge funds, the Federal Reserve has a big advantage in that it can fund itself cheaply, and for the most part, at its own discretion.

Unlike most hedge funds, it issues 0-day 0% Commercial Paper, which is accepted almost everywhere as a means of completing transactions.
Banks affiliated with them must place reserves with the Fed, on which they earn interest of around 0.25%
The affiliated banks, not finding as many opportunities as they would like to lend privately on a risk-adjusted basis, leave more money than they have to at the Fed, again earning about 0.25%.

What a cheap funding base.? They can buy almost any asset and make money, so long as equity/credit risk is limited, and so long as the yield curve doesn’t hit new records for steepness.? Given that the Fed does not have to mark most of its positions to market, and does not have to worry about margin calls in the conventional sense of the term, they make money year after year, and hand most of the profits over to the US Treasury, which keeps accounts for the Fed’s main owner, the US Congress.

Life is tough when you have to serve multiple conflicting interests.

They demand that you create conditions for full employment, something beyond your control.
They ask that you restrain inflation, which is possible.
They ask that you lend, because the banks affiliated with you are not lending, and an increase in lending is always a good thing, right?

So, like Keynes, the fools that think that a lower rate of interest is always better urge that the Federal Reserve should expand its balance sheet and buy up more Treasuries, Agencies and Agency MBS, forcing rates lower.? What good can come from forcing high-quality long rates lower?

My answer is, not much.? Existing debts if non-callable, will be worth more.? If debtors are solvent, and can refinance, they? can lower their debt service costs, though that is a minority of borrowers.? Beyond that, it will lead the favored debtors to borrow more — Treasury, Fannie, Freddie, etc.? We need more borrowing, right?

But a greater effect can be the speculative frenzy engendered by dropping the rate that savers earn to such a low level, leading them to invest more aggressively to meet their income targets.? As with any other sort of speculation, the game is over when people rely on the occurence of capital gains.

I think quantitative easing is a mistake; I also think it does not help matters much.? It transfers resources from creditors to debtors in a funky way.? That is not the right way to go if you want a country to grow.? (Which, contrary to the received wisdom, would mean that raising short term rates would be better for the US and Japanese economies than engaging in quantitative easing.? There would be short-term pain, but there will be pain regardless of how this policy is conducted.)

If the Fed makes a bow in the direction of quantitative easing on Tuesday, such as reinvesting the proceeds of MBS in more MBS, the markets will rally, but I would fade it, because it will have no long-term beneficial? impact on the economy.

There is no free lunch.? Any action that seems to cost nothing on the part of the Fed or the Federal Government will have no long-term effect on the economy.? Quantitative easing is one of those comforting fairy tales that is a fraud, whether intentionally so, or not.

At the Towson University Investment Group’s International Market Summit, Part 1

Posted on 17 April 2013 by David Merkel

Hello. ?My busy time is over, and I am back to live blogging. ?On Tuesday evening, I was one of five speakers at the?Towson University Investment Group’s International Market Summit. ?It was a fun time. ?Before I came, there was a list of 29 questions we could be asked, in addition to Q&A. ?As it was we were asked 6 of the questions in the main period, and 2 more in the Q&A.

I told the students at Towson that I would post a bunch of links to my blog for the questions asked that I have already answered. ?I will probably do a second post for the questions I am competent to answer that did not get asked.

Anyway, here goes:

1??????? Give us a short summary of things that keep you up at night and worry you in today?s markets.

Too Many Par Claims versus Sub-Par Assets

2??????? How big of an impact do you see the unwinding of QE having on the US and global economy?? In the event of inflation, how will markets react?

Easy in, Hard out

3??????? Give us some insight on how you behaviorally reduce the impact that a volatile market has on your investing strategy?

The Portfolio Rules Work Together?Rules 7 & 8 are particularly important for knowing when to sell.

4??????? Provide some tips to young investors starting out looking for both career and investment advice.

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

5??????? Should the current monetary policy of increasing the money supply be continued?

No. We should take losses and let the system reset. ?Get the government out of the macroeconomics business.

http://alephblog.com/?s=Queasing

6??????? Do you believe that High Frequency trading helps add liquidity in the market or that it distorts the market.

23,401 Auctions

391 Auctions

Other useful stuff that we discussed:

Buffett?s Career in Less Than 1000 Words

How to Become Super-Rich?

Hit the ?Defer? Button, Thanks?

Winding Down the Eurozone

Aim for the Middle

That’s all for now. ?I will follow this up, answering most of the questions not asked at the?Towson University Investment Group’s International Market Summit.

More to come…

The Best of the Aleph Blog, Part 15

Posted on 10 May 201220 June 2017 by David Merkel

This stretches from August 2010 to October 2010:

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.? I never knew that I could haggle so well.

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.? Also, how to make money in the bond market when you reach the risk limits. 😉

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.? Also, on aggressive life insurance managements.

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.?? Also, the end of my time as a bond manager, and the parties that came as a result.?? Oh, and putting your subordinates first.

Queasing over Quantitative Easing

Queasing over Quantitative Easing, Redux

Queasing over Quantitative Easing, Part III

Queasing over Quantitative Easing, Part IV

Queasing over Quantitative Easing, Part V

Queasing over Quantitative Easing, Part VI

The problems with the Fed’s seemingly “free lunch”strategy.? Pushes up asset prices and commodity prices, benefiting the rich versus the poor.

The Economic Geography of Publicly-Traded Companies in the United States by Sector

The Economic Geography of Publicly-Traded Companies in the United States by Sector (II)

Shows what US states have diversified vs concentrated economies by sector, and what states dominate each sector.

Portfolio Rule One

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

Portfolio Rule Two

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

Portfolio Rule Three

Stick with higher quality companies for a given industry.

Portfolio Rule Four

Purchase companies appropriately sized to serve their market niches.

Portfolio Rule Five

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Portfolio Rule Six

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Portfolio Rule Seven

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Portfolio Rule Eight

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

The Portfolio Rules Work Together

How the portfolio rules work together to create a “margin of safety.”

The Rules, Part XVIII

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.? Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

The Rules, Part XIX

There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset.? If a risk control model has an asset becoming more risky when prices fall, it is wrong.

?The Rules, Part XX

In the end, economic systems work, and judicial systems modify to accommodate that.? The only exception to that is when a culture is dying.

?Managing Illiquid Assets

Illiquidity is an underrated risk.? Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.? Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don?t trade often.

Of Investment Earnings Assumptions and Century Bonds

If we could turn back the clock 65 or so years and set up a more conservative method of accounting for pension liabilities, we would be much better off today.

Who Dares Oppose a Boom?

This piece won a small prize, and in turn, I received three speaking engagements.

Fairness Versus Economics

Fairness Versus Economics (2)

People care more about fairness than improving their own economic/social position.

Earnings Estimates as a Control Mechanism, Flawed as they are

Earnings Estimates as a Control Mechanism, Flawed as they are, Redux

Earnings estimates have their problems, but they exist to give us a flawed method of estimating the future performance of companies.

-==-=-=-=-=–=-=

That’s all for now.? Never thought I would do so many long series when I started blogging.

Ten Notes on the Current Market Scene

Posted on 24 August 2010 by David Merkel

1) Start with the big one from yesterday.? On of my favorite monetary heretics, Raghuram Rajan, whose excellent book I reviewed, Fault Lines, pointed out how he had gotten it right prior to the crisis, versus many at the Fed who blew it badly.? Rajan suggests that Fed Funds should be at 2-2.25%, which to me would be a neutral level for Fed Funds.? That’s a reasonable level.? The economy needs to work its way out of this crisis, even if it mean failures of enterprises relying on a low short rate.? Entities that can’t survive low positive rates that give savers something to chew on should die.? Mercilessly.? Monetary policy at present is a glorified form of stealing from savers, who deserve more for their sacrifice.

2) Peter Eavis, an old friend, echoes my points on QE, in his piece Government Clouds Value of Investments.? When the government is actively trying to destroy the willingness to hold short-term assets, and engages in QE, it makes all rational calculations on investments a farce.

3) I agree with John Hussman in a limited way.? QE artificially lowers interest rates, which lowers the forward value of the US Dollar.? That doesn’t mean it will generate a collapse; I don’t think it could do that unless the Fed began to do astounding things, like monetize a large fraction of all debt claims.

4) The US Government is so dysfunctional that the baseline budget has increased 4.4 Trillion over the next 10 years.? This is the beginning of the end of the supercycle, and the reduction of America to the influence level of Brazil.? Earnings levels will converge as well, but more slowly.

5) While we are thinking soggy, think of Japan.? Years of fiscal and monetary stimulus have availed little.? Overly low interest rates have fostered an economy satisfied? with low ROEs.? Low interest rates coddle laziness, and encourage stagnation.

6) There are limits to stimulus, whether monetary or fiscal.? There is no magic way to produce prosperity by government fiat.? Stimulus, by its nature, will run into constraints of default or inflation, if taken far enough.? If not, why doesn’t the Fed buy up all debt?? (leaving aside laws) Isn’t QE a free lunch?

7) Deflation is tough; it weighs upon cities, states and other municipalities, who hide their true obligations.

8 ) Hoisington, the best unknown bond manager.? Where do they think long rates are going?? 2% or so on the 30-year.? Makes the current buyers of bond funds look like pikers.? That’s over a 35% gain from here.? If they are right, their fame will be legendary.? Now, that could explain the willingness to fund ultra-long duration debt, because the gains will be bigger still.? What a great confusing time to be a bond investor, until something fails.

9) Or consider the Norfolk Southern 100-year bond deal yesterday.? Quoting the WSJ:

In what bankers hope will be the first in a new round of 100-year bond sales, Norfolk Southern Corp. raised $250 million Monday by selling debt that it won’t have to repay until the next century.

—

Investor interest was strong enough that the company increased the size of the new sale from $100 million. Market participants said investors had expressed an interest in buying at least $75 million of the debt before the company decided to announce the $100 million deal.

—

The interest rate on Norfolk Southern’s new debt is 6% for a yield of 5.95%, about 0.90 percentage points more than where the company’s outstanding 30 year debt was trading Monday. It was the lowest yield for 100-year debt bankers could recall, breaking through the 6% yield on the company’s 100-year issue in 2005.

—

“There is no question, obviously, that you are giving up a bit of liquidity, but you’re getting a pickup of 90 basis points to move out of the 30-year,” said Jeff Coil, senior portfolio manager at Legal & General Investment Management America. “But you’re getting good income on a stable cash credit in a sector where there are only a handful of rails left.”

Mr. Coil said the firm had a “sizeable” order in the deal. There were approximately 20 investors overall.

Moody’s Investors Service rated the new senior fixed-rate bonds Baa1, and both Standard & Poor’s and Fitch Ratings rated them BBB+.

Is 0.90%/year enough to compensate from going from 30 to 100 years?? I think so. The difference in interest rate sensitivity of a 30 versus a 100 are small at a yield of 5-6%, and if you have a liability structure that can handle it, as a life insurer might, it makes a lot of sense.? After all, a life insurer can’t economically invest in equities because of capital restrictions. You could compare it to investing in long dated preferred stock or junior debt, but then if there is a default, the losses are more severe than with a senior unsecured bond.

10) I’ve never found the yield curve model for recession/recovery compelling.? Limited data set, not covering the Great Depression, etc.

More to come.