Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control
Author: David Merkel
David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does -- on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor's and master's degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth.
Implied volatilities have fallen below long-run averages for equity indexes.
The equity market is within spitting distance of a new high.
The Fed is loosening (will they do more?)
The discount window is largely vacant.
Away from real estate, and real estate finance, things seem pretty chipper.
The yield curve is normalizing.
Inflation as measured by the government is low.
Long term interest rates are low, for investment grade borrowers.
Commercial paper problems are gone.
LBO debt difficulties will be solved soon, through a combination of losses to the banks, and canceled deals.
Or maybe not:
Inflation is rising globally.
The dollar is weak.
US inflation should start to rise as a result.
Housing prices are weak and getting weaker.? Default and delinquency statistics are rising.
The CDO [Collateralized Debt Obligation] problems are still not solved.
Defaults should begin to increase significantly on single-B and CCC-rated corporate debts in 2008.
The TED [Treasury-Eurodollar] spread is still in a panic-type range.
I’m seeing more of my stocks get closer to the upper end of my rebalancing range.? I will begin reducing exposure if the market run persists.? I’m not crazy about the market here, but I am not making any aggressive moves.
Not such a bad quarter for the S&P 500, up around 2%. Unfortunately, I was down 4%. Value was out of favor, as were many of my favored industries. I got whacked along with many of the quant funds it seems. This leaves me flat versus the S&P 500 for the year. We’ll see what the fourth quarter brings.
I still like my stocks. For those that follow me, remember that my favored holding period is around three years, which is how I would recommend that people measure my ideas, over a three-year rolling horizon.
This is a rental, not a purchase per se, but toward the close, I bought some Flagstone Reinsurance.? It’s a new-ish company with one of the top 2 property reinsurance models in Bermuda.? Trading near tangible book, 6x earnings, with high quality assets and reasonable operating leverage, it is a reasonable play for the fourth quarter.
Why the fourth quarter?? No guarantee here, but property losses are headed for another light year.? No major storms in the Southeastern US so far, and by this time of year, prior patterns tend to maintain.? You can see the stock price of Ren Re take off, but Flagstone, Montpelier, and IPC Re have not moved so much.
One complicating factor: the second good year in a row will make surplus bulge at insurers, leading to lower rates next year.? I’m waiting to see articles on how the Southeast windstorm models are unduly pessimistic, or watch the state of Florida take the modelers to court.? (The State would lose, but the government there would be game to try it.)
What this means is that the rally in these shares will be cut short by the fears of falling premium rates, sometime after the third quarter earnings are reported.? So, be nimble here, and there should be a short-term rally in the property-centric reinsurers.
Apologies for not posting last night.? A power outage hit our neighborhood, and ate my post.? It also ate a decent amount of the work I was doing to respond to some questions of Bill Rempel, aka NO DooDahs!? It seems that I am used to having the “autosave” on at work and not home.? Well, that will change.
I should have something more up this evening, with a big post off of Bill’s questions Saturday evening.
There are still significant areas of concern that have not unwound yet — residential housing exposure will increase as housing prices fall further, including lawsuits which will eventually prove not meritorious, and CDO exposure.
It is my firm belief that their hedges hold in minor moves, but not major moves.? VAR modeling is fine for when the winds are calm, but not when they are gale force.? At gale force the Extreme Value Theory models kick in, and they are untested at present.? Berkshire Hathaway’s experience in unwinding GenRe’s swap book was telling; few things were marked conservatively.? That is probably true industrywide, partly because auditors are incapable of audit the swap books in all of their complexity, or they’d be working for the investment banks themselves.
New accounting regulations make earnings quality more opaque, and less comparable across time periods and companies.? This should result in lower multiples, akin to big commercial insurers.
That’s all.? Personally I think the investment banks will be a buy sometime in 2008, but I am waiting to see how the current leverage unwind affects them.
I’m about to add advertising to my blog, and I’d like to ask a small favor from my readers.? If you happen to see an advertisement that is morally objectionable, please send me an e-mail.? Include the URL of the ad.? Examples would include:
Payday lenders
Gambling
Tarot Reading
Known Investment Scams
There are likely more, but that’s a start.? Google on ads is not “don’t be evil,” but rather, is amoral in their ad filtering, not allowing even for rudimentary category blocking.? One has to block ads URL by URL.? Klunky, if you ask me.
Again, thanks to all my readers for their help in making this a better site.
Though I don’t agree with all of his theories, John Hussman did an excellent job describing how little the recent Fed loosening has done for monetary policy. There still has not been a permanent injection of liquidity since May 3rd. The monetary base is flat. The real changes in monetary policy have come through additional leverage at the banks. That comes through explicit policy waivers, policy changes (e.g., permitted collateral at the discount window, removal of stigma), and the “wink, wink, naughty boy” returning to bank exams.
That reflects in the monetary aggregates. M2 and MZM both have moved up smartly since the beginning of the temporary loosening, as have total bank liabilities, which is a good proxy for M3. That said, because LIBOR is high relative to Fed funds, it is less good of a proxy, because banks are less willing to lend unsecured to each other in the Eurodollar markets.
Think of it this way, US Dollar LIBOR has only incorporated 16 basis points of the 50 basis point rate cut, measured from the equilibrium level that existed previous to the latest crisis in 2007. During the rate rise, they moved pretty much in lock-step.
So, things are a little better on the liquidity front in the short-run, but not much better. If the banks begin to become more conservative, just for survival reasons (i.e., more leverage is permitted, but they don’t want to use it), the small effects of regulatory easing will be erased.
Position: none, but while I wrote this, my youngest boy (10) came up to me, and asked me to explain what the stock market was like during 9/11, and during the Great Depression. It is very rewarding to be with my family during the day.
After this, Dr. Jeff Miller of A Dash of Insight pinged me asking me to clarify a little.? My response went like this:
You’re right, I need to be plainer about where I agree with him, and disagree with him, and I’ll probably put that into a post tonight at my blog.? Oddly, his models, from what I can gather, work off of some sort of cash flow yield for valuation, and even have a “don’t fight the Fed” component to them, in addition to momentum.? The reason this is weird, is that from those simple measures, he should be far more bullish, but he is not.? My suspicion is that he assumes that profit margins will mean revert, which they will, but maybe that will happen a lot more slowly than many anticipate.
As for his theory on the Fed, he is off.? The Fed has real impact on the economy through its effect on short term rates, admittedly with a lag, and they can’t fix inverted situations, no matter how low rates go (like Japan).? They affect bank leverage quite a bit, and though not cost-less, it has a real impact on the economy, with less of a lag, unless they go too far.
In essence, Hussman got the data right, and part of the interpretation, but missed increased leverage at the banks, which so long as it is sustainable, will stimulate economic activity.? He also missed that “Don’t fight the Fed” generally works.? I understand his valuation arguments, but he needs to get more sophisticated, and look at relative valuations of stocks to bonds.? Stocks are quite attractive on a relative basis, at least for now.
Monetary policy and its effects are complex, and non-nuanced explanations do a disservice to readers, particularly when the investment prescription is too simplistic.? At present, the Fed has done little to increase the money supply directly, but has encouraged the banks to lend more.? If the banks can tolerate that, then good.? If not, then watch out, because the banks are integral to our credit-based economy.
There is a misunderstanding about contrarianism, that somehow if a lot of people think something, it must be wrong, so take the other side of the trade.? We can make an exception here for some financial journalists, because they are often late to catch onto a story, and thus, the magazine cover indicator often works.
My point here is that intelligent contrarianism does not work off of what market players think, but how much they have invested relative to their investment policy limits, and the capital that they have available to carry the trade.? When there are many investors that have gone maximum long on a given company, that is a situation to either avoid or short, because unless new longs show up, the current longs have no more buying power — it is a crowded trade.
I saw this with housing in 2005, as I wrote a piece on residential real estate that proved prescient.? It drew a lot of controversy, but my point was plain.? Where would additional buying power come from?? In September of 2005, I concluded that we were at the inflection point.? One of my theories about inflection points is that there is no good numerical signal of an inflection point, but qualitative chatter undergoes a shift at the inflection points.? In that case, I had a series of googlebots trawling the web for real estate related chatter.? The tone shifted in September/October of 2005, but it was largely missed by the media and the markets.
Though I have nothing written on the web on the Internet Bubble, the qualitative chatter change that happened in March of 2000 was commentary from a variety of companies that had relied on vendor financing were turned down by their vendors.? That was new, and it indicated a scarcity of cash.? My rule of thumb on bubbles is that they are primarily financing phenomena; bubbles pop when cash flow proves insufficient to finance them.
Now, with both the residential real estate and internet bubbles, there were a bunch of naysayers prior to the bubbles.? Most were way too early.? Keynes observed something to the effect that markets can remain irrational longer than an investor can remain solvent.? Risk control is a key here, as well as cash flow analysis. When does the financing fall apart?? What will the inflection point, with all of its fog, look like?? Where is the weak spot in the financing chain?
Those naysayers were an inadequate reason to take a contrarian position; many of them didn’t have a dog in the fight, aside from intellectual bragging rights.? Rather, the contrarian position was to ask what side had overcommitted relative to their ability to carry the positions, and the ability of others to get financing to buy them out.
Where I differ with many permabears is that I am usually unwilling to extend my logic to second order effects.? Just because one area of the economy is falling apart, doesn’t mean that a related area will of necessity get blasted.? There are dampening effects to almost any economic phenomena, such that you don’t get cascading effects where failure in one area leads to failure in others, leading to a failure of the system as a whole.? The exception is of course the great depression, and that was a situation where the whole economy was overlevered.? We’re not there today, yet…
Okay, one semi-practical application, and then this article ends.? I get a certain amount of pushback for being bearish on the US Dollar.? I’ve been bearish on the US Dollar since mid-2002, when I saw that our monetary and fiscal policy were shifting to aggressive levels of debasement stimulus.? Today I heard someone dismiss further US dollar weakness because “everyone knows that.”? Well, if everyone knows that, tell it to the foreign investors who are stuffed to the gills with US dollar claims (bonds), such that their economies are beginning to suffer higher inflation.? I see a continued crowded trade here, and I am waiting to see where the pain points are, such that foreign central banks begin to intervene to prop up the dollar.? It hasn’t happened yet, and we are within 20 basis points of taking out the all time low in the dollar index, set back in 1992.
There’s no order to this post, so enjoy my reflections on broader trends that are affecting the markets.
Corn-based ethanol is costly, and a mistake for our government to subsidize it, when we could buy sugar-based ethanol from Brazil. I’m no environmentalist, but even I can see the advantages of eliminating sugar subsidies and quotas here in the US. The only people hurt are some rich farmers that bribe Washington to keep the subsidies. With a little encouragement from the US, Brazil could adopt more environmentally friendly harvesting techniques, while not kicking up costs that much. Such a deal, better economics, and better for the environment.
Stories like this always make me skeptical. Remember cold fusion? Maye there is a real innovation here that produces more energy than it consumes on net. I wouldn’t bet on it, though.
Since the creation of the Earth, farming has been the dominant occupation of man, until now. More people are employed outside of farming, than inside it. This is not big news, except to confirm that what happened to the developed world 80 years ago is happening to the world as a whole now.
ETFs are not open end mutual funds, where there is one price struck per day for liquidity. For small ETFs, the bid-ask spread can be quite wide on small funds. This shouldn’t be too surprising; the same is true of any small stock. If there is demand for an ETF concept, more units will get created as people bid for them, and the bid-ask spread will narrow.
Rationality in markets is misunderstood. You can bring bright people to manage money, and they will still in aggregate become prey to the speculative aspects of the markets. Some will resist it, but most won’t. It is not a question of intelligence, but of discipline.
Give Hersh Shefrin some credit. I think that behavioral finance is a much richer explanation of the markets than modern portfolio theory. MPT exists because it is easily mathematically tractable, which allow professors to publish, and not because it is a correct description of reality.
It’s tough to be an orphan company. Much as I like investing in companies that have no analyst coverage, if they are cheap enough, when a company loses analyst coverage, the stock price typically declines, and often, the company disappears within a few years. Perhaps the lack of analyst coverage is a proxy for the demand for a company to be public, rather than private.
Here’s a good article on why the market crashed in October of 1987. My quick summary for why it happened was that bonds were more attractive relative to stocks, and dynamic hedging left the market unstable, as many player were willing to sell on big down days.
Will junk defaults triple from 2007 to 2008? Seems reasonable to me; given all of the CCC and single-B issuance over the last few years, the companies that have recently issued bonds seem weak to me.
I know why Sarbanes-Oxley [SOX] came into existence: to give one of America’s least productive Senators a fitting legacy.? I think the legislation was perhaps well-intended, but on the whole, it has perhaps imposed more costs than produced benefits.? Today I am faced with one of the costs: Lafarge SA has delisted, and now trades on the pink sheets.? Now, big institutional investors will buy and sell shares of this fine firm on the Paris bourse, but I’m not big, so I end up with an illiquid nonsponsored ADR.? This is the third time this has happened to me since the passage of SOX, because my investing travels the world in a cheap way, through ADRs.
It has been said in many ways, but I will summarize it in this way: there is price, quantity, and quality.? You can at most regulate two out of three, and usually, it’s not wise for a government to regulate more than one variable at a time.? Often, it is wisest not to regulate, unless there are material problems in quality that ordinary people cannot verify, and yet ordinary people have a common need for (think of food safety, and our government does well at that, but could do better).
Large companies are complex, and the accounting is more so.? The personal burdens placed on the CEO and CFO are misplaced, in my opinion, and the degree of auditing/testing prior to SOX was adequate to catch most abusive situations.? Are financial statements higher quality now?? Yes, but at a cost: Higher accounting costs, particularly for smaller firms, more firms going private, and fewer foreign firms listed in the US.? (Note to those pushing for unification of GAAP and IFRS.? If you’re trying to get more listings in the US, it would be better to aim for reform of SOX.? If GAAP and IFRS are the same, and I were a medium-sized US firm, maybe I would list in London.)
There is a logical balancing point to regulation, and SOX tipped the balance, imposing more costs than the value of improvements in quality.
