I do and don’t believe in the efficient markets hypothesis [EMH].  I do believe in the adaptive markets hypothesis [AMH].   The efficient markets hypothesis posits that:

• Past public information can’t be used to obtain better-than-average returns. (weak form of the EMH — cuts against technicians)
• Past and present public information can’t be used to obtain better-than-average returns. (semi-strong form of the EMH — cuts against fundamental analysis)
• Public and private information can’t be used to obtain better-than-average returns. (strong form of the EMH — believed by few)

In practice, the academic community holds to the semi-strong  form, while the investment community holds to the weak form.  One thing is certain: the market is dominated by large institutions, and the market on the whole, less fees, cannot beat the returns of the market on the whole.

Part of the problem with the EMH is that with respect to the market as a whole, of course it is true.  The real question is whether any particular strategy covering a small portion of the assets of the market can consistently beat the returns of the market on the whole.  I believe the answer to that question is yes.

An implicit assumption of the EMH is that research costs are free.  They are not free.  Also, it implicitly assumes that a dominant number of investors understand what information drives the markets.  Both assumptions are not true — even in the most clever firms, there is information that is missed, and research costs are expensive, and not always rewarded.

But the effort to earn above-average returns forces the market closer to the EMH.  When the competition is tough, finding excess returns is hard.  This makes it a limiting concept.  We never get there, but effort to find above-average returns gets us closer to that ideal.  Conversely, when many decide to index, those who do not index have a better chance at earning above normal returns, because there is a large chunk of naive capital in the market seeking average returns with certainty.

I want average people to use index funds for many reasons:

• It lowers their costs.
• It is tax-efficient.
• Most people aren’t very good at picking equity managers.  They go for the manager who is hot, in the style that is hot, rather than one that did better in the past, and is in a cold spell now.  They go for large fund groups that spread their research over large asset bases, diluting whatever skill they might have.   The best managers are the smaller specialists running their own funds, and who eat their own cooking.  They are also inconvenient to use.
• It improves conditions for the remaining active managers.

I also want them to buy-and-hold (dirty words) because they aren’t very good at market timing, and also have enough in safe assets to lower the downside of returns to a level that does not panic them.  Most people are bad at most investment decision-making.  Better to hand it off to those who don’t panic or get greedy, than to be a part of those who buy into tops or sell into bottoms.

On the AMH, quoting from another piece of mine of the topic:

The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it’s not worth the search costs any more.

And so it is for those of us who are active managers.  We have a twofold task:

• Base our strategies in areas that are unlikely to be overfished for long — e.g., low valuation, positive momentum, and earnings quality.
• Dip into areas that are temporarily out of favor, whether those are industries, countries, or odd risk factors.  (Odd risk factors: occasionally certain factors in the markets are poison, and even the slightest taint marks a security off-limits, even though those that are barely affected are fine.  My example would be Enron-like structures 2001-2002.  Few would buy the stocks or bonds of companies that had them, even though those structures were not large enough to impair the company, as they did with Enron.  We bought the bonds of a Dominion subsidiary with abandon, because we knew the covenants the bonds had would not kill Dominion, and we had extra value as a result.  What killed Enron benefited us, indirectly.)

To active managers then, I warn: watch how your main strategy goes in and out of favor.  It happens to all of us.  Add to your main strategy most when it is out of favor, and add to whatever alternative you have when your main strategy is running hot.

To average investors, then, I advise: if you adjust frequently, add to your winners and prune your losers.  If you adjust infrequntly (once a year or less), prune your winners and add to your losers.  In the short run, momentum persists, in the longer-term, it mean reverts.

Know yourself.  If you are prone to panic and fear with investments, better to hand the job off to someone competent who will be dispassionate.  If you have conquered those emotions, you can potentially do better yourself in investing.  But ask yourself what your sustainable competitive advantage is in investing.  If you don’t have one, better to index.

Just a brief post here.  The Economist features a simple symmetric model to try to explain cycles in the financial markets.  Cute model, but it can’t explain booms and busts.  The key missing feature is credit that can default.  Defaults are asymmetric.  With bonds you can make a little with high certainty, or lose a lot with low certainty.  This is true of all lending, leaving aside convertibles.

In a true bust, defaults are rampant, as badly capitalized firms fail amid weakening demand.  During booms, some  firms magnify the results by levering up (borrowing more).  This is the behavior that created booms and busts, together with the momentum effects that Brad DeLong’s model demonstrates.

Modeling in default behavior and leverage should complete the model.

No, this isn’t another discussion of SFAS 157, though there are some similarities.  There has been a bit of a brouhaha over repayment of TARP options.  Isn’t the government getting shortchanged?

Maybe.  Maybe not.  This one is tough to answer, because at least as yet, there is no active market available for really long-dated call options.  Let me give you an example from my own experience.

I used to run a reasonably large options hedging program for a large writer of Equity Indexed Annuities [EIAs].  Much as I did not like the product, still I had to do my job faithfully, and when we were audited by a third party, they commended us having an efficient hedging program.

But here was our problem:  the EIAs lasted for ten years, but paid off in annual installments, based on average returns over each year.  Implied volatility might be low today, and the annual options that we purchased to hedge this year might be cheap, but the product had many years to go.  What if implied volatility rose dramatically, making future annual hedges so expensive that the company would lose a lot of money?

Maybe there could be another way.  What if we purchased the future hedges today?  A few problems with that:

1. We don’t know how much we need to purchase for the future — the amount needed varies with how much the prior options would finish in the money.
2. But the bigger problem is once you get outside of three years, the market for options, even on something as liquid as the S&P 500, is decidedly thin.  There’s a reason for that.  The longer-dated the option, the harder it is to hedge.  There are no natural sellers of long dated options, and relatively few Buffetts in the world who are willing to speculate, however intelligently, in selling long-dated options.

There is an odd ending to my story which is tangential to my point, but I may as well share it.  Eventually, the insurance company wanted to make more money, and felt they could do it by hiring an outside manager (a quality firm in my opinion — I liked the outside manager).  But then they told them not to do a total hedge, which was against the insurance regs, given their reserving practices.  Not hedging in full bit them hard, and they lost a lot of money.  Penny wise, pound foolish.

So what about the TARP options?  Did the US Government get taken to the cleaners on Old National Bank?  Is Linus Wilson correct in his allegations and calculations?  Or is jck at Alea correct to be a skeptic?

It all boils down to what the correct long term implied volatility assumption is.  Given that there is is no active market for long-dated implied volatility / long-dated options for something as liquid as the S&P 500, much less a mid-sized bank in southern Indiana, the exercise is problematic.

In quantitative finance, one of the dirty secrets is that common parameters like realized volatility and beta are not the same if calculated  over different intervals.  Also, past is not prologue; just because realized or implied volatility has been high/low does not mean it will remain so.  It tends to revert to mean.  With the S&P 500, implied volatility tends to move 20% of the distance between the current reading and the long term average each month.  That’s pretty strong mean reversion, though admittedly, noise is always stronger in the short run.

Let’s look at a few graphs:

Daily Volatility for ONB:

Or weekly:

or monthly:

or quarterly?

Here’s my quick summary: the longer the time period one chooses, the lower the volatility estimate gets.  Price changes tend to mean revert, so estimates of annualized realized volatility drop as the length of the period rises.  Here’s one more graphic:

I’m not sure I got everything exactly right here, but I did my best to estimate what volatility level would price out the options at the level that the US government bought them.  I had several assumptions more conservative than Mr. Wilson:

• In place of a low T-bill rate for the risk-free rate, I used the 10-year Treasury yield.  (Which isn’t conservative enough, I should have used the Feb-19 zero coupon strip, at a yield of 3.79%.)
• I set dividends at their current level, and assumed they would increase at 5% per year.
• I modeled in the dilution from warrant issuance.

But I was more liberal in one area.  I assumed that ONB would do an equity issuance sufficient to cut the warrants in half.  If the warrants were outstanding, the incentive to raise the capital would be compelling, and it would get done.

The result of my calculation implied that a 21% implied volatility assumption would justify the purchase price of the warrants.  That’s nice, but what’s the right assumption?

There is no right assumption.  Short-frequency estimates are much higher, even assuming mean reversion.  Longer frequency estimates are higher if one takes the present reading, but lower if one looks at the average reading .  After all, Old National is a boring southern Indiana bank.  This is not a growth business.  If it survives, growth will be modest, and the same for price appreciation.

The Solution

It would be a lot better for the US Treasury to get itself out of the warrant pricing business, and into the auction business, where it can be a neutral third party.  Let them auction off their warrants to the highest bidder, allowing banks to bid on their own warrants.  I’ll give the Treasury a tweak that will make them more money: give the warrants to the winning bidder at the second place price.

By now you are telling me that I am nuts — giving it to the winner at the second place price will reduce proceeds, not increase them.  Wrong!  We tell the bidders that we want aggressive bids, and that they will get some of it back if they win.  I’ve done it many times before — it makes them overbid.

So, with no market for these warrants, I am suggesting that the Treasury creates their own market for the warrants in order to realize fair value.  Is it more work?  Yeah, you bet it is more work, but it will realize better value, and indeed, it will be more fair.

I’m leaving for two days.  I might be able to post while I’m gone, but connectivity is never guaranteed, particularly in southwestern Pennsylvania.  (Sometimes I call it “the land that time forgot.”) Apologies to those that live there — Pittsburgh is the capital city of Appalachia.

Here are a few thoughts of mine:

1) Many have been critical of Buffett after a poor showing in 2008.  Much as I have criticized Buffett in the past, I do not do so here. The mistake that many make in analyzing Berky is forgetting that it is first an insurance company, second an industrial conglomerate, and last an investment vehicle for Warren Buffett for stocks, bonds, derivatives, etc. With most of his investments, he owns the whole company, so you can’t tell how Buffett’s investing is doing through looking at the prices of the public holdings, but by reading Berky’s financial statements. By that standard, 2008 was not a banner year for Berky — book value went down — but it was hardly a disaster. Buffett remains an intelligent businessman who deserves the praise that he receives.

From The Investor’s Consigliere, he agrees with me.  Berky is more like a special private equity shop than like a mutual fund.

2) I’m past my limit for cash for my broad market portfolio.  I have sold bit-by-bit as the market has risen.  I’m planning on buying more of my losers, or finding a few new names to throw in.  Will the current “bull market” evaporate?  There are some sentiment measures that say so.  Also, when cyclicals lead, I get skeptical.

3) As correlations rise, so does equity market risk.  Are we facing crash-like risks now?  I don’t think so, but I can’t rule it out.  My opinion would change if I knew that major foreign investors were willing to “bite the bullet” and recognize the losses that they will experience from investing in Treasuries.

4) My initial opinion of Ben Bernanke, which I repudiated, may be correct.  My initial opinion was that he would be a disaster.  Now that the transcripts of the 2003 Fed meetings are out, he was among the most aggressive in loosening policy, which was the key blunder leading into our current crisis.  It also explains the novel policies adopted by the Fed over the last 18 months.

5) Investors are geting too excited about a recovery in residential housing.  Such a recovery is not possible while 20%+ of all residential properties are under water.  Foreclosures happen because of properties under water where a random glitch hits (death, disaster, disability, divorce, debt spike (recast or reset), and disemployment).

6) I have long had GM and Ford as “zero shorts.”  Sell them short, and you won’t have to pay anything back.  Though Ford is prospering for now, GM is declining rapidly.  In bankruptcy the common is a zonk.  With dilution, the common will almost be a zonk.

7) I worry over our government’s involvement in the markets.  First, I am concerned over contract law.  The bankruptcy code in the US strikes a very good balance between the needs of creditors and debtors.  I worry when the government tampers with that.  I fear that the Obama administration does not grasp that if they attempt to change certain regulations, it will have a disproportionate effect on the economy.

I have almost always liked TIPS.  Do I like them now?  Of course, particularly if they are long-dated.

9) Much as I do not trust it, we have had a significant rally in leveraged loans and junk bonds.

10) Did major banks support subprime lenders?  Of course many did.  No surprise here.

11) The EMH exists in a dynamic tension with its opposite.   Because many, like me, are willing to hunt out inefficiencies, the inefficiencies often get quite small.  So it is that those that come into investing with no hint that the EMH exists think it is ridiculous.  Coming from a household where the EMH had been stomped on for many years (thanks, Mom) made me ill-disposed to believe it, and not just because we subscribed to Value Line.

12) He who pays the piper calls the tune.  To the degree that the government gets involved in business, it will intrude into lesser details that should only be the province of shareholders.  What this says to management teams is “don’t let the government in in the first place,” which should be pretty obvious.  Major shareholders with secondary interests are often painful.  With the government, that secondary interest is regulation, which makes them a painful shareholder.

With that, I bid all of you adieu for a time.  May the Lord watch over you.

While reading the book Trend Following, I was reminded of something that I read in The Intelligent Investor (I have the Fourth Revised Edition.)  These are two very different books.  What could be the same?

Fortunately, you don’t have to have a copy of The Intelligent Investor to see this.  Appendix 1 of the book is, the edited transcript of Warren Buffett’s talk that he gave at Columbia University in 1984 for the 50th anniversary of publication of Security Analysis can be found here.  The PDF version can be found here — it has the tables, but will take a while to load.

Buffett chooses 9 investors in the mold of Ben Graham, all value investors, and shows how they have soundly trounced the market over their tenures.  He uses that correlation to demonstrate that since they all used the same basic theory of investing, it is unlikely that their wonderful performance is due to mere chance.

In appendix B of his book, Michael Covel chooses 14 (or so) investors who are trend followers, and shows how they have soundly trounced the market over their tenures.  He uses that correlation to demonstrate that since they all used the same basic theory of investing, it is unlikely that their wonderful performance is due to mere chance.

See the similarity?  Now, I think that both approaches work to some degree, though not all of the time.  I have known a number of managers that have married the two approaches, usually with some success.  (As Humble Student Cam Hui points out, marrying the two may be more difficult than it seems.  I’m going to have to dig up that copy of the Financial Analysts Journal.)

I would criticize one aspect of Buffett’s logic, and the same would apply to Covel.  I’ve known my share of bad value investors.  Usually they overemphasize cheapness, and forget “margin of safety” as the key intellectual concept of value investing.  It’s easy to come up with a group of great managers following a certain strategy in hindsight.  Where is the grand study of all investors of that class, be it value investing or trend following?  Almost any strategy could be made to look good if one can cherry-pick the investors with the advantage of hindsight.

So, what would qualify as a valid study?  You’d need a relatively complete census of the group following a given strategy, including those that failed and dropped out.  After that, audited returns would help, as Mr. Covel likes to point out.  An alternative would be to follow a smaller closed cohort of managers following a certain management style.  The problem with that is you yourself might have a really good eye for management talent apart from the investment style.

Another alternative would be an academic-style study where the researcher defines the buy and sell criteria and then sees if the method beats the market, whether adjusted for risk or not.  Now, regarding risk, that is one of many places where I agree with Mr. Covel.  Standard deviation does not measure it; beta doesn’t measure it; tracking error doesn’t measure it.  Maximum drawdown, or maybe some obscure statistic from extreme value theory would probably be the best measure.

Why drawdown?  It best measures the ability of a manager to continue his strategy without panicking.  Most of us would question our sanity after a certain level of loss, and give up.  For different investors, the number is different.  For those managing external money, it is more important, because normal investing processes get destroyed when investors pull their money.  Where is that maximum level where investors will stay on board?  It depends on how they were sold on investing their money with the manager.

What are the problems with doing an academic-style study?

• Often does not include costs of commisions, market impact, etc.  Liquidity is implicitly free, while in the real world, it is costly, particularly for undervalued oddball securities.
• Data-mining may allow anomalous result that are noise to be reported as signal.
• Managers using the style being modeled argue that it does not truly represent what they do.
• Some studies get skewed by using calendar-year-end dates, where trading is often unusual.

Does that mean doing  definitive studies of trading strategies is impossible?  No, but it is quite expensive to do, so those interested in questions like this often resort to shortcuts, such as academic studies, limited peer group studies, etc.

Now, fairly comprehensive studies for things like growth and value managers exist (tsst… value wins), and some studies for CTAs exist.  But I’m not aware of any comprehensive studies for trend followers.  The academic studies show that price momentum is an important factor in market returns, and many investors with good returns use momentum.

It begs the question, if price momentum, or trend following is a panacea, why is it not more broadly embraced by the money management community?  That is tomorrow’s essay.

Any investment strategy can be overused.  Part of the job of a portfolio manager is to ask the question “To what degree am I in or out of the consensus? Where am I in the cycle for my strategy?”

Few managers are conscious of the water that they swim in.  They assume their strategies provide consistent advantage, when in truth the advantage is periodic, even if it works better than average over the long haul.  The truth is that every strategy has limits, and when too many parties apply a strategy, the excess returns disappear, or even go negative.

All investors have to sit down and ask the question, “What aspects of the market will I try to take advantage of?” with the corresponding question, “What will I ignore?”  Adding to that, “How much of the market can I invest in, given my advantage?” (What is the carrying capacity of my strategy?)

Most value managers don’t care for momentum.   Most growth managers don’t care much about valuations.  Some things will be ignored.

It is tough to be a institutional asset manager.  The competition is fierce.  What’s worse, you and all of your competition comprise 80% or so of the market.

Further, you know what side your bread is buttered on.  If you have average, or at least not fourth quartile performance, the assets will stick with you, and your firm will make money off them.  The economics of the business are simple.  For the most part, risk-taking is not rewarded, and risk-reduction has some stickiness.

Adding to the problem are the investment manager consultants.  Because most of them are a net loss, they gravitate to what is unchangable.  Modern Portfolio Theory, though wrong, is a respected basis from which academics and some others make investment decisions.  Using Sharpe ratios, and other objective bits of investment nonsense, they winnow the field of investment managers.

The thing is, for those managers that submit to this mularkey, it enforces mediocrity at best.  For those that don’t accept it, not much money flows to them, whether the manager is good or bad.  They don’t fit the model that doesn’t represent reality.

Never underestimate the power of a simple model to overwhelm the minds of simple-minded people.  Most consultants, and most academics, would rather have a wrong model that allows them make money, or publish, than get things right.  Truth is, the right answer is hard to get to, and doesn’t fold into simple mathematics easily.

Technical analysis is akin to voodoo in the minds of most professional investors.  Mention it prominently, and you are kicked out of the game.  There are close substitutes though: for growth investing there is price momentum, and for value investing there are behavioral finance anomalies.

In closing, these two articles that ask why mutual funds don’t adopt technical trading methods illustrate the problems with large scale investing.  Smaller investors can take advantage of market anomalies that bigger firms pass up.  Imagine for a moment that Fidelity, Vanguard, and Capital Group decided to apply the full range of identified anomalies across the entirety of their portfolios, and trade them as aggressively as smaller players might.  The prospective excess profits from the anomalies would disappear rapidly, and might go negative as enough money chased them.  Most players would eventually abandon applying the strategies because they stopped working.  Too much money chasing them.

The lesson for most of us smaller players is to be aware of how much money is using strategies like ours, and adapt when the space where we thought we had a durable competitive advantage has become crowded.  That’s not easy, but then, regular outperformance is tough to do, and tougher, the more money one manages.

1) There are firsts for everything.  Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952.  America has always been a pro-debt and pro-debtor nation.  It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period.  But, the Pilgrims did extinguish the debt.  Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity.  With the decline in housing values, the fall in the ratio was inevitable.  The low ratio puts downward pressure on home prices, because it means that more homes are underwater.  Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector.  Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble?  Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more.

5) Now these same low yields whack Treasury money funds. How many will close?  How many will cut fees?  How many will break the buck, and credit negative interest?  An unintended consequence of monetary policy.  Another unintended consequence reduces liquidity in the repo markets.  Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates.

6) Brave Ben Bernanke is fighting the Depression.  If his theories are right (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy.  But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle.

7) Inflation is the lesser evil at this point.  It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go, and Elizabeth Warren now confirms it for the Treasury.  My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.”  So it is for the TARP bailout.  Policy made hastily rarely works.  Spend more time, get it right.  The market won’t die as you work it out.

9) But will AIG die, or the automakers?

• Sales are slow for assets at AIG.  (no surprise valuations are crushed, and all likely buyers face lower P/Es and higher debt costs.)
• And who knows where the writeoffs end?  As I said long before the failure of AIG, don’t trust the financial statements.  The palce was too complex, and the culture of fear inhibited objective financial reporting.
• GM’s suppliers are seeking cash. Just one of the costs of financial stress.
• Suppliers worry over a lack of demand if the automakers fail. They should retool for Japanese and European automakers.
• From Credit Slips, the important idea is that without a good business plan the automakers are toast anyway.  I predict they will be back hat in hand in half a year even with a bailout.
• A GM bankruptcy would take a long time, and a prepack would not get done before the cash runs out.  Maybe, but I would still take it through bankruptcy, with the US Government as the DIP lender.

10) Even VCs are looking at the survivability of their portfolio holdings.  Who can survive and become cash-flow positive in a tough environment.  Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers.  Watch the loan covenants, so that you can get good recoveries in a default.  If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults.  For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices.  Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss.  This is a tough time for anyone taking credit risk.  That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics.  I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers.  He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes.

16) You can give the banks funds, but you can’t make them lend.  Would you lend if you didn’t have a lot of creditworthy borrowers?

17) The export boom is dead, for now.  Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed.  Sorry, but the secret to changing the residential real estate market is not lowering interest rates, but writing-off  portions of loan balances.  Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater.  Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?

19) On commercial property, when do you extend on a loan vs foreclosing?  In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan.  More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position.  With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now.  (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar?  As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever.  Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized?  The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming.  As the interest rate differentials narrow in real terms, the US Dollar should improve.

But, there are complicating factors.  Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates.  Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply.

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies.  For now, put your macroeconomics books on the shelf, because they won’t be useful for some time.

One of my commenters wrote in response to my piece Book Reviews: The Complete Guide To Option Pricing Formulas, and Derivatives, Models on Models:

1. Kurt Osis Says:
   December 13th, 20085:05 pm at EditDavid:

   How can advocate people using these models which clearly don’t work? Estimating volatility is a suckers bet. Even if you could estimate the underlying “actual” volatility with 100% accuracy there would be sample error in your realized volatility. And of course the volatility isn’t just changing, the fundamentals of the underlying are changing.

   I once heard of a man named Mandelbrot who said volatility was infinite, in which case these sigmas and lemmas are a bit beside the point, no?

Kurt, I’ve met Mandelbrot, and have discussed these issues with him.  The two books that I recommended are also up on those issues.  Implied volatility estimates as applied to option pricing formulas are a fall-out.  No one thinks they are true, but they are a paramater used to keep relationships stable across options of similar expirations.

Intelligent hedgers hedge options with options; they don’t try to apply the theoretical equivalence that lies behind the traditional Black-Scholes formula and do dynamic hedging with the common stock itself.  That is the philosophy behind the books that I reviewed.

I’m on your page, Kurt.  Variance is infinite, and B-S blows up.  But within the options world, there has to be a way of calculating relative value, and these books aid us in that calculation.

If you think I am wrong here, go to your local library, and get these books via Interlibrary loan.  Read them, and you will see that we are all in agreement.

1) What a mess.  I had been lightening up on equity exposure over the last week, but seemingly not enough.  The last three months have been hard for me, with my performance trailing the S&P 500 in each of the last three months.  Well, at least I admit it when I lose; let’s see if I can’t do better in the future.

2) The rally in long Treasuries is the cousin to the fall in equities.

A $4 move in the long bond would be significant enough — that is a top 5 move, but the shocker is seeing the 30-year yield near 3.20%.  That should lead to lower mortgage yields, refinancing, and perhaps, lower rates in the short run.  The long run is another matter.

3) Part of this came from Bernanke’s comments that the Fed would buy Treasuries.  If I may, what isn’t the Fed going to buy?  Do they really want to flatten the yield curve when the long end is this low already?  Don’t they have enough to do with instruments that have credit risk?  They can flatten the Treasury curve, but the corporate yield curve is out of their reach for now.

4) One example of that is the junk bond market, where the average yield is now over 20%.  Areas where the government does not guarantee see little liquidity, because government guarantees in other areas help siphon liquidity away.

5)  So I’m not impressed with the FDIC insured bond offerings from a public policy standpoint.  They crowd out non-guaranteed bonds.  But I would be inclined to buy the bonds in place of allocations to Treasuries or Agencies.

6) TIPS, excluding the long end, are trading below par.

Also, the on-the-run securities are trading at a premium, because their inflation factors are close to 1 because they are young securities.  The inflation factors can’t go below 1, but older securities can see more past inflation erased, should we get a period of sustained deflation.  I don’t see that coming over the intermediate-term, but in the short-term we could see that.  Eventually the Fed will have to monetize many of the promises that it is making.

7) Perhaps we need another means of calculating how bad it is for non-guaranteed areas of the market, like A2/P2 CP.  That is a true horror.  I remember criticizing those investing in levered nonprime CP back when I was writing for RealMoney, but most of those investors are dead or gone now.  My measure of credit stress, the 2-year Treasury less A2/P2 yields, is at a new record.

8 ) It is no surprise here that GM is scrambling, as are the other automakers.  Let them try to get debtors to compromise.   They will try to get the PBGC to take on the pension liabilities in foreclosure, though that may not be so easy.  They have refused to accept some liabilities in the past.

9) I was an early critic of reverse auctions organized by the US Treasury, largely because of the complexity involved.  I guess it took Paulson longer to realize the immensity of setting up those auctions.  It’s not as if the problem is unsolvable, but it would take a lot of work, and the payoff at the end is uncertain.

10) Is anyone else concerned that the Yuan is falling relative to the US Dollar? This graph gives the history since they “floated” the Yuan.  (Note the dirty float free market-like movements. )

Granted, it is a large-ish 2-day blip, but for the global economy to heal, we need China to begin to use the large surpluses that they have built up, buy abroad, and build up their domestic markets.

It would be a simple matter of fairness as well.  As it is, the surpluses in the government’s hands fuel a bloated financial system and inflation, which could be partially solved by importing more goods for their citizens to buy.

11) It’s my view that the economics profession comes out of this crisis with a black eye or two.  There is a lot of room for humility here.  Neoclassical economics does a lousy job of understanding how the real economy (goods and services) interacts with the financial economy (stocks, bonds, etc.).  That is a strength of the Austrian school, though.

Even on a microeconomic basis, periods of stress like this can make one question some of the theorems of Modigliani and Miller.  The way that assets are financed does make a difference when there is financial stress, and even more in insolvency.  Also, the financing windows are not always open.  Theories that rely on markets remaining open and liquid, such as many arbitrage-type arguments are not valid except when the market has “fair weather.”

12) There is no shortage of liquidity for the US Treasury, which takes that liquidity, gives T-bills to the Fed, which uses them to replace bail out specific lending markets, and downgrade the quality of their balance sheet buy up securities where liquidity is temporarily in short supply.  Personally, I don’t think it will work.  It is much easier to get into a market than to get out, particularly if you are a large player with no profit motive.  Three last semi-related articles that I found interesting:

• Quantitative easing: printing money like mad to ward off deflation
• Should We Penalize Liquidity Preference?
• Profiting off the Liquidity Preference

T-bills are in high demand, perhaps the government should take advantage of it and issue a lot of them.  There are some dangers though:

a) This could be what finally does in the dollar.
b) The US debt maturity structure has been shortening of late — I wouldn’t want it to get too short, or we could face rollover risk, as Mexico did in 1994.

It might be better for the US Government to lock in long funding rates while they are available.  Who thought the 10-year or 30-year could be so low?

I have lots of models, but I am only one person, so some of my models sit idle becuase I don’t have time to update them.  Well, today, as I was reading Barron’s, I ran across the “Current Yield” column, and read this:

THE STOCK MARKET IS PRICED FOR a recession, but the bond market is priced for a depression. So says Rob Arnott, the brainiac who heads Research Affiliates, an institutional advisory.

That’s not hyperbole. Corporate bonds rated Baa or triple-B, the low end of investment grade by Moody’s and Standard & Poor’s designations, offer the biggest yield premium since the early 1930s, notes RBC Capital Markets.

That’s a problem for pulling the economy out of the credit crisis, but an opportunity for investors. Indeed, investment-grade corporates with near-record premiums arguably offer better return potential than common stocks, especially relative to their risks. “I haven’t seen this many markets offering double-digit opportunities since 1989-90 or ever so briefly in 2002,” says Arnott.

Part of it reflects the sheer weight of numbers. Corporates rated Baa yield about 550 basis points (5.5 percentage points) more than comparable Treasuries, nearly half again the spread in the 2002 post-WorldCom-Enron debacle and twice the average of post-war recessions.

You have to go back to the early 1930s, when Baa corporates yielded 700 basis points over Treasuries, to find a comparable situation. And notwithstanding all the hyperventilation in the media that this is worst financial crisis since the Great Depression, there’s never been such a full-court response to the threat of debt deflation — the $700 billion TARP, the bailout of Fannie Mae and Freddie Mac, the likelihood of trillion-dollar deficits and a doubling in the Federal Reserve’s balance sheet in just over two months.

I know things are bad in the corporate bond market, but I didn’t think it was that bad.  This made me ask, “Hmm… what about my stocks versus bonds model?”  That article is one of my better ones; a lot of time and effort got poured into that.  So, I sat down and re-engineered the model, since, embarrassingly, the original model was lost.

The key question is whether the yield on BBB corporates is more than 3.9% higher than the earnings yield on the S&P 500.  The answer is yes, and that means we should sell stocks and buy corporate bonds.  But, here is the embarrassing thing for me.  The first recent signal to sell stocks and buy bonds came in mid-August, but since I didn’t track the model regularly, I missed that.  Since the original model worked off monthly data, even selling in early September would have preserved a lot of value.  It is not as if corporate bonds have done well since August, but they have done much better than the S&P 500.

Here’s a graph summarizing 2008 via my model:

When the green line goes over 3.9%, it is time to buy corporate bonds. That is not a frequent occurrence; this model gives of signals only a few times per decade. Check out my original piece for more details.

So, with that, I offer my conclusions:

• It is still time to allocate money to corporate bonds versus equities.  Where I have flexibility with my own money, I am allocating money away from Equity and to BBB investment grade and high yield corporates.
• Though there are a lot of reasons to worry, corporate yield spreads discount a lot of trouble.
• The model indicates a fair value of the S&P 500 at around 700.  Uh, I’m not predicting that, but if we hang around at yield levels like this for long, yes, the equity market will adjust to the competition.  More likely is the equity market treads water while corporates rally.
• A caveat I toss out is that all areas of the credit markets where the government is not meddling are disproportionately hurt, because investors are fleeing toward guaranteed areas.  Thus, corporates are hurting.
• College endowments and other investors that hate to buy conventional assets should consider corporates now.  It is my bet that a portfolio of low investment grade and junk grade corporates will outperform a 60/40 portfolio of Stocks and T-Notes.
• If you have the freedom to sell protection on a broad basket of corporates, this might be a good time to do it, when everyone else is scared to death.  Time to insure corporate credit, perhaps.
• One more caveat before I am done.  The rule has only been tested on data since 1953.  It is not depression-proof.    I hope to gather the data from that era and validate the formula, but that will be difficult.

So, be careful out there, and remember that corporate bonds typically do better than stocks in a prolonged bear market for credit.  Yield levels like the present typically bode well for corporate bonds versus stocks.