Before I start tonight, a reminder, those that want to follow me on Twitter can do so here.  I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog.  I’m still working with it.  Thanks to all of those that tweeted and retweeted, and those that are following me now.

One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro.  If Greece defaulted, Greece would lose the low cost funding of the Euro.  The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line.  Tough love is the best policy; don’t bail others out if you care about the union as a whole.

On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.  There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.  In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.  There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can’t make good on his obligations.  As with many speculators, he overcommits.  He is short of funds because many trades are going against him at the same time.  It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.  The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.  After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip.  They were one of the main classes of marginal borrowers.

-=-=-==-=-=–==-

Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu.  There are trades that no one wants to take at any price that a seller could live with.  There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer.    Complexity is a minus.  We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them.  It is the price of creating safe securities.

No surprise: people pay a lot more for certainty, even if it is seeming certainty.  We see it in corporate bond spreads.  High quality borrowers borrow cheaply.  Low quality borrowers pay up. So what else is new?

What is new is the low-ish spreads for going down in quality.  This one could go either way; spreads are wide against history, but might be narrow against current difficulties.  The rebound has been rather sharp.

Note: this is reposted because of a system glitch.

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.  Ready for how much they made?  Ta-da!  They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.  I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.  But Paul Kedrosky crystallized it for me when he posted this.  And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.  What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back “scaredy cat” regulators who don’t let banks deal in anything they don’t understand, which isn’t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS — if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?  Probably, but consider this article here.  I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody’s Baa series — because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I’ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment — few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don’t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.  Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream — “Ratings are supposed to be good over a full market cycle!” When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can’t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)  Barry comments on how Goldman Sachs bags clients.  Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.  My comment:

I always advise retail investors not to buy structured notes — Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn’t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than “buyer beware,” and “Don’t buy what someone else wants to sell you. Buy what you want to buy.”

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.  It was featured by Barron’s and picked up in a piece by Barry.  Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.  My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.  My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.  They recently did a piece on whether it is better to buy a home now or wait a while.  My comment:

Ordinarily, I don’t think much of video on the web.  Writing is usually a more concise way to get a view across.  But video can be more effective if it gets past the genre of “talking heads,” in which case, one is usually better off reading a transcript.  Consider the State of the Union message as an example: regardless of who is president, would you rather spend an hour on it, of five minutes?  And, it would be five minutes where you are not distracted by the crowd, and can dissect things rationally.  I pick reading.

There are places where video can be useful, but it has to be well thought out.  I first saw the above video over at “The Big Picture,” which has enough readership to kick up a video’s viewings.  I thought it was clever, representing the economist’s views in a short catchy way, and capturing their philosophies  as well.  The next day, I showed it to three of my boys — they thought it was interesting, and mentioned it the next night at dinner.  My wife, incredulous at the idea of an economics rap video, then watched it the next night with all of the kids, while I cleaned up the dinner dishes.

Then the surprise happened.  “Dad, what are animal spirits?”  “Are animal spirits the bull and the bear?”

Interesting.  The video prompted questions from the children for me to answer.  I’ve written on Animal Spirits before, at least twice.  Animal spirits attributes irrational risk taking and avoidance to businessmen, as if they are irrational animals.

I told my children that businessmen are generally rational, and they make their decisions off of their own balance sheets, and the general willingness of the market to spend, which is related to balance sheets in aggregate.

The contrasts of the video are considerable:

• Keynes is known, Hayek is unknown.  Desk clerk immediately knows Keynes.
• The two men are hybrid in what they portray.  To some degree they represent the schools of thought that each was a leader of, and to degree the men themselves.
• Hayek reaches into the hotel room drawer, and rather than finding the Bible, finds the General Theory. Similarly, Keynes says, “I am the agenda.”  This is a statement of the dominance of Keynesian thought in modern macroeconomics.  Keynes was important, but not as dominant while he lived.
• Hayek assumes they will go via the subway.  Keynes hires a limo.  Keynes is worldly wise, having a great time, and Hayek is uncomfortable.  Keynes has alcohol; if Hayek is having alcohol, he is sipping it through a thin straw.
• Alcohol is an allusion through the whole piece.  Stimulus is just more of “the hair of the dog that bit you.”  The boom is a good time where we drink freely, and the bust is where we deal with our hangover.  It was no surprise to see that the Bartenders were named “Ben” and “Tim” and that they were serving up alcohol for as long as the patrons would survive.  Even the pyramiding of the glasses had meaning — building up to a stuporous, unsustainable level.
• Keynes holds money as he begins his rap, and throws it midway through.  It is an aspect of how incentives from the government or central bank can lead behavior for a time.
• Keynes ends his rap with “We’re all Keynesians now.”  Keynes himself did not live to hear that comment uttered by Friedman in the ’70s.
• Keynes and Hayek had different views on spending and savings.  On spending, Keynes didn’t think what money was spent on mattered, only that it was spent.  Hayek felt that intelligent spending would grow the economy more.  On savings, Keynes was negative, whereas Hayek said that moderate savings were valuable, and would facilitate future investment.
• As for animal spirits, businessmen only get bold when they have sufficient free capital to act.  When interest rates are artificially low some businessmen invest, trusting that good times will continue.  Alas, those good times never last; avoid long commitments when times are good.
• There are liquidity traps, but they occur when banking systems are broken due to misregulation.
• “In the long run we are all dead.”  Well, Keynes, way to care for our progeny.  You had no kids, for a variety of reasons, but some of us care for how our children, and the nation that we love will do after we have died.

The video portrays a Goliath and David situation.  Keynes is dominant, and totally assured of his position in the world.  Hayek is less certain of himself, but certain in his message.

My wife and my kids have a better understanding of the current economic situation now than they did before the video came out.  I am grateful that the video was made.

Would that there were one time horizon — a goal to shoot for, similar to the dispensationalists that plague Christianity with an announced date for the return of Christ.  But a major reason that the Chicago School (as well as the Keynesians) is wrong in their view of economics is that there are multiple time horizons that people consider.

Why one time horizon?  It makes the math simple.  It is similar to the foolish Modern Portfolio Theory which has one version of risk which bears no resemblance to risk in the real world.  Modern Portfolio Theory exists so that bright people who can’t interpret the real world can receive salaries and look smart.  What’s that, you say, Modern Portfolio Theory has a fixed time horizon?  Another reason to cast it over the edge.  It is useless.

There have been a series of interviews at The New Yorker with Chicago School economists to try to test them in their allegiance to the free markets.  There is a problem here in that what makes sense in the short run does not always make sense in the long run.

Bubbles develop from short-run thinking.  What has worked in the immediate past  will work even better in the future.  In hindsight, it sounds dumb, but remember that most people are imitative; they imitate the seeming success of others.  People are rational, but not rational in the way that most economists posit.  Imitating your neighbor is a logical move for many actions.  If he is doing something that looks good, it can make a lot of sense to do the same thing — e.g., asking for the recipe for the delicious meal you had at their house, as well as asking where they got a certain obscure ingredient.

Imitation conserves on thinking.  People avoid thinking, because it hurts.  “If it works for my loser brother-in-law, than it certainly will work better for  me,” is the way some think.  There is the implicit appeal to taking an action out of greed or jealousy.  Smart people avoid those temptations, and think for themselves, looking to the long term consequences of any action.

Momentum investors live on the short-term horizon; value investors invest for the long term — if success comes quickly, very good, if slowly, good.  The ability to wait is a plus, because the ability to wait allows for optionality that may produce more value.

Back to bubbles.  They usually exist because financing is too cheap relative to what financing costs on average over a full market cycle.  Lending or equity investing at such times goes on with little thought for what can go wrong.

“This junk bond won’t default.”

“This equity will grow into its valuation, and then some.”

But near the peaks of bubbles, two things happen.  The prices of the assets being financed are so high, that one borrowing to own the asset faces a negative arb — he has to keep paying to keep the asset afloat — the net yield is negative.  The second thing is that chatter becomes uncertain, and the pace of closing deals slows.

These are signs that the cash flows that the assets throw off are less than the cash flows needed to hold the assets.  Such a condition can only exist for a short time during a mania.  When the pace of deals slackens, and the arb is negative it is time to run, not walk to the exits.

If enough economic actors did this, bubbles would self-deflate.  But it hurts to think.  Valuation questions are tough, and it is much easier to mimic the seemingly successful actions of others.

Better it would be if the Fed, which is the main blower of bubbles through easy monetary policy, would pull back on policy when aggregate levels of debt in the economy get above 200% of GDP, or, would allow us to go through recessions where there is significant pain, and liquidation of bad investments.  But no, during the bubble years, Greenspan was lionized for keeping the economy going smoothly — limiting the impact of recessions.  All that time, debts kept building up until the ratio far exceeded that achieved during the Great Depression.  Now Bernanke is lionized for increasing the Debt/GDP ratio while shifting debts from private to public hands.  He has saved us from the final reckoning of debt service.  Now what will the US Government do as its total obligations pass 4x GDP and head toward 5x GDP?  As I have said before, we are in uncharted waters here.

Debt is not neutral.  It creates inflexibility in the economy, because an economy built on fixed commitments has higher bankruptcy risks than one built on equity commitments.  Real reform would force banks to delever.  It would force the US Government to delever.  Real reform would get the government out of the prosperity business (it has never been good at that), and get it to focus on areas where it can make a difference — justice, defense, public health, and other public goods.

One simple solution: phase out the deduction for interest expenses, and phase in a deduction for dividends (preferred dividends would be at 50%).  Disallow trust preferred and hybrid debt structures.  Make finance more transparent by eliminating complex structures, and limiting all derivative transactions such that only hedgers may initiate transactions.  Transactions between two speculators should be regulated as gambling, because that is what it is.

If the government is not willing to take actions that hurt those being regulated, they are not worthy of being called a government.  The government should look out for the best interests of the nation as a whole, regardless of whom it might seem to favor.

Once again, back to bubbles.  Bubbles don’t get popped by the powers that be because the powers that be like bubbles as they are inflating.  Who would be a humbug and stop the sunbeam of prosperity when it is shining with full power?

But when the deflation of the bubble happens, everyone points the finger outward, few point at themselves.  Let Messrs. Greenspan, Paulson, Geithner, and Bernanke, among others, come before the cameras and apologize for their mismanagement of the US economy, and, let them suggest that the government get out of the economy business, because the government has consistently failed there.

To come back to the beginning of this article, the fetish of rationality exists in economics because the math doesn’t work without it.  Many tests of rationality have failed, yet the profession does not give up, because their skills are useless if man is not economically rational.

It is time to unemploy a lot of economists.  Unemploy them at the Fed; if we don’t eliminate the Fed, at least let’s slim it down.  Unemploy them at universities and colleges.  Let the business departments teach practical economics, and close the economics departments themselves.

The failure of Keynesian, Chicago School, and Neoclassical economics in this present crisis is severe.  We need a new economic paradigm to replace the failures that exist within our universities.

Neoclassical economics will fail; I may not live to see it fail, but it will fail.

I finished the first phase of a project today.  But first let me tell you a story.  It was 1990, and the Society of Actuaries Investment Section was holding a conference.  It was a great conference; I still have the binder from it.  There are few meetings from twenty years ago that still have relevance for me.

One of the presentations was by Stanley Diller, a managing director of Bear Stearns, who insulted all of the actuaries at the conference by telling them the the insurance industry was dead wrong for talking about yields and spreads.  Everything was duration and convexity, and those that did not understand that would lose.

He ended his presentation suddenly, did not take questions, and stormed out of the room.  I’m not sure why, but I had a seat in the back, and intercepted him.  I said, “You can’t just say this and not give any justification for your views, how do you back it up?”  He thrust a business card into my hand and said, “Call my secretary, she will send you the info.”  He stormed away.

The next day I called the secretary, and she told me she would send the information.  Two days later, I had it, and a few days later, I had replicated it in my own model.

Since then, I have used the model profitably many times.  Today I use it to describe the yields in Treasury Notes and TIPS.  I have used it to produce an estimate of future inflation expectations.

Using closing prices, here is my estimate of the coupon-paying yield curve:

And here is the spot curve (estimating where zero coupon bonds would price):

And finally, the forward curve, which estimates the expectations of future short-term rates, inflation, and real rates:

Pretty neat, huh?  Let me tell you a little about the model:

• Values are as of the close 12/22/2009, but the model can be run in real time.
• It is estimated from the full coupon-paying Treasury Note and Bond markets — over 200 bonds in the model.
• The model estimates a nominal spot curve, fitting prices with 4 parameters, over 99% R-Squared.
• The model estimates a forward inflation curve, fitting TIPS prices with 4 parameters, over 99% R-Squared.
• The two models are estimated jointly, through nonlinear optimization.
• The model has one constraint — nominal spot yields must be positive after 4 months.
• Every other curve is derived from those two curves.

What are the useful things that we learn from the model?

• There are mispricings in the Treasury and TIPS curves, but they are typically small, and would be hard to make money off of.  That’s  demonstrated by the high R-Squareds.
• The Fed has achieved its goal of making real rates negative in the short term.
• And, has made made nominal rates negative for some very short instruments inside 6 months of maturity.
• Inflation expectations start low, and peak around 2022, then tail off.
• Long term inflation expectations are still under 3.5% — ignore the portion of the inflation and real curves after 23 years, they are extrapolations.
• Implied short-term real yields go positive in 2011, peak in 2024 and tail off thereafter.
• The nominal forward curve is steep as a mountain on both sides.  Though there is a lot of fear over what will happen over the next 12-14 years, those fears have not been built into the prices of longer-dated Treasury securities.
• The nominal spot curve peaks after 22 years — in my experience, that is normal, and is a reason why longer nominal note yields decline.  US Treasury — take note.
• Inspecting the differences between coupon-paying yields on Treasuries and TIPS makes inflation expectations look more tame than they really are.  Federal Reserve — take note.
• 30-year TIPS would likely fund cheaper than 20-year TIPS — US Treasury, take note.  The scarcity value would help as well.

This is just the beginning.  I’m not planning on writing about this every day, but I should be able give you some updates every now and then.  Hopefully the firm I work for should be able to benefit through research that this enables me to create for institutional clients.

Full disclosure: I own shares in Vanguard’s TIPS fund.  And truth, we all own Treasuries somewhere if we look deep enough.

When I was a grad student, I always felt weird about Keynes.  I grew up in a home that was not explicitly “free market” but was implicitly so.  My Dad was a small businessman and my Mom was a retail investor (as well as home manager).  My Dad’s business did well, but it had its share of hard times, including the depression of 1979-1982 in the Rust Belt, where many of his competitors did not survive.  He had to be a member of the local union and run a closed shop, but as an owner, he had no vote in union matters.

I worked for my Dad for two summers.  During one of them, when we went to get parts, the parts dealer said to me,”I’ve heard good things about you.  Even the union steward has heard about you.”  My face and my Dad’s face went white. I was not in the union. After an uncomfortable pause, he said, “Eeeaaah! Got you!” and he laughed.  Dad and I looked at each other, embarrassed but relieved.

My Mom, like Keynes, and like me, has beaten the stock market for most of her life.  There are excess profits available for wise investors, some of which stem from the foolishness of other investors.

Keynes was a fascinating man who understood asset markets well, but when trying to consider the economy in general, looked to what would work in the short run.  The author of Where Keynes Went Wrong points out repeatedly from Keynes’ writings his view that interest rates are almost always too high, and that interest rates should only rise when inflation is rising quickly.  Can lowering short term rates juice the economy.  Yes, in the short run, but in the longer run it fuels inflation and bubbles.

The strength of Where Keynes Went Wrong is that it spends a lot of time on what Keynes actually said, rather than the way Keynesianism developed into a branch of Macroeconomics, eventually becoming part of the dominant macroeconomic paradigm — the Neoclassical Synthesis.  I admit to being surrprised by many of the statements Keynes made — granted, the author is trying to prove Keynes wrong so he goes after what is least defensible.

The author dissects the errors of Keynes into a few main headings:

• Lower interest rates are almost always better.
• Growth comes through promoting consumption.
• You can’t trust businessmen to do the right thing when it comes to capital allocation.
• Government planning is superior to decentralized planning, because experts in government can allocate capital better than businessmen.
• Crashes require government intervention.  Using the balance sheet of the government will have no long run negative impacts.
• Markets do not self-correct.
• Globalization is good, and the nations of the world can cooperate on creating a standard of value independent of gold.

For the most part, those are my words summarizing the author.  After going through what Keynes said, he then takes it apart point-by-point.  The author generally follows the Austrian school of economics, citing Mises, von Hayek, and Hazlitt.

After that, the book continues by taking on the rhetoric of Keynes, both oral and written.  He was one sharp man in being able to express himself — orally, there were few that could match him in debate.  In writing, where time is not so much of the esssence, there is more time for readers to take apart his arguments, and point out the fallacies.  The author points out much of the fallacies in how Keynes would argue his points.

The book finishes by pointing out the paradoxes involved in Keynesianism, e.g., in order to reflate a debt-ridden system, the government must lower rates and borrow yet more.  Also shows how beginning with manipulating the money supply leads to greater intervention in credit, banking, currency, and other economic policies over time, and why the politicians love the increase in power, even if they realize that the policies don’t work.

One surprise for me was how many ways Keynes suggested to intervene in a slump, and how many of them are being used today.

• Rates down to zero.
• Direct lending by the Fed.
• Directing banks to make certain loans.
• Bailouts.
• Nationalizing critical companies.
• Inflating the currency.

The idea of letting the economy contract in any way was foreign to Keynes.  He felt that a seemingly endless prosperity could be achieved through low interest rates.  Well, now we have low rates, and a mountain of debt — public and private, individual and corporate.  Welcome to the liquidity trap created by Keynesian meddling, together with the way our tax code encourages debt rather than equity finance.

I recommend the book; it is an eye-opener.  It makes me want to get some of Hazlitt’s books, and, read the whole of Keynes General Theory for myself.  The book that my professors once praised as a tour de force has holes in it, but better to read it all in context.

Quibbles

The book could have used a better editor.  Too many things get repeated too often.  The book also has two sets of endnotes, one for reference purposes, and one for expanded discussions.  The endnotes that were expanded discussions probably belonged in small type at the bottom of the page rather than as endnotes.  Many of the endnotes are quite good, and it is inconvenient to have to flip to the back to see them.

Also, on page 274, the author errs.  The risk to a business owner is higher after he borrows money.  The total risk of the business is not higher, but the risk to the equity owner is higher.  Whether that risk is double or not is another question.

There’s another error on page 328.  When I buy stock in the secondary market, I am putting my capital to work, but someone else is withdrawing capital from the market.  There is no net investment.  When I buy an IPO, not only do I put my money to work, but there is more investment in the economy (leaving aside the venture capitalists that are cashing out).  It is hard to say when investment in the economy is increased on net.

The table on page 330 is confusing.  The first row should have been set apart to show that GDP is not a government obligation.

Finally, I don’t think that Say’s Law (”Supply creates its own Demand.” Or in the modern parlance, “If you build it, they will come.”) is true, but neither is its converse (”Demand creates its own Supply”).  The two are interconnected, and either one can cause the other.  Markets are complex chaotic systems, and entrepreneurs sometimes produce goods that no one wants.  Similarly, when consumers discover a new product or service, that demand can help create a whole new industry.  Supply and demand go back and forth — the causality doesn’t go only one way.

Who would benefit from this book: Send it to your Congressman, send it to your Senator.  Make sure every member of the Fed gets one, and the fine folks at the Treasury as well.  Beyond that, think of your liberal friends who think of Keynes as a hero, and give them one.  After reading this, I want to add Keynes’ General Theory to the list of books the everyone cites, and no one reads.  (That list: The Bible, Origin of the Species, The Communist Manifesto)

If you want to buy it you can get it here: Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.  Those that want to support me can enter Amazon through my site and buy stuff there.  Don’t buy what you don’t need for my sake.  I am doing fine.  But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.  Win-win.

Every one one us has limited bandwidth for analysis of data.  We pick and choose a few ideas that seem to work for us, and then stick with them.  That is often best, because good investors settle into investment methods that are consistent with their character.  But every now and then it is good to open things up and try to see whether the investment methods can be improved.

For those that use market indicators, this is the sort of book that will make one say, “What if?  What if I combine this market indicator with what I am doing now in my investing?”  In most cases, the answer will be “Um, that doesn’t seem to fit.”  But one good idea can pay for a book and then some.  All investment strategies have weaknesses, but often the weaknesses of one method can be complemented by another.  My favorite example is that as a value investor, I am almost always early.  I buy and sell too soon, and leave profits on the table.  Adding a momentum overlay can aid the value investor by delaying purchases of seemingly cheap stocks when the price is falling rapidly, and delaying sales of seemingly cheap stocks when the price is rising rapidly.

Looking outside your current circle of competence may yield some useful ideas, then.  But how do you know where you might look if you’re not aware that there might be indicators that you have never heard of?  Market Indicators delivers a bevy of indicators in the following areas:

• Options-derived (VIX, put/call)
• Volume and Price driven (Money flow, rate of change, 90% up/down days, and more)
• Where the fast money invests (money in bull vs bear funds, sector fund sizes, and more)
• Analyzing the likely motives of other classes of investors (margin balances, short interest, etc.)
• Price Momentum and Mean-Reversion
• Measuring asset classes and sectors using fundamental metrics  (Fed model, sector weightings, Q-ratio, etc.)
• Investor sentiment surveys
• How to use analyst opinions, if at all?
• News reporting and reactions of stocks to news
• Odd bits of news (CEO behavior, little things that indicate a qualitative change in the life of a company)
• Insider buying and selling
• Commodity market data (COT, etc.)
• Bond market behavior (credit cycle, Fed moves, Credit Default Swaps, and more)
• Changes in the capital structure (M&A, equity/debt issuance, etc.)
• Monitoring the greats (13F filings)

No one can use all of these indicators.  You can probably only use a fraction of these indicators.  But being aware of how others view the market can widen your perspective, and help to reduce negative surprises on your part.

Quibbles

By its nature, since the book cuts across a wide number of areas in 216 short pages, you only get a taste of everything.  I liked this book, but there is room for a second book in this area — one of additional indicators passed over (I have a bunch!), or going into greater depth on the indicators covered.

Who will benefit from this book?

You have to have a quantitative bent, at least to the level of being willing to go out and collect simple data in order to benefit here.  Now, most serious investors do that, so I would say that serious investors can benefit from the “cook’s tour” of market indicators that this book gives, unless they are so serious that they know all of these indicators.  (Like me.)

If you would like to buy the book, you can buy it here: Market Indicators: The Best-Kept Secret to More Effective Trading and Investing.

Full disclosure: This book is unusual for me in two ways.  First, the author (not the PR flack) sent me a copy, with a nice handwritten letter thanking me for my blog and my assistance.  That is why there is the second reason.  Pages 80-81 summarize the longer argument made in my blog post, The Fed Model, where I take the so-called Fed model, and rederive it using the simple version of the Dividend Discount Model, giving a more robust model with reasonable theoretical underpinnings.

I earn a small commission from Amazon for anyone entering Amazon through my site, and buying anything there.  Your price does not rise from my commission.  Don’t buy anything you don’t want to buy if you want to reward me for my writing.  Only buy what you need if Amazon offers you the best deal.

When I write a piece, and entitle it “Toward…” it means that I don’t have all of the answers.  Typically I think I am getting somewhere, but the speed of progress is open to question.  That said, good questions and constructive criticism aid me on my way.

From Private Equity Beat at the WSJ: Toward a new theory of the cost of equity capital, on the Aleph Blog. We confess to not being entirely up on the benefits of Modern Portfolio Theory versus Modigliani-Miller irrelevance theorems, which is probably why we are journalists and not PE execs. But we nonetheless find this analysis of how to price equity interesting.

From Eddy Elfenbein at Crossing Wall Street: I like the logic, but my question is—what if a firm has little or no debt?

Good question.  The total volatility of a firm can be broken up into three pieces: financial leverage, operating leverage, and sales volatility.  Saturday’s piece dealt with financial leverage and its costs.  An unlevered firm in the financial sense still possesses operating leverage and volatility of sales.  Different unlevered firms have different costs of equity capital because they have different levels of sales volatility, and different degrees of operating leverage.

That will manifest itself in option implied volatility, which is a crude measure of what people would pay to gain and lose exposure to the equity of the company.  The cost of equity should be positively related to that.  More volatile companies should have a higher cost of equity.

Another way to look at it is to ask what is the effect on the firm if the company issues or buys back equity.  How much does the generation of free cash flow change relative to the price paid or received for equity?

Another question:

Doug Says:

October 19th, 20098:25 am

“As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.”

How do you account for the potential for earnings growth in this calculation? The debt investor trades seniority and (in some cases, collateral) for a fixed claim on cash flows. Common stock investors often (but not always) will earn rising “coupons” and get back value much greater than “par” at the end of his/her investment.

I realize that models such as gordon growth take this into account, but you don’t address it in your “debt plus a premium” calculation.

Doug, good point.  The FCF yield, unlike a dividend yield, as used by the Gordon and other DCF models, reflects the ability of the company to reinvest the FCF that is not paid out as dividends.  It reflects growth already in a crude way.  If the ability to grow via reinvestment is below the FCF yield, then the company may as well just sit around and buy back stock.  If the ability to grow earnings is higher (unusual), then the FCF yield will understate prospects.

That’s a crude way of phrasing it, but the FCF yield is a good place to start.

Finally, regarding my thoughts on M-M:  Take Falkenstein’s recent book — high yield tends to underperform with both debt and equity. Or consider that less levered companies tend to return better over the long haul (Megginson, Corporate Finance Theory, page 307.)

M-M, like the CAPM, does not survive the data. Low leverage is a positive factor for returns in both debt and equity, and a decent part of that is the high costs of financial stress for highly levered firms.

Summary

The idea here is to try to view the cost of equity capital as a businessman would, rather than an academic who has little exposure to the world as it operates.  Look to the degree of certainty in obtaining cashflows; the yields on various assets should rise as certainty declines.

I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

• Beta is not a stable parameter; also, it does not measure risk well.
• Company-specific risk is significant, and varies a great deal.  The effects on a company with a large amount of debt financing is significant.

What did they do in the old days?  They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks.  If less scientific, it was probably more accurate than MPT.  Science is often ill-applied to what may be an art.  Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

I’ve also never been a fan of the Modigliani-Miller irrelevance theorems.  They are true in fair weather, but not in foul weather.  The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency.  The cost of financing assets goes up dramatically when a company needs financing in bad times.

But the fair weather use of the M-M theorems is still useful, in my opinion.  The cost of the combination of debt, equity and other instruments used to finance depends on the assets involved, and not the composition of the financing.  If one finances with equity only, the equityholders will demand less of a return, because the stock is less risky.  If there is a significant, but not prohibitively large slug of debt, the equity will be more risky, and will sell at a higher prospective return, or, a lower P/E or P/Free Cash Flow.

Securitization is another example of this.  I will use a securitization of commercial mortgages [CMBS], to serve as my example here.  There are often tranches rated AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, and junk-rated tranches, before ending with the residual tranche, which has the equity interest.

That is what the equity interest is – the party that gets the leftovers after all of the more senior capital interests get paid.  In many securitizations, that equity tranche is small, because the underlying assets are high quality.  The smaller the equity tranche, the greater percentage reward for success, and the greater possibility of a total wipeout if things go wrong.  That is the same calculus that lies behind highly levered corporations, and private equity.

All of this follows the contingent claims model that Merton posited regarding how debt should be priced, since the equityholders have the put option of giving the debtholders the firm if things go bad, but the equityholders have all of the upside if things go well.

So, using the M-M model, Merton’s model, and securitization, which are really all the same model, I can potentially develop estimates for where equities and debts should trade.  But for average investors, what does that mean?  How does that instruct us in how to value stock and bonds of the same company against each other?

There is a hierarchy of yields across the instruments that finance a corporation.  The driving rule should be that riskier instruments deserve higher yields.  Senior bonds trade with low yields, junior bonds at higher yields, and preferred stock at higher yields yet.  As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.

Thus, and application of contingent claims theory to the firm, much as Merton did it, should serve as a replacement for MPT in order to estimate the cost of capital for a firm, and for the equity itself.  Now, there are quantitative debt raters like Egan-Jones and the quantitative side of Moody’s – the part that bought KMV).  If they are not doing this already, this is another use for the model, to be able to consult with corporations over the cost of capital for a firm, and for the equity itself.  This can replace the use of beta in calculations of the cost of equity, and lead to a more sane measure of the weighted average cost of capital.

Values could then be used by private equity for a more accurate measurement of the cost of capital, and estimates of where a portfolio company could do and IPO.  The answer varies with the assets financed, and the degree of leverage already employed.  Beyond that, CFOs could use the data to see whether Wall Street was giving them fair financing options, and take advantage of finance when it is favorable.

I’ve wanted to write this for a while.  Though this is an outline of how to replace MPT in estimating the cost of capital, it has broader ramifications, and could become a much larger business, much like the rating agencies started with a simple business, and branched out from there.

Maybe someone is doing this already.  If you are aware of that, let me know in the comments.

-==-=–=-==-=–==-=-=-=-=–==-=-=-=-

PS — Sorry that I have been gone for the last few days.  Church business took me away. I’m back now, and will be posting on Monday.

Why don’t average investors use discounted cash flow analyses?  Typically, they don’t use them for several reasons.

• Most people don’t want to use an algebraic formula to estimate anything.  As some legendary trader reputedly yelled at a quant, “No formulas!  You can make me add, subtract, multiply, and divide!…  And don’t make me to divide too often!”
• It is not intuitive to most.  It takes a bond-like or actuarial approach to analyzing stocks — forecasting future free cash flows and discounting them at the firm’s cost of capital.
• It is highly sensitive to assumptions one employs.  Small changes in growth rates or discount rates can make a big difference in the estimate of value.  It lends itself easily to garbage in, garbage out.  (I remember a Dilbert cartoon where an analyst told Dogbert that scientific decision analysis required forecasting future free cash flows and discounting them.  He added that the discount rate had to be right or the analysis would be garbage.  Dogbert’s comment was to the point: “Go away.”)
• It takes a lot of work, and shortcuts are easier, providing most of the analysis with less effort.

Now, most professional investors don’t use DCF either, for many of the above reasons.  But there are a number that do, among them Buffett.  Morningstar uses DCF for its stock recommendations.  It’s not a bad system after one makes the effort as an organization to standardize your free cash flow estimates and discount rates.  Most professionals invert the process, and rather than trying estimate what a stock is worth, they estimate what they think the company will return at the current market price.

Expectations Investing is one way to formalize DCF, and a rather comprehensive one.  It would be a good way for an investment organization to formalize its investment process, but is way too complex for one person implement, unless one is following some type of simplifying system like Morningstar, ValuEngine or any of the other purveyors of DCF analyses out there.

In the process of formalizing DCF, the book explains the problems with traditional P/E analysis, and how a focus on free cash flow can remedy the problems.  A weak spot in the book is their discussion of cost of capital.  Their cost of equity capital analysis relies on beta, which is not a stable parameter, nor does it really capture what risk is.  That said, inverted DCF can work without discount rates.  The book takes the approach that the discount rates are the less critical factor, because when they change for one firm, they typically change for all firms.  The book’s solution is to use current prices to drive DCF backwards and determine market free cash flow expectations for a stock.

The analyst can then look at those expectations, and try to determine whether they are too high or too low.  The analyst can also look at whether there might be changes due to unit growth, product price changes, operating leverage, economies of scale, cost efficiencies, and changes in the marginal efficiency of capital.  After the analysis, usually one or two factors will stand out capturing a large portion of the variability.  The analyst then focuses on those, and what drives them.  Unexpected changes lead to revisions to the analyst’s model, and the game continues.

Beyond that, the analyst needs to understand how the company in question fits into its industry.  The book discusses Michael Porter’s five forces, the value chain, disruptive technologies, and the economics of information.  Beyond that, the book touches on:

• Real Options — the ability of a company to pursue value enhancing projects or not.
• Buybacks — do them when the company has no better opportunity, and the shares are undervalued.
• Mergers and Acquisitions — how to tell when are they good or bad ideas.
• Reflexivity — Are there situations where a higher or lower stock price affects the business?  High/low valuation makes financing easy/difficult.
• Understanding management incentives — how will they affect financial results and management behavior over the short and long runs.

At 195 pages in the body of the book, Expectations Investing is not a long book for what it covers.  The flip side of that is that is breezes over much of the complexity inherent in what they propose.  One other shortcoming is that little time is spent on financials, which are a large part of the market, and for which it is intensely difficult to calculate free cash flow.  After reading the book, I would have no idea on how to apply their DCF model to valuing a bank or an insurance company.

Aside from financials, if someone were to ask me, “Is this how valuation should be done?” I would say, yes, ideally so.  But it brings up one more critique: though I hinted at it above, most of the shortcuts that investors use are special adaptations and first approximations of the DCF model.  That is why shortcuts have validity — if you know the critical factors that drive profitability for a given company or industry, why waste your time on a big model with many inputs?  Cut to the chase, and use simpler models industry by industry.

Who would benefit from this book: someone who either wants a detailed means of calculating a DCF model, or a taste of the issues that an analyst/investor has to consider as he evaluates the worth of a company’s stock.

This is a neutral review from me.  I neither encourage or discourage the purchase of the book.  It has its good and bad points.  But if you want to purchase it, you can find it here: Expectations Investing: Reading Stock Prices for Better Returns.  I have a copy of Damodaran’s The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses (2nd Edition), weighing in at 575 pages, as well as his book Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Second Edition (similar size, with a quarter inch of dust on my shelf.  Guess I don’t use it that much).

I could do a review of one or both of those, but if Expectations Investing is overkill for the average investor, and light for the professional, then either of Damodaran’s books are for the professional only.  At best I think it would only produce a review on the weaknesses of DCF analysis.

Full disclosure: If you enter Amazon through my site, if you buy something there, I get a small commission.  Your price does not change.  I review old and new books, and I don’t like them all; my goal is to direct readers to the books that can best help them.