1) Where are we?? Is the equity market cheap or dear?? Personally, I think it is cheap, and though it might rally in the short run, it could get cheaper.? When the financials are compromised, all bets are off.? Here are some article indicating that things are cheap:
And, not cheap, consider the arguments of this humble student of the markets.? He considers survivorship bias and war as factors that investors should consider.? I agree, and I would urge all to consider that wars often occur as a result of economic crises.
2) The trouble is, quantitative finance is tough.? We don’t have enough data.? Our models are poor, and until recently, often reflected two major bull cycles, and only one bear cycle.? My view is that the equity premium is more like 3% over the long run, and not the 6% bandied about by careless consultants.
3) During the “great moderation,” I argued over at RealMoney that volatility and credit spreads were too low, and would eventually snap back.? Okay, we are there now.? Volatility is high, and so are credit spreads.? The brain-dead VAR models used by Wall Street have been falsified again.? Quantitative investors have gotten savaged again; it only works when implied volatility is flat/declining — it is an implicit credit bet.
4) This is a global crisis.? Where is it appearing?
The Gulf States (notable since they have had huge trade surpluses)
5) As I have mentioned before , the IMF, previously seeming irrelevant, has a new lease on life.? But how much firepower do they have, and will countries in crisis send them money to aid foreigners?
7) How do we pay back what we borrow?? Who will borrow more from us?? Those are? the great unanswered questions as we attempt to bail out many troubled entities.? I’m a pessimist here, and think that we will have higher long rates as a result, and that “Bernanke” will become a cuss word.? (Among the cognoscenti, only “Greenspan” will do as a proper insult.)? On the despondent side, will the US default in 2009?? Doom-and-gloomers are always early, and ignore the flexibility in the financial system prior to failure.? I see default as more of a 2017-2020 issue.
8 ) Uh, let Lawrence Meyer pontificate.? There is nothing good about a zero Fed funds rate.? Let him wax grandiloquent about Japan over the past two decades.? Consider how low interest rates destroy money markets funds.? Consider as well how much low rates destroy saving, sometyhing that we have had too little of.
9) In an environment like this, every M&A deal is open to question.? M&A is credit sensitive, and higher volatility impairs the flow of credit.
10) I don’t think that GAAP mark-to-market accounting has had a material impact on this crisis.? True, many accounting firms have interpreted mark-to-market as mark-to-last-trade, but that is not what SFAS 157 specifies, and firms can ignore their auditors (with some risk).? The truth is that the firms that have failed choked on bad balance sheets and inadequate cash flow.? It doesn’t matter what the accounting rules are when a company is running out of cash.? Cash is impervious to accounting rules.
11) Want a closer view of the Fed and politics.? Read this piece at The Institutional Risk Analyst.? While at RealMoney I espoused a view that the Fed was more political than economic.? This article confirms it.
12) How do I view Greenspan’s apology?
13) At a prior employer, we often commented that credit risk in credit cards appears late in the credit cycle.? Well, we are there now.? It is seemingly the last form of credit to default on.? In this environment, one can lose their home, but losing financial flexibility can be bigger.
14) The FDIC can modify many mortgages, at a cost to taxpayers.? It could cost a lot, and many people who made dumb decsions could be bailed out by the prudent.
15) If John Henry were alive, he would be smiling.? Let humans make markets, and not machines.
I have been on both sides of the table in equity money management.? I have hired and fired managers.? Now I am looking to be hired as a manager, and I face something that distresses me — the consultants that advise potential clients.? Personally, I think the consultants could do a lot better if they abandoned their overly simplistic model that categorizes managers on capitalization, value/core/growth, and domestic/international.? It does not serve their clients well — I believe the most fundamental risk model in a globally connected world considers industry exposures, and ignores other variables.
Why?? Industries tend to occupy specific areas of the “style box.”? At one firm that I worked at, external consultants complained that our risk control procedures were nonstandard, because they were focused on industries and sub-industries.? I counter-argued that our methods were better, because with a given industry, there was little variation in market capitalization and value/growth, but industry performance varied considerably.? Though I am no longer with the firm, it continues to do well, while many that used the consultants’ model have died.
Look at it another way. Isn’t investng about finding attractive opportunities, regardless of how big they are, where they are located, or how quickly they grow?? I think so, as does Buffett, Munger, Muhlenkamp, Heebner, Hodges, Rodriguez, Lynch, and many other successful fundamental investors.
Sometimes largecap names are attractive, sometimes smallcap.? Sometimes deep value is attractive, sometimes growth at a reasonable price.? Good managers analyze where the best value is, regardless of non-economic factors.
But if you have to cram me into the style box, fine, I am a midcap value manager that buys a few foreign stocks.? But there is a huge loss in constraining intelligent investors through the style box.? The better a manager is, the more one should ignore non-economic distinctions, and let him perform.
Some people don’t like the concept of blame.? They view it as useless because it wastes time in looking for a solution.? I will tell you differently.? Blame is useful because it identifies offenders, which is the first step in eliminating the problem.? The trouble is that few have the stomach to get rid of the offenders.
So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.? This was a good discussion, unlike many that I hear.? But the discussion (on NPR) eventually focused on “who should we blame?”? Okay, here is my incomplete version of who we should blame:
1) The Federal Reserve, especially Alan Greenspan.? For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.? Rates were reduced before significant pain was felt by those who had borrowed too much.? The 1% Fed funds rate in 2003 was the pinnacle of that effort.? It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.
2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:
a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.? Gotta do that.? Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.? They compromised lending standards more and more, along with private lenders as the boom went on.
b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.? The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.? Ginormous bust — how many large standalone investment banks are left?
c) Particularly the Democrats in Congress defended the GSEs as their own pet project.? I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.
d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.? There is no good reason for these measures.
e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.? Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).? In that case you must restrain the growth of credit.
f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.? Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.
g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.? Hucksters.
3) Lenders steered borrowers to bad loans.? There was often implicit fraud, and in some cases, fraud.? The lenders paid their staff to do it.
4) Borrowers were lazy and greedy.? What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?? Regardless of the housing price mania, you should have gone slower, and done more homework.? Caveat emptor — you neglected that.
5) Appraisers were slaves of the lenders who wanted to originate and sell.
6) Those that originated MBS did not check the creditworthiness adequately.? They just sold it away.? Investment banks did not care where a profit was coming from in the short run.
7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.
8) Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.
9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.
10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.? They entered into businesses that would not survive difficult times.
11) Regulators let themselves be compromised by those following the profit motive.? Many hoped to make money after joining private industry later.
12) America.? We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.
13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.? This made our interest rates too low, encouraging overinvestment and overconsumption.
14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.? Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.
15) Auditors that did a cursory job auditing financial entities.? As the boom went on, standards got lower.
16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.? In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.
17) Pension and other funds that believed the academics.? It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.? Capitalistic economies are unstable by nature!? Why should we expect certain strategies to workallo the time?
18) Governmental entities that happily expanded government programs as the boom went on.? Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.? Governments should not rely on increased taxes from capital gains, or real estate tax assessments.
19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.? It is hard to write about what could go wrong in the markets.? Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.? The system is biased in favor of happy talk.? Just watch CNBC.
20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.? Maybe our financial interests made us look like we were talking our books.? I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.? Now I am getting my just desserts.
This is an incomplete list.? I invite you to add others to the list in your comments.
I read your blog frequently, and I always find it very insightful and realistic, and without invective, which is refreshing. I’d like to pose a question to you, to which?you can probably provide a good answer.
Given the current pessimistic mood of the U.S. economy and financial markets, I’ve been trying to figure out where the light at the end of the tunnel will be for U.S markets. But I get stuck at this point: Baby Boomers retiring.?Their portfolios are the ones that have grown over the past 30+ years, and they will soon be drawing upon those savings as a source of income?at a steady rate, and one that allows them to live at similar quality of life as when they retired. I have read plenty (I think) on the current state of Social Security, but I’ve seen nothing on the private pillar of retirement.
This future, steady drawdown?must have some effect on U.S. equity markets, correct??Enough to keep markets moving sideways? Downwards for the long-term?
As an early 30-something who has been financially responsible (no consumer debt, no mortgage, high savings rate), I’m trying?to figure out what might?happen to my savings long-term, and how heavily a portfolio should be weighted?with U.S. securities.
Could you possibly point me in the right direction where I can find some?literature or statistics?on how Boomer’s retirements will affect U.S. markets?
So went a recent question from one of my readers.? I’ve been studying this topic for 20 years, and writing about it for 15 years.? The questions are difficult, and the answers are not clear.? Let me point you to one thing that I have written on the topic: Society of Actuaries Presentation.
The US is bad off demographically, but most of the rest of the world is worse off.? The US has a problem because it has not been saving, but that is largely because much of the rest of the world is neo-mercantilist, and is subsidizing export industries, and the US buys.
Remember the lesson of the mercantilist era: the consumers won.? Those that tried to get gold got gold, and at a high cost in terms of other goods.? In the same way, the neo-mercantilistic nations are sucking in dollars that are worth less and less.? On page 32 of my presentation, it is amazing that the net debt position of the US has been flat, because our debts are worth less dur to the decline of the dollar.? What a boon it is to be the world’s reserve currency.
Now, as for the “retirement” of the Baby Boomers: there will be some stagnation in our equity markets to the degree that retirement causes liquidation of assets.? That said due to low savings rates, it is quite possible that retirement dates will be extended for most Baby Boomers.? They will need to labor longer, and they should do so, after all, at age 65 the average retiree is not within ten years of death.
To the extent that this causes labor shortages, the US will see greater employment prospects for its people.? In Japan that seems to be happening now.? But America welcomes immigrants (legal or illegal) in a greater way than most countries do.? That will mute any gains for unskilled labor in the US.
My advice for you is to look at global demand.? Rather than looking at investing with countries as a first screen, consider it through the lens of industries.? Look to which industries are benefiting from increased global demand, and if they are at reasonable valuations, buy them.
I know this is not a full answer, but it is the best medium-to-short answer that I can give you.
Pensions are complicated.? Necessarily so, because of the wide numbers of parties involved, and the contingencies involved (mortality, morbidity, asset returns, insolvency) over a long period of time.? Anyone who has had a cursory look at the math (or regulations) behind setting pension liabilities, contributions, etc., knows how tough the issues are, and why real experts need to handle them.
I’ve worked at the edge of the pension business for much of my career.? I have designed defined contribution plans, created stable value products, done asset allocation for defined benefit [DB] plans, terminal funding, and other incidentals.? That said, I am a life actuary [FSA], not a pension actuary [EA].
Tonight’s main issue revolves around a good article by the estimable Matthew Goldstein of Business Week.? Steve Waldman, filling in at Naked Capitalism, commented on the article as well.
Here’s my take: it is legal today for companies to shift their pension liabilities to life insurance companies in the Terminal Funding business.? All they have to do is send a description of the liabilities of the plan to the dozen or so companies that are in the business with adequate claims paying ability ratings, and the companies will send back an estimate of what they would require as a single premium payment to take on the liabilities.? Low bidder wins (and loses — he mis-bid).
So, why don’t plan sponsors take the life insurers up on this?? Easy.? The cost of buying the annuities from the insurers is more expensive than the amount of assets in the trust.? For those companies that are overfunded, they don’t care to terminate — it is a great benefit for their employees.
Terminal funding was most common in the late 80s, when companies could terminate DB plans, and any excess assets would revert to the company.? Then the law changed, and most excess assets would be taken by the Federal Government.? Another reason why overfunded plans do not terminate — the excess assets are valuable to the plan sponsor, but are trapped assets.? They are valuable because they give flexibility, and reduce future contributions.
Why is it more expensive to buy annuities from insurance companies than the assets on hand in the trust?
The main reason is that the plan sponsor gets to assume the rates he will earn on plan assets (within reason).? That rate will almost always be higher than the rate that an insurance company can invest at after expenses.? Pension funding rules are significantly more liberal than life insurance reserving and risk-based capital rules.
Insurers must mainly invest in bonds, whereas pension funds can invest in any asset class, subject to the prudent man rule.
Insurers must keep surplus assets to keep the company sound through downturns.? Pension plans have no such requirement.
Insurance companies have profit margins and overhead that pension plans do not.
Often there are funky, hard-to-value benefits in the pension plan.? Subsidized early retirement is the simplest of those.? The insurance companies don’t have a good way of pricing them, so they toss out some guesses.? Often the winner is the one that ignored the cost of the odd ancillary benefits.
Now, for a proposal from the Treasury to be effective, they somehow have to wave their hands at the issues that I just put forth.? Even if they allow other regulated financial companies to take over pension plans, they have the following issues:
Who is responsible for shortfalls?
Does the company taking over the plan have to put in some subordinated capital to give them “skin in the game.”? (Essentially, the life insurers have to do that today.)
How do profit incentives work?? Do they accrue inside the plan as a buffer against shortfalls, or do excess earnings (however defined) get immediately? or over time paid to the buyer of the pension liabilities?? (You can guess what the liability buyers want.)
How do underfunded plans get transferred compared to adequately funded plans?? Hopefully the plan sponsors of the underfunded plans have to pony up to fund them at levels that are adequately funded, then they can transfer them.? It would be a sham to transfer underfunded plans to an entity that says that can fund the plans because they have an ultra-aggressive investment strategy.? The blow-up will leave behind even bigger deficits.
Call me a skeptic here, while I call the head of the PBGC a Pollyanna.? To Bradley Belt: If you think this will solve your underfunding/insolvency problems, think again.? Only through high risk investment strategies succeeding can all of the underfunding be invested away.? Ask this: how would you feel today if the plan sponsors of underfunded plans all adopted highly risky investment strategies?? You would worry.? Well, unless the liability buyers have skin in the game, you will worry just as much after the sale of liabilities.
Sometimes I think politicians/bureaucrats believe in magic.? Some little tweak, a loosening of regulations, and poof!? The problem goes away.? It is rarely that simple, particularly when you are dealing with the math and complexities of long term compound interest, which in my opinion are inexorable.? (Kind of the inverse of compound interest being Einstein’s eighth wonder of the world — it is a wonder when you are compounding assets looking forward, without liabilities to fund, but when your discounted liabilities are greater than your assets, my but that eighth wonder of the world fights you fiercely.)
Now, I’m not going to discuss this at length, because I am getting tired, but the Wall Street Journal had another pension article this week.? A good article, and I must say that I don’t get how the practices described are legal.? The anti-discrimination rules were put into place to deter this issue.? Why they are not enforced here is a mystery to me.? Regulated pension plans should not be able to invest in the debts of non-regulated pension plans.? To allow anything else, is to make a mockery of the regulations.? (Another reason why regulated and non-regulated financials should be separated.)? The Treasury has anti-abuse rules that they can invoke against such practices.? Why don’t they use them?
My guess is that the Bush administration doesn’t care about the issue.? Perhaps the next President will care more.? And, with respect to the sale of pension liabilities, my guess is that that gets left to the next President and Congress, who will not allow the practice as proposed.
PS — One last note: what would be fair, if pension liability buyouts are allowed, is to allow participants the option to roll their net assets into a rollover IRA.? Back in the 80s, many people got burned by less than creditworthy companies who bought their pension liabilities and went belly-up themselves.? It is a normal aspect of contract law that you can’t take a debt and transfer it to another party unilaterally, unless the creditor consents.? So it should be in pension liability transfers.
A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.
Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.
Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.
As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.
I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.
Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.
That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.
Position: none
I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?
The Investor Base Becomes Fundamentally-Driven
1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.
2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.
3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.
4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.
5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.
6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.
7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.
8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.
9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.
10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.
11) Value investors find no lack of promising ideas, only a lack of capital.
12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.
14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
8 ) High quality companies keep buying back stock, not aggresssively, but persistently.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
12) Value investors find no lack of promising ideas, only a lack of capital.
13) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
14) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot — e.g. money market funds, collectibles, gold, real estate — they chase the next trend in search of easy money.
15) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don’t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying “So what else is new?”
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn’t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don’t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me in the game in 2001-2002. I hope that I — and you — can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company — it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
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That’s all for this post.? After comments are in, I will reformat the piece as one post and republish it.
1) Going back to one of my themes, be wary of companies that sell their best assets to bail out their worst assets.? Tonight’s poster child is GM.? How to get cash?? Borrow against the remainder of GMAC, foreign subsidiaries (most promising part of the corporation), etc.? Not a promising strategy.? As I have said many times before GM common is an eventual zero.? Same for Ford.? All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.
2) So where does GM cut expense?? White collar retiree medical care.? This is rarely guaranteed, except to unions, so it is legal to cancel it.? A word to those whose corporations or state/municipal employers presently have retiree medical care.? It is worth your while to find out whether there are guarantees of coverage or not.? If there aren’t, I can assure you that it will be terminated in the next ten years.? If there are guarantees, then you need to see whether there are standards of care guaranteed, and whether the plan sponsor has the wherewithal to make good on his promises.
One more prediction: many states and municipalities will devise clever ways to escape guarantees over the next 20 years.? That will include Chapter 9 of the bankruptcy code.
3) Note to the SEC, not that the powers-that-be read me: if you’re going to require a contract to borrow shares in order to short for a bunch of financial companies, then require it for every company, now.? Shorts are not the problem.? Failure to properly locate and borrow shares is a problem.? Let there be a level playing field in shorting, and let the investment banks that are lending out more than they have suffer.? (Ironic, huh, ‘cuz they are the ones complaining…)
4) Note to the new management of AIG: please do the following: a) locate lines of business with low ROAs and significant borrowing for funding in order to achieve high ROEs.? b) Close down those lines.? Possible areas include GIC-MTN programs, and life insurance generally.? c) Take a page out of Greenberg’s early playbook, and exit lines, or sell off divisions where it is impossible to achieve superior ROEs.? (I can see American General re-emerging, with SunAmerica in tow!)
First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don’t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.
Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn’t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO’ed it rather than spinning it off to shareholders…
But here’s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)
Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.
Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.
Position: none, and I have never understood the attraction to GE as a stock
6) One to think about: if US Bancorp is having a bad time of it, shouldn’t most large banks be having a worse time of it?? I spent a little time this evening reviewing the prices of junior debt securities of marginally investment grade banks (and a few mutual insurers, also).? The pressure on marginal financial institutions bearing credit risk is huge.
7) Speaking of junior debt securities, Moody’s gave the GSEs, and the US Government a shot across the bow when it downgraded the preferred stock ratings of Fannie and Freddie.? With the fall in the common and preferred stock prices, any possiblity of private capital raising fades.? The Administration and Congress should realize that whatever flexibility/help they grant the GSEs will be taken, and quickly.? Budget for the worst case scenario.
8) Then again, Ackman’s plan to restructure the GSEs, which is similar to mine (given in the last week), is reasonable.? Leverage is reduced and a market panic is avoided.
9) But even if neither plan is implemented, the dividends may be cut for the GSEs common stocks.? Shades of GM.? What is more significant, is if the GSEs feel they can’t issue preferred stock at acceptable yields, maybe they will omit those dividends as well.
10) Now, in the midst of expensive bailout talk, is there a cost imposed on the US?? Yes.? The dollar is weak, and default swaps on US government debt are rising in yield.? (Thought: how do swaps on US government debt pay off?? Hopefully not in dollars…? Also, what qualifies as an event of default?? Inflation doesn’t count, most likely, and yet that is one of the main ways for a government to try to escape debt.
11) Socialism!? Is the bailout socialism? Even for a libertarian like me, I can justify a bailout like Ackman’s, because it hurts those that tried to profit from the public/private oligopoly.? But no, I can’t justify what Paulson is trying to do, and maybe, just maybe, the market is sending him a message that half-measures won’t work.
12) More on preferred stocks.? They have been crushed.? This reinfirces why I rarely recommend preferred stocks, or junior debt securities: the payoff is low in success, and losses are high when things go wrong.
13) Let me get this straight.? You trusted Wall Street on an implicit guarantee?? You didn’t get a formal guarantee in writing?? Oh, my, it happens every decade… implied promises fail, and the cold, hard, printed text governs.? “Yes, that could technically be called, but don’t worry, they never do that.” “AAA insurance obligations never fail.”? “Portfolio insurance will protect you; you don’t have to buy puts.”? Never trust implicit promises of Wall Street, because in a real crisis, they go away.
14) Looking over some of my indicators, it looks like we are close to a bounce.? It feels a lot like January of 2008.? So, is it time to buy??? I’m not sure, but I am adding little by little to my stockholdings.? I’m probably going to up the equity percentage in some of my accounts where I have few options (old job Rabbi Trusts).
15) Not that I am likely to liquidate 401(k) assets, or anything like it.? That some are doing so is a sign of the stress that we are under.? Don’t do it, if you can avoid it.? Better, perhaps, to take in a boarder.? It increases cash flow on an underused asset, and optimally, increases community relations.
A word before I start: I’m averaging two book review requests a month at present. I tell the PR people that I don’t guarantee a review (though I have reviewed them all so far), or even a favorable review. They send the books anyway.
Included in every book is a 2-6 page summary of what a reviewer would want to know, so he can easily write a review. Catchy bits, crunchy quotes, outlines…
I don’t read those. I read or skim the book. If I skim the book, I note that in my review. Typically, I only skim a book when it is a topic that I know cold. Otherwise I read, and give you my unvarnished opinion. I’m not in the book selling business… I’m here to help investors. If you buy a few books (or anything else) through my Amazon links, that’s nice. Thanks for the tip. I hope you gain insight from me worth far more.
If I can keep you from buying a bad book, then I’ve done something useful for you. I have more than enough good books for readers to buy. Plus, I review older books that no one will push. I hope eventually to get all of my favorites written up for readers.
Enough about my review process; on with the review:
When the PR guy sent me the title of the book, I thought, “Oh, no. Another investing formula book. I probably won’t like it.” Well, I liked it, but with some reservations.
The authors are a father and son — Gerard Appel and Marvin Appel, Ph. D. They manage over $300 million of assets together. The father has written a bunch of books on technical analysis, and the son has written a book on ETFs.
Well, it is an investing formula book… it has a simple method for raising returns and reducing risks that has worked in the past. The ideas are simple enough that an investor could apply them in one hour or so every three months. I won’t give you the whole formula, because it wouldn’t be fair to the authors. The ideas, if spun down to their core, would fill up one long blog post of mine. But you would lose a lot of the explanations and graphs which are helpful to less experienced readers. The book is well-written, and I found it a breezy read at ~200 pages.
I will summarize the approach, though. They use a positive momentum strategy on three asset classes — domestic equities, international equities, and high yield bonds, and a buy-and-hold strategy on investment grade bonds. They apply these strategies to open- and closed-end mutual funds and ETFs. They then give you a weighting for the four asset classes to create a balanced portfolio that is close to what I would consider a reasonable allocation for a middle aged person.
Their backtests show that their balanced portfolio earned more than the S&P 500 from 1979-2007, with less risk, measured by maximum drawdown. Okay, so the formula works in reverse. What do we have to commend/discredit the formula from what I know tend to happen when formulas get applied to real markets?
Commend
Momentum effects do tend to persist across equity styles.
Momentum effects do tend to persist across international regional equity returns.
Momentum effects do tend to persist on high yield returns in the short run.
The investment grade buy-and-hold bond strategy is a reasonable one, if a bit quirky.
Keeps investment expenses low.
Gives you some more advanced strategies as well as simple ones.
The last two chapters are there to motivate you to save, because they suggest the US Government won’t have the money they promised to pay you when you are old. (At least not in terms of current purchasing power…)
Discredit
The time period of the backtest was unique 3/31/1979-3/31/2007. There are unique factors to that era: The beginning of that period had high interest rates, and low equity valuations. Interest rates fell over the period, and equity valuations rose. International investing was particularly profitable over the same period… no telling whether that will persist into the future.
I could not tie back the numbers from their domestic equity and international equity strategies in the asset allocation portfolio to their individual component strategies.
I suspect that might be because though the indexes existed over their test period, tradeable index funds may not have existed, so in the individual strategy components they might be done over shorter time horizons, and then used indexes for the backtest. This is just a hypothesis of mine, and it doesn’t destroy their overall thesis — just the degree that it outperforms in the past.
They occasionally recommend fund managers, most of whom I think are good, but funds change over time, so I would be careful about being married to a fund just because it did well in the past.
If style factors or international regional return factors get choppy, this would underperform. I don’t think that is likely, investors chase past performance, so momentum works in the short run.
Though you only act four times a year, that’s enough to generate a lot of taxable events if you are not doing this in a tax-sheltered account.
It looks like they reorganized the book at the end, because the one footnote for Chapter 9 references Chapter 10, when it really means chapter 8.
The Verdict
I think their strategy works, given what I know about momentum strategies. I don’t think it will work as relatively well in the future as in the past for 3 reasons:
There is more momentum money in the market now than in the past… momentum strategies should still work but not to the same degree.
International investing is more common than in the past… the payoff from it should be less. There aren’t that many more areas of the world to go capitalist remaining, and who knows? We could hit a new era of socialism abroad, or even in the US.
Interest rates are low today, and equity valuations are not low.
Who might this book be good for? Someone who only invests in mutual funds, and wants to try to get a little more juice out of them. The rules on managing the portfolio are simple enough that they could be done in an hour or two once every three months. Just do it in a tax-sheltered account, and be aware that if too many people adopt momentum strategies (not likely), this could underperform.
Full disclosure: If you buy anything from Amazon after entering through one of my links, I get a small commission.
I’ve written about “the lost decade” before at RealMoney.? A lost decade is where? the stock market goes nowhere, or loses money for ten years.? My purpose in doing so was to point out:
That it is normal for lost decades to occur.? Stock returns are weakly autocorrelated.? Good years tend to be followed by good years, and bad years by bad years.
Once a generation, you have to get a severe boom and a severe bust.? It is partly driven by monetary policy/financial regulation laxity, followed by tightness.? It is partly driven by the fear/greed cycle, because most people, even professional investors, chase performance.
This has a chilling effect on retirement planning.? Recall my recent article on longevity risk.? In that article, I tried to point out the similarities for retirement investment planning between Defined Benefit plans, and an individual with his own unique retirement circumstances, typically with defined contribution plans.
I’ll amplify the last point, because the WSJ doesn’t do much with it.? Nothing kills a DB plan’s funding level worse then a protracted flat/falling equity market, and low bond yields (showing not much alternative for reinvestment).? Same for an individual financial plan.? If a DB plan has an assumed earnings yield of 8%, and the stock market earns zero, and bonds earn 5%, with 60/40 stocks/bonds, than plan earns 2% when it needs 8%.? The funding deficits grow rapidly, and corporations finally bite the bullet, and begin making contributions to their DB plan, cutting earnings in the process.
As for individuals, they should start to save more for their retirements after such a long bad market, in order to get their retirement funding back on track.? Oops, wait.? This is America.? We don’t save personally (particularly Baby Boomers), and our governments run deficits (even more on an accrual basis when we look at Medicare, Social Security, and other long-term inadequately funded programs.? Only our corporations save on net.
So, what to do?
Save more.
?Don’t materially increase or decrease allocations to stocks.? Things may be rough for a while longer, until excesses in the US financial system and in China are worked out, but positive returns will recur.
Avoid investing in companies with large pension funding deficits.
Avoid investments with high embedded leverage, whether individual companies, or ETFs.
Be wary of investing in esoteric asset classes this late in the performance cycle.? They may do well for a while longer, but their time is running out.? (It could be one year or another decade.)
Be ready for increasing inflation.? Even with the income giveup, it is probably wise to have bond durations shorter than the benchmark.
To the extent you can, push back retirement, or plan that you will do it in phases, where you slowly leave the formal labor force.
Of course, you could be a good stock picker, but that’s not a common gift.? The choices are hard when we have a “lost decade.”? There’s no silver bullet; only ways to mitigate the pain.
.) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
A word before I start: I’m averaging two book review requests a month at present. I tell the PR people that I don’t guarantee a review (though I have reviewed them all so far), or even a favorable review. They send the books anyway.