I have a friend who works for the Williams Inference Service.  Those who work for WIS spend their time looking for deep trends in our world that are underappreciated.  I dedicate a little of my time to that as well, and try to draw investable conclusions from odd bits of data that come across my radar.  But even without explicit conclusions, it richens my knowledge of our world, and perhaps with other data, will yield some return for me.  If nothing else, I love reading and writing, so join with me on this tour of articles around the web.

1. I’m not sure if pollution problems in China are any worse than the problems faced by the US or the UK at similar points in their development.  That said, one major constraint on their ability to grow is pollution.  These articles from the Wall Street Journal are an excellent example of that: heavy metals in the food supply, and lead in jewelry that they sell domestically and export, with the lead coming from US scrap metal.  These practices may allow businesses to survive in the short run, but soon enough, jewelry will get tested in the US, and importers sued for liability.  In China, there will be increasing pressure for change, perhaps even violent change.  In Chinese history, there is a tendency for change not happen, or to happen rapidly when troubles for average people become too great.
2. Demographics is a favorite topic of mine, particularly as the world slowly heads into a shrinking population.  For the most part, national economies don’t work so well when population levels shrink, which leads to pressure to import low skilled laborers from nations with surplus workers.  One nation that is at the front of the problem is Japan, where the population is shrinking pretty rapidly today.  Japan is now seeing that its pension system will be hard to sustain because of the lack of children being born.  Europe will face this problem as well.  The US less so, because of the higher birth and immigration rates; for us, the foreign debt will be our problem.
3. Is war with Iran a done deal in a few years?  I hope not.  Given the mismanagement of the Iranian economy in the hands of the cronyist mullahs that run the joint, and the genuine difficulty of producing effective nuclear weapons without a strong academic/technical/manufacturing base, my guess is that there will be another revolution there before a significant bomb gets made.  (We’re still waiting on North Korea; what a joke.)  Economically, Iran is a basket case.  As I have mentioned before, they have mismanaged their oil resources.  What is less noticed is their coming demographic troubles.  Not all Muslims are fanatics, and many are having small families, which will generate it’s own old age crisis thirty years out.  That said, if Iran is provoked, it’s leaders will not give in; they iwill fight, as the second article i cited points out.  Better to quietly hem the current Iranian leadership in by supporting their enemies, than to risk another war that the US does not have the resources to fight.  Iran is weaker and more divided than it looks; its government will fall soon enough.
4. Memo to all quantitative investors: are you ready for IFRS?  IFRS, the European accounting standard, particularly for financials will change enough things that older formulas of calculating value and safety may need to be severely modified.  The larger the importance of accrual items to an industry, the worse the adjustment will be.  All I say is, watch this.  If it changes, it will affect the way that we numerically analyze investments.  We are definitely losing foreign economies on our exchanges, mainly due to Sarbox, not accounting rules, but I think we are rushing through a compromise with IFRS to protect the interests of our exchanges, and I think that is a mistake.
5. Then again, maybe we don’t need the Europeans to mess up our accounting rules; we can do just fine ourselves.  Our accounting standards are a hodgepodge between amortized cost and fair value standards… we keep moving more and more toward fair value, but will the auditors be able to keep up?  Auditing amortized cost is one thing; there are different skills required when fungible but not liquid assets can be written up on a balance sheet. (Think about real estate or mortgage derivatives.)  Accounting will become less reliable in my opinion.
6. I wish we had a harder currency; why else do I buy foreign bonds?  Anyway, I appreciated this short partial monetary history of the US, from the Civil War onward, from Elaine Meinel Supkis.
7. When you can’t deliver the underlying, typically futures markets don’t work well.  It is no surprise then that a derivatives market on economic indicators closed.  Futures markets exist to allow commercial interests to hedge.  Where there is nothing to hedge, it is akin to mere betting, and without the extra thrill of a sports contest, that rarely attracts enough interest to be economic.  That said, aren’t the VIX futures and options contracts catching on?
8. Not sure what the second order effects will be here, but a rule is finally coming that will require the trade execution occur at the best price.  It will be extra work for the exchanges, but it will probably centralize exchanges in the intermediate term.  If you have to share data, why not merge?
9. One reason that Buffett was/is that best was his ability to learn from mistakes.  He kept his mistakes small and eventually found ways out of many of them.  US Air?  Salomon Brothers?  He eventually gets cashed out.  General Re?  The earnings from investing float bails him out. The “Shoe Group” and World Book?  Small, and you can’t win them all.
10. What do you do when the market has passed you by?  You got burned 2000-2002, and moved to a more conservative posture, only to find that the market ran like wild while you weren’t there.  What do you do now?  My advice: do half of what you would do if the market hadn’t run.  If you are at 20% equities, and you know that in normal times you should be at 60% equities, raise your investment level to 40% equities.  If the market rallies, you have more on, if it falls, you will have the chance to reinvest another 20% into equities at more attractive prices.
11. I usually agree with Eddy Elfenbein; he’s very common sense.  But here I do not.  Get me right here, Eddy is correct in all that he says.  I frame the problem differently.  You have someone sitting on cash, and the market has appreciated to where valuations are high-ish.  You can  1) invest it all now, 2) dollar cost average, or 3) do nothing.  Eddy doesn’t consider that many will choose 3.  On average, 1 beats 2 by a small margin, but 2 beats 3 by a wide margin.  Dollar cost averaging is a way to get psychologically unprepared people into the market who would never risk putting it all in at once.  We use DCA to get inexperienced investors from a bad place to a “pretty good” place, because the best place is unimaginable to them.
12. Desalination is the wave of the future, even in the US.  Potable water is scarce globally (think of India and China), and the cost of potable water justifies the energy and other costs associated with desalination.  The article that I cited does not capture the environmental costs of desalination, in my opinion, but it gives a good taste of what the future will hold.

And, with that, that completes my tour of the periphery.  Next week, I hope to provide more color for you on our changing risk environment.

Recently there has been a discussion of the so-called “Fed Model,” with some questioning the validity of model, and others affirming it. Even the venerable John Hussman has commented on models akin to the Fed Model that he dislikes. This piece aims at taking a middle view of the debate, and explain where the Fed Model has validity, and where it does not.

What is the Fed Model?

The Fed Model is a reasonable but imperfect means of comparing the desirability of investing in stocks versus bonds. It can be considered a huge simplification of the dividend discount model, applied to the market as a whole, rather than an individual stock. The dividend discount model states that the value of the stock is equal to the future stream of dividends discounted at the corporation’s cost of equity capital.

What simplifying assumptions get applied to the dividend discount model to create the Fed Model?

1. The market as a whole is considered rather than individual stocks.
2. A constant ratio of earnings is paid out as dividends.
3. The growth rate of earnings is made constant.
4. A Treasury yield (or high/moderate quality corporate bond yield) is substituted for the cost of equity capital.
5. Instead of following a strict discounting method, the equation is rearranged to make an explicit comparison between bond yields and equity yields.

Assuming that the dividend discount model is valid, or at least approximately so, what do these simplifying assumptions do to the accuracy of valuing the market as a whole? The first assumption is more procedural in nature, and does no major harm. The fifth assumption simply reorganizes the equation, and doesn’t affect the outcome, but only the presentation. The real changes come from assumptions 2-4.

Dividends are more stable than earnings, so the payout ratio certainly varies over time. Additionally, corporations have shown less willingness to pay dividends, and investors have shown less inclination to demand dividends, to the payout ratio today is roughly half of what it was in the early 60s.

Earnings don’t grow at a constant rate, either. Over the last 53 years, earnings have grown at a 6.7% rate, but that has included times of shrinkage, and boom times as well.

As for the cost of capital to a corporation, I believe that the Capital Asset Pricing Model is genuinely wrong, and I refer you to Roll’s famous critique for what should have been its burial. Academics need risk to be something simple though, with risk being the same for all investors (not true), so that they can easily calculate their models, and publish. The CAPM provides useful, if mistaken, simplification to financial economists. It is not going away anytime soon.

One day I will write an article to explain my cost of equity capital methods in more depth, which derive corporate bonds and option pricing theory. In basic, for any corporation, the basic idea is to compare the riskiness of the equity to that of a bond. Look at the yield on juniormost debt security of the firm, the cost of equity is higher than that. Examine the implied volatility [IV] on the longest dated at the money options for the firm. How do those implied volatilities compare with other firms? In general the higher the IV, the higher the cost of equity capital.

Practically, when looking at the capital structure of the firms in the S&P 500, I think that the yield on a BBB bond plus a spread could be a good proxy for the weighted average cost of capital for the firms as a group. I’ll get to what that spread might be in a bit. We have BBB yield series going back a long way. Equity risk for the S&P 500 (a high credit quality group) is probably akin to the risk of owning weak BB or strong single-B bonds on average. (My rule of thumb for cost of equity capital in an individual corporation is take the juniormost debt yield and add 3%. For those with access to RealMoney, I have written more on this here.)

To summarize then: there’s not much I can do about assumptions 2 and 3. The only thing I might say is that earnings are a better proxy for value creation than dividends, and that expectations for longer-term earnings growth do not change nearly as much as actual earnings growth does. On assumption 4, a BBB bond yield plus a spread will be a reasonable, though not perfectly accurate proxy for the cost of equity. My view is that spread should be between 2.5%-3.0%.

The Results

With that, the “Fed Model” boils down to a comparison of BBB bond yields less a spread versus earnings yields. Wait, “less” a spread? Didn’t I say “plus” above?

Let’s consider how a stock differs from a bond. With a bond, all that you can hope to get is your principal and interest paid on a timely basis. With equity, particularly in a diversified portfolio, one can expect over the long term growth in the value of the business from a growing dividend stream, and reinvestment of retained earnings. As I mentioned above, that has averaged 6.7%/year earnings growth over the past 53 years.

If I were trying to balance the yield needed from bonds to compete with equities, it would look like this, then:

Earnings Yield + 6.7% = BBB bond yield plus 2.5-3.0%

Or,

Earnings Yield = BBB bond yield - 4% (or so)

Here is how earnings yields and BBB bond yields have compared over the years.

Thus my criteria for investing would be under the “Fed Model,” when the earnings yield is more than 4% less than the BBB bond yield, invest in bonds. Otherwise, invest in stocks. Following this method, how would a portfolio have done since 1954?

Wow. Pretty good rule, in hindsight. Is the spread of 4% the best spread for simulation purposes?

Pretty close. The optimum value is 3.9%. This chart uses an actuarial smoothing method to give a fairer view of noisy historical results. (Life actuaries use this smoothing method in cash flow testing to calculate required capital, because sometimes small changes in spread produce large differences in the results for a particular scenario.)

The strategy produces a return roughly 2.0%/year higher than investing in stocks only, with a standard deviation roughly 1.5%/year lower. At least in a backtest, my version of the “Fed Model” works.

Limitations

Okay, given the above, I endorse my version of the “Fed Model” as being useful, but with five caveats:

The first thing to remember is that the “Fed Model” doesn’t tell you whether stocks are absolutely cheap, but whether they are cheap versus bonds. There may be other more desirable asset classes to choose from: cash, commodities, international bonds or equities, etc.

The second thing to remember is that when interest rates get low, yields do not reflect the true riskiness of bonds – a slightly superior model would be 107% of BBB yields less 4.7%. But that could just be an artifact of backtesting. To its credit though, the slightly superior model behaves the way that it should in theory, in term of how credit spreads move.

Number three, ideally, all models would not use trailing earnings yields, but expected earnings yields. That said, trailing yields are objective, and expected yields have often proiven wrong at turning points.

The fourth limitation: a high earnings yield might reflect low earnings quality or profit margins higher than sustainable. No doubt that is possible, and particularly in the current era. On the flip side, there may be times when a low earnings yield might reflect high earnings quality or profit margins lower than sustainable. A rule is a rule, and a model is only a model; they don’t reflect all aspects of reality, they are just tools to guide us.

What P/E ratio would the current BBB bond yield (6.74%) support? I am surprised to say that it would support a P/E in the high 30s; 39.8 for the simple model, and 35.2 for the “slightly superior” one. With the current trailing P/E at 18.1, that would indicate that on an unadjusted basis, the market could be twice as high as it is presently.

That thought makes me queasy, but here three other ways to look at it:

• How inflated are profit margins? If they are going to regress by less than half, then stocks are still a bargain.
• Are bond yields/spreads too low? The recycling of the current account deficit into US debt instruments keeps yields low, and the speculation in the credit markets keeps spreads low. What should be the normalized BBB yield?
• Will earnings growth slow beneath the 6.7% average? If so, the spread needs to come down.

Fifth, this is simply a backtest, albeit one that conforms to my theories. The future may not resemble the past.

Conclusion

My version of the Fed Model provides us with a way of comparing corporate bond yields with earnings yields, giving credit for growth that happens in capitalist economies that are free from war on their home soil. There are reasons to think that current profit margins are overstated, and perhaps that corporate bond yields will rise. All of that said, there is a large provision for adverse deviation in the present environment.

I would rather be a moderate bull on stocks versus bonds in this environment as a result. Don’t go hog wild, but current bond yields are no competition for stocks at present. If you think bond yields will normalize higher, perhaps cash is the place you would rather be for now.

Bond investors and value investors tend to be cautious in investing. It is possible to be too cautious, though, and so sometimes it pays to lay out the bull case. Indirectly, I learned this after several years of sitting next to the high yield manager at Dwight Asset Management (a very good firm that few know about). He wasn’t unconcerned about negative developments, but knew that fewer bad things happen than get talked about, and that they tend to take longer to happen than most imagine. He knew that he had to take some risks, because if you wait for the market to correct before you enter, you will miss profits while waiting, and the correction could be a long time in coming.

Also, I fondly remember our weekly economic conference calls in 2002, where the high yield manager and I would take the bull side in the discussions. For me it was fun, because it was so unlike me (I tend to be a bear), and it helped me to learn to balance the risks, and not be a perma-bull or a perma-bear.

So with that, here’s my quick list on what is going right in this environment:

1. Earnings yields are higher than bond yields, particularly among many investment grade companies, fostering buybacks and occasional LBOs. Profit margins may mean-revert eventually, but it might be a while for that to happen, given the global pressures that are keeping wage rates low.
2. The financing of the US current account deficit is still primarily being done through the purchase of US dollar denominated debt securities, keeping interest rates low in the US. This may shift if enough countries experience inflation from the buildup of US dollar reserves that they do not need, and allow their currencies to appreciate versus the US dollar. That hasn’t happened in size yet.
3. ECRI’s weekly leading index continues to make new highs.
4. Money supplies are growing rapidly around the world. Most of the paper is creating asset inflation, rather than goods inflation so far.
5. Bond yields have moderated since the yield peak in mid-June. Spreads on corporate investment grade debt have not widened much. Financing is cheap for the creditworthy.
6. Short sales are at a record at the NYSE. Part of that is just the influence of hedge funds.
7. Vulture investors have a lot of capital to deploy. Marginal assets are finding homes at prices that don’t involve too much of a haircut. (I’m not talking about subprime here.)
8. On a P/E basis, stocks are 45% cheaper than when the market peaked in March 2000.
9. Sell-side analysts are more bearish than they ever have been.
10. Investment grade companies still have a lot of cash sitting around. The washout from 2000-2002 made a lot of companies skittish, and led them to hold extra cash. Much of the cash has been deployed, but there is still more to go.
11. The FOMC is unlikely to tighten before it loosens.
12. Yield-seeking on the part of older investors is helping to keep interest rates low, and the prices of yield-sensitive stocks high.
13. DB Pension plans and endowments are still willing to make allocations to private equity.
14. The emerging markets countries are in aggregate in better fiscal shape than they ever have been.
15. Trade is now a global phenomenon, and not simply US/Europe/Japan-centric.
16. The current difficulties in subprime are likely to be localized in their effects, and a variety of hedge funds and fund-of-funds should get hit, but not do major damage to the financial system.

Now, behind each of these positives is a negative. (Every silver cloud has a dark lining?) What happens when these conditions shift? Profit margins fall, interest rates rise, inflation roars, risk appetites decrease, etc?

These are real risks, and I do not mean to minimize them. There are more risks as well that I haven’t mentioned. I continue to act as a nervous bull in this environment, making money where I can, and realizing that over a full cycle, my risk control disciplines will protect me in relative, but not absolute terms. So I play on, not knowing when a real disaster will strike.

Editing note — my apologies.  The second paragraph omitted the word “not” in the original publication.  What a word to omit, not.   

The Efficient Markets Hypothesis in its semi-strong form says that the current market price of an asset incorporates all available information about the security in question. Coming from a family where my Mom was a successful investor, I had an impossible time swallowing the EMH, except perhaps as a limiting concept — i.e., the markets tend to be that way, but never get there fully.

I’m a value investor, and generally, over the past fourteen years, my value investing has enabled me to earn superior returns than the indexes. A large part of that is being willing to run a portfolio that differs significantly from the indexes. Now, not everyone can do that; in aggregate, we all earn the market return, less fees. The market is definitely efficient for all of us as a group. But how can you explain persistently clever subgroups?

Behavioral finance has been the leading challenger to the efficient markets hypothesis, but the academics reply that behavioral anomalies are not an integrated theory that can explain everything, like the EMH, and its offspring like mean variance analysis, the capital asset pricing model, and their cousins.

Though it is kind of a hodgepodge, the adaptive markets hypothesis offers an opportunity for behavioral finance to become an integrated theory. First, behavioral finance is a series of observations about how most investors systemically misinterpret investment data, allowing for value investors and momentum investors to make money, among others. The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it’s not worth the search costs any more.

Consider risk arbitrage strategies for a moment. Arbitrage strategies earned superior returns through 2001 or so, until a combination of deals falling through, and too much money chasing the space (powered by hedge fund of funds wanting smooth returns) made it less worthwhile to be a risk arb. It is like there were too many fishermen in that part of the investment ocean, and the fish were depleted. After years of poor returns money exited the space. Today with more deals to go around, and fewer players, risk arbitrage is attractive again. No good strategy is ever permanently out of favor; after a strategy is overplayed to where the prospects of the assets are overdiscounted, a period of underperformance ensues, and it gets exacerbated by money leaving the strategy. Eventually, enough money leaves the the strategy is attractive again, but market players are slow to react to that, becaue they have been burned recently.

Strategies go in and out of favor, competing for scarce above-market returns in much the same way that ordinary businesses try to achieve above market ROEs. Nothing works permanently in the short run, though as a friend of mine is prone to say, “There’s always a bull market somewhere.” Trouble is, it is often hard to find, so I stick with the one anomaly that usually works, the value anomaly, and augment it with sector rotation and the remainder of my eight rules.

Now, I’m not a funny guy, so my kids tell me, but I’ll try to end this piece with an illustration. Here goes:

Scene One — Efficient Markets Hypothesis

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Nonsense. If there were a twenty dollar bill on the street, someone would have picked it up already.” They walk past, and a little kid walking behind them pockets the bill.
Scene Two — Adaptive Markets Hypothesis, Part 1
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. A little kid walking behind them runs in front of them, grabs the bill and pockets it.

Scene Three — Adaptive Markets Hypothesis, Part 2
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says quietly, “Tsst. Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. He grabs the bill and pockets it. The little kid doesn’t notice.
Scene Four — Adaptive Markets Hypothesis, Part 3
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He grabs the bill and pockets it. No one is the wiser.
Scene Five — Adaptive Markets Hypothesis, Part 4
An economics professor and a grad student are walking along the sidewalk, and the grad student is looking for a twenty dollar bill lying around. There aren’t any, but in the process of looking, he misses the point that the professor was trying to teach him. The professor makes a mental note to not take him on as a TA for the next semester. The little kid looks for the twenty dollar bill as well, but as he listens to the professor drone on decides not to take economics when he gets older.

As part of my 2-part project on the Fed Model, I want to give you the results of my recent investigation. This is the simpler of the two projects. A little while ago, Bespoke Investment Group published two little pieces on the relationship between the yield curve and the absolute level of the S&P 500 over short time periods. (You can see my comments below what they wrote.)

My data went from April 1954 to the present on a monthly basis. I regressed the yields on the three and ten-year treasuries, and a triple-B corporate bond spread series on twelve month trailing earnings yields for the S&P 500. The regression as a whole is highly statistically significant. Except for the t-statistic on the 10-year Treasury yield, the other regressors have t-statistics that are significant at a 95% level. I only did two passes on the data, because I didn’t realize until later that I had the spread series… in the first pass that did not have the spread series, the ten-year yield was significant.

Anyway, here are the statistics. What this says is that in the past trailing earnings yields tended to:

1. decline when BBB spreads rose
2. rise when three-year treasury yields rose
3. rise when parallel shifts of the yield curve up
4. rise when the yield curve flattens, with no adjustment in the overall height of the curve

The last three observations make sense, while the first one does not, at least not on first blush. Typically, I associate higher credit spreads with higher E/Ps, and thus lower P/Es, because tighter financing is associated with a lower willingness for equity investments to receive high valuations. I’m not sure what to do with that last observation; perhaps it is that my practical experience exists over the last 20 years which have been different than the whole data sample. Or, perhaps my readers will have a few ideas?

As for the main current upshot from this admittedly limited model is that current trailing E/Ps, and thus P/Es, are fairly valued against current treasury yields and bond spreads. Here are two graphs that illustrate this:

The nice thing about these graphs is that they easily point out the stock market undervaluation relative to bonds in 1954, 1958, 1962, 1974, 1980, 1982, and September 2002, and overvaluation relative to bonds in 1969, early 1973, 1987, and March 2000 and March 2002. Now this model might have suggested staying in bonds for most of the 90s, but the 90s were a relatively good decade to be in bonds, though not as good as equities.

This is the first time I have done a post like this, and so I put it out for your consideration. Comments?

Cody has an point that everyone should listen to in his post, Cody on Your World with Neil Cavuto.  I still regard myself as a moderate bull here, but it is altogether wise to take something off the table here.  My methods have me forever leaning against the wind.  As an example, near the close yesterday I trimmed some Anadarko Petroleum as a rebalancing trade.  I still like Anadarko, but at a higher valuation, it pays to take something off the table.  Why?  Because we don’t know the future, and something could happen out of the blue that transforms the risk profile of the market in an instant.

So, what does this mean for me?  I’m up to 12% cash in my broad market portfolio, which is higher than the 5-10% that I like it to be, but not up to the 20% (or down to zero) where I have to take action.  My balanced mandates are taking on cash to a lesser extent.  A 5.25% yield is pretty nice.

Now, here’s where I am different (not better, but different) than Cody.  Cody advocated taking 20% off the table (in his Fox interview), whereas I am forever taking little bits off the table as the market runs.  My robotic incrementalism takes the emotion out of the selling and buying processes.  That said, I may leave something on the table versus someone making bigger macro adjustments.

Whatever you do, it has to be comfortable for you in order to be effective.  The market may go up further from here; on average, I expect it will do so, but I can imagine scenarios where it will not do so.  That’s why I take a little off the table each time my stocks hit upper rebalance points; my baseline scenario may not happen, and rebalancing to target weights protects against what is unexpected.  It is a modest strategy that guards against overconfidence, and will always allow you to stay in the game, no matter how bad the market gets.

I don’t have to be a raving bull or raving bear.  I just have to control my risks, and over the long run, I will do pretty well.  Cody will do well too; he just does it differently.

Full Disclosure: long APC

Once every two months or so, I go through my “research stack” and look at the broad themes that have been affecting the markets. Here is what I found over vacation:

Inflation

1. Commodity prices are still hot, as are Baltic freight rates, though they have come off a bit recently. Lumber is declining in the US due to housing, but metals are still hot due to global demand. Agriculture prices are rising as well, partly due to increased demand, and partly due to the diversion of some of the corn supply into ethanol.
2. While the ISM seemingly does better, a great deal of the increase comes from price increases. On another note, the Implicit Price Deflator from the GDP report continues to rise slowly.
3. Interest rates are low everywhere, at a time when goods price inflation is rising. Is it possible that we are getting close to a global demographic tipping point where excess cash finally moves from savings/investment to consumption?
4. At present, broad money is outpacing narrow money globally. The difference between the two is credit (loosely speaking), and that credit is at present heading into the asset markets. Three risks: first, if the credit ignites more inflation in the goods markets which may be happening in developing markets now, and second, a credit crisis, where lenders have to pull back to protect themselves. Third, we have a large number of novice central banks with a lot of influence, like China. What errors might they make?
5. The increase in Owners Equivalent Rent seems to have topped out.

International

1. Global economy strong, US is not shrinking , but is muddling along. US should do better in the second half of the year.
2. The US is diminishing in importance in the global economy. The emerging markets are now 29% of the global economy, while the US is only 25%.
3. Every dollar reserve held by foreigners is a debt of the US in our own currency. Wait till they learn the meaning of sovereign risk.
4. Europe has many of the problems that the US does, but its debts are self-funded.
5. The Japanese recovery is still problematic, and the carry trade continues.
6. Few central banks are loosening at present. Most are tightening or holding.
7. There is pressure on many Asian currencies to appreciate against the dollar rather than buy more dollar denominated debt, which expands their monetary bases, and helps fuel inflation. India, Thailand, and China are examples here.

Economic Strength/Weakness

1. We have not reached the end of mortgage equity withdrawal yet, but the force is diminishing.
2. State tax receipts are still rising; borrowing at the states is down for now, but defined benefit pension promises may come back to bite on that issue.
3. Autos and housing are providing no help at present.

Speculation, Etc.

1. When are we going to get some big IPOs to sop up some of this liquidity?
2. Private bond issuers are rated one notch lower in 2007 vs 2000. Private borrowers in 2007 are rated two notches lower than public borrowers, on average. Second lien debt is making up a larger portion of the borrowing base.
3. Because of the LBOs and buybacks, we remain in a value market for now.
4. Volatility remains low – haven’t had a 2% gain in the DJIA in two years.
5. Hedge funds are running at high gross and net exposures at present.
6. Slowing earnings growth often leads to P/E multiple expansion, because bond rates offer less competition.
7. Sell-side analysts are more bearish now in terms of average rating than the ever have been.
8. There are many “securities” in the structured securities markets that are mispriced and mis-rated. There are not enough transactions to truly validate the proper price levels for many mezzanine and subordinate securities.

Comments to this? Ask below, and I’ll see if I can’t flesh out answers.

1) The TED [Treasury-Eurodollar] spread, which is a measure of market confidence, is up dramatically over the past two months, from 18 basis points to 52 at present. That indicates decreased confidence in the banking system, though swap spreads have not widened to confirm that judgment.

2) The Indian Rupee has rallied almost 10% against the dollar over the past two months, because of the need to recycle the US current account deficit, and restrain inflation at home, tighter monetary policy is needed in India, and many other developing nations. That means upward pressure on their local currencies, which will hurt their exporters. India is letting that process happen at present, other developing countries are allowing dollar liquidity to further inflate their economies.

My view is that the next major blow-up will happen as a result of a neophyte developing large country central bank overshooting on their tightening of monetary policy. China is my lead candidate, but India could do it as well.

3) Ordinarily I like what Jack Ciesielski has to say. He is far beyond me in terms of understanding the nuances of accounting standards, and I recommend his work to all professionals. I think his recent Barron’s article misses a nuance of SFAS 159, though. If SFAS 159 were mandatory, Fannie and Freddie might have some difficulties. But SFAS 159 can be ignored by any company that wants to ignore it, and used to the degree that any company wants to use it, so long as they disclose where they are using it and where they aren’t using it. So, I’m not sure the SFAS 159 has much relevance to Fannie and Freddie over the short run. Over the long run, it might be different if SFAS 159 becomes mandatory, or if the US adopts International Financial Reporting Standards.

4) I have posted at RealMoney on numerous occasions regarding overvaluation of many risky asset classes versus safe asset classes. I appreciated the piece at TheStreet.com regarding Jeremy Grantham, and the piece over at The Big Picture discussing it. I think he is right, but early. We haven’t run out of liquidity yet, and perhaps we get an exponential rise in risky assets that signifies the end. On the other hand, tightening global central banks in aggregate could be the end. For the cycle to change, we need a fall in profit margins, and a rise in discount rates. I think both are on the way, but they don’t come like clockwork.

As an aside, if managed timber is still cheap to Mr. Grantham, that could be a good place to hide. Decent return, and some inflation protection.

5) Dig this article from Businessweek. Know what it reminds me of? Manufactured housing back in 2000-2003. Lenders bent over backwards to keep loans current, at a price of future credit quality, and only gave up when their companies were facing death. Most died; a couple survived and much of the remaining corpus is part of Berky now.

The banks will keep marginal lending alive until it becomes a serious threat to their well-being; after that they will act to protect the banks. The severity of loan defaults thereafter will be very high.

6) How much international goodwill has the US lost through unilateralism? Part of that cost is measured by the fall in the dollar. The current account deficit presumes on the good graces of the rest of the world, but at the edges, if our policies aren’t well-liked, the deficit will get cleared at lower exchange rates for the dollar. Just another reason that I am long foreign currencies.

7) Central bank tightenings? Look at Japan and China. I have a little more belief that China will continue to tighten; they have been doing so for the last year. The acid test is how much they are willing to let their currency appreciate, and I think China will let that happen.

I am more skeptical about Japan. Their central bank is not very independent, and regardless of the article I cited, there isn’t a lot of reason for the Bank of Japan to act rapidly. Central Banks are political creatures that avoid pain; they are not entrepreneurs, particularly not in Japan.

What’s better in accounting, rules or principles? The current mood in accounting leads toward principles. The idea is that principles allow for a more accurate description of the corporate economics than the application of rules that though consistent, may not fit all companies well.

I split the difference on this issue. We need rules and principles. Rules for consistency and comparability, and principles for accuracy to individual situations. That is why I would have two income statements and two balance sheets. One off of amortized cost that would be consistent and comparable across all firms, and one off of fair market value, that would give management’s view of the economics of their firm.

9) I had been critical of the FOMC over at RealMoney because they had not been injecting enough reserves into the banking system in order to keep the Fed funds rate at 5.25%. Over the last week they have amended their ways. They have bought bonds and sold cash, and now Fed funds resides more comfortably near 5.25%. (I would post a link, but as I write the Fed website is not responding.

10) A harbinger of things to come: Fitch downgrades some 2006 subprime deals.

11) The Wall Street Journal was “dead on” this morning about talking about the degree of leverage being applied to the markets. I’ve been writing about this at RealMoney for some time, and I would advise everyone to look closely at their asset portfolios, and ask what assets would be at the most risk if financing were interrupted. For equity investors, I would encourage you to be long stocks with high ROAs, not high ROEs.

Do derivatives make a mockery of margin requirements? You bet they do, and we can start with furures and options, before moving on to private agreements.

12) Leave it to Caroline Baum to catch the mood of the government, and apologists for the current economy. Ex-housing, we are doing fine. Another way to say it is housing is doing lousy, and export-oriented sectors have not made up the difference.

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That’s what I am seeing now. Are you seeing thing I am missing, or do you disagree with what I have said? Post here, and let’s discuss it.

Perhaps for blogging, I should not do this. My editors at RealMoney told me that they liked my “Notes and Comments” posts in the Columnist Conversation, but they wished that I could give it a greater title. Titles are meant to give a common theme. Often with my “Miscellaneous Notes” posts, there is no common theme. Unlike other writers at RealMoney, I cover a lot more ground. I like to think of myself as a generalist in investing. I know at least a little about most topics.

Now, I have to be careful not to overestimate what I know, but the advantage that I have in being a generalist is that I can sometimes see interlinkages among the markets that generalists miss. Anyway, onto my unrelated comments…

1) So many arguments over at RealMoney over what market capitalization is better, small or large? Personally, I like midcaps, but market capitalization is largely a fallout of my processes. If one group of capitalizations looks cheap, I’ll will predominantly be buying them, subject to my rule #4, “Purchase companies appropriately sized to serve their market niches.” Analyze the competitive position. Sometimes scale matters, and sometimes it doesn’t.

2) My oscillator says to me that the market is now overbought. We can rise further from here, but the market needs to digest its gains. We should not see a rapid rise from here over the next two weeks, and we might see a pullback.

3) My, but the dollar has been weak. Good thing I have enough international bonds to support my balanced mandates. I am long the Yen, Swissie, and Loony.

4) Sold a little Tsakos today, just to rebalance after the nice run. Cleared out of Fresh Del Monte. Cash flow looks weak. Suggestions for a replacement candidate are solicited.
5) Roger Nusbaum is an underrated columnist at RealMoney in my opinion. Today, he had a great article dealing with understanding strategy. He asked the following two questions:

• If you had to pick one overriding philosophy for your investment management, what would it be?
• If you had to pick four of your strategies or tactics to accomplish this philosophy, what would they be?

Good questions that will focus anyone’s investment efforts.

6) In the “Good News is Bad News” department, there is an article from the WSJ describing how the SEC may eliminate the FASB by allowing US companies to ditch GAAP, and optionally use international accounting standards [IFRS]. If it happens, this is just the first move. Eventually all companies will follow an international standard, that is, if Congress in its infinite wisdom can restrain itself from meddling in the management of accounting. The private sector does well enough, thank you. Please limit your scope to tax accounting (or not).

7) Also from the WSJ, an article on how employers are grabbing back control of 401(k) plans. Good idea, since most people don’t know how to save or invest. But why not go all the way, and set up a defined benefit plan or a trustee-directed defined contribution plan? The latter idea is cheap to do; we have one at my current employer. Expenses are close to nil, because I mange the money in-house. Even with an external manager, it would be cheap.Would there be people who complain, saying they want more freedom? Of course, but they are the exception, not the rule, and of those who complain, maybe one in five can do better than an index fund over the long haul. I am for paternalism here; most ordinary people can’t save and invest wisely. Someone must do it for them.

Finally, the “hooey alert.” The concept of using custom indexes to analyze outperformance smacks of the inanity of “returns-based style analysis.” I wrote extensively on this topic in the mid-90s. Anytime one uses constrained optimization to calculate a benchmark using a bunch of equity indexes, the result is often spurious, because the indexes are highly correlated. Most differentiation between them is typically the overinterpretation of a random difference between the indexes. Typically, these calculations predict well in the past, but predict the future badly.

That’s all for now.

Full Disclosure: long TNP FXY FXF FXC

The Wall Street Journal had two bits on international diversification: a poll, and an article. Both were good as far as they went, but the past outperformance of international over domestic stocks doesn’t help us analyze which will be better in the future. That macro question is hard, particularly because once a streak gets long, it gets more touchy to be long. But let’s look at a “micro” angle on foreign investing.

One of the reasons to invest abroad is to diversify currency risk. Let’s pretend for a moment that we know the dollar is going down over the next few years. What stocks would I buy? I would buy foreign companies that import US goods (costs are getting cheaper), foreign companies that are purely local (earnings stream rising in dollar terms), and US companies that export (sales should rise as the dollar falls).

Now let’s pretend for a moment that we know the dollar is going up over the next few years. What stocks would I buy? I would buy foreign companies that export goods to the US (sales should rise as the dollar rises), US companies that are purely local (earnings stream rising in foreign currency terms), and US companies that import (costs are getting cheaper).

All that said, foreign investing is more complex because of:

• Expropriation risk
• Different accounting standards
• Often less disclosure
• Poor corporate governance (US investors don’t know how good they have it, or on the negative side, SOX chases foreign firms away from US listings.)
• Inability to get fair redress in the courts
• Language issues
• Foreign trading costs if not listed in the US.
• War
• Exchange controls

As for me, I am mainly country-indifferent in investing. I agree with John Templeton, who said something to the effect of: “Buy the cheapest companies in a given industry.” I do look for the “rule of law,” though. Just as when we buy shares in a company, we check to see how they treat outside passive minority shareholders, with foreign firms, we have to go a step further, and ask how the country treats foreign outside passive minority shareholders.

With bonds the issue is simpler, because it boils down to yield, currency and repayment issues. The challenge there is to understand what will drive the relative forward interest rate policy between countries. In the intermediate term, it is better to invest in currencies where the central bank is tightening, particularly if there are any “surprise” tightenings.

I believe in international diversification; in general it is a good thing. But it should not be done blindly; investors should consider the factors that I have mentioned above, if not more factors.