I am a risk manager first, and a profit maker second.  I tend not to trust solutions that are “magic bullets” unless there is some barrier to entry — why can you do it, and few others can?  Knowledge travels.

So, regarding the “endowment model” of investing, I have been partly a believer, and partly a skeptic.  A believer, because endowments do have the ability to invest for the long-term, and not everyone else does.  A skeptic, because many endowments were taking on too much illiquidity.

Liquidity is an underrated factor for investors who have charge over portfolios that have a long-term stable funding base.  I had that advantage once, as the main investment manager for an insurer the had a large portfolio of structured settlements.  In insurance liabilities, nothing is longer than a portfolio of structured settlements.

Buy long-dated debt?  Illiquid debt?  If the pricing is right, sure; you should have to pay to rent the strength of a strong balance sheet, where the funding is intact.  WHen managing that company’s portfolio I didn’t have to worry about a run on the portfolio, because I kept more than enough liquid assets to satisfy the demands of policyholders should they decide to surrender.

Pushing it Past the Illiquidity Limit

I decided to write about the endowment model after reading this article, of which I will quote the first paragraph:

There has been much written in the popular press lately about the failures and even the “death” of the endowment model. The discourse regarding this matter has been surprisingly simplistic, naive and exceedingly short sighted. As was the case with Mark Twain, reports on the death of the endowment model have been greatly exaggerated. Let’s start with the facts. The “endowment model” practiced by most of the big university endowments and many big foundations (but also by some astute smaller endowments and foundations) has overwhelmingly outperformed virtually all other models over any reasonable time period, and has done so for a very long time now. There is no single model, mode or manner of investing that outperforms in every environment and over every time period, and the endowment model of investing was never predicated on being the exception to this obvious reality. In fact, endowments’ time horizons are as long as any investor’s horizon, and hence are strictly focused on the long term. This is a huge advantage because there is clearly a significant liquidity premium to be captured by investing long term, not to mention the ability to better avoid the chaotic noise and behavioral finance mistakes that arise with a short term environment and outlook – especially in volatile markets.

The idea here is that you will obtain better returns if you can focus out to an almost infinite horizon — after all, endowments will last forever.  There is an edge to having a long investment horizon, but there are still reasons to be cautious, and not aim a majority of investments in such a manner that means that they cannot be touched for a long time.

Here is my example: Harvard.  At the end of fiscal 2008, those that managed Harvard Management Company were heroes.  The largest university endowment, stupendous returns, etc.  Who could ask for more?

The risk manager could ask for more.  With an endowment of nearly $37 billion in June of 2008, only $16 billion was liquid assets.  Of that $16 billion, $11 billion was spoken for because of commitments to fund limited partnerships.  Harvard also had $4 billion in debt, not all of which was directly attributable to the endowment, but still would be a drag on the total Harvard entity.   If this is representative of the endowment model, let me then say that the endowment model accepts illiquidity risk more than most strategies do.  Even after their great investment successes, Harvard did not have enough liquidity.

Then Came Fiscal 2009 — We’re out of liquid assets!

My guess is that sometime in the fourth quarter of calendar 2008, the powers that be at Harvard concluded that they were in a liquidity bind — negative net liquid assets, and there is a need for liquidity at Harvard, to pay for ordinary operations, as well as expansion.  Thus they moved to sell illiquid investments, and take a haircut on them.  They reduced their forward commitments by $3 billion.  They also raised $1.5 billion in new debt, $500 million worth of 5-, 10-, and 30-year debt each.

This is clear evidence of a panic, and an indication that the portfolio was too illiquid.  What else might indicate that?  Well, Harvard had to scale back capital projects, and had a round of layoffs of ancillary personnel.

The idea of an endowment is that you can run your institution without fear of the future.  But that also implies that those endowed will not make abnormal demands on the endowment.  That applies to the amount disbursed and the liquidity of the underlying investments.

Now at the inception of fiscal 2010, Harvard is much in the same place as it was in 2009.  Net of debt and commitments, Harvard’s endowment does not have liquid assets on net.  (My estimates: $12.5 billion of liquid endowment funds, $8 billion of funding commitments, and $5.5 billion of debt.)  Granted, it was wise to move the endowment’s cash policy target from -5% to -3% to +2% over the past two fiscal years.  Even if cash doesn’t return anything, it is still valuable.  You can’t pay professors with shares of a venture capital partnership.

The Horizon Isn’t Infinite

This brings me to my penultimate point, which is that the investment horizon for endowments is different for other investors in degree, but not in kind.  The horizon for an endowment is infinite only under conditions of permanent prosperity.  Well, anyone can invest forever under conditions of permanent prosperity.  The forever-growing investments can be borrowed against.

The investment horizon must take into account the possibility of a depression, or at least a severe recession or war, if you want to have an endowment that will truly last forever.  There has to be cash and high quality liquid debt adequate to provide a buffer of a few years of expenses.  That will give the institution more than adequate time to adjust to the new economic conditions.

Most college endowments that have not gone overboard on illiquid investments and don’t have a boatload of debt probably don’t have to worry here.  But for those that bought into the alternative investments craze, the idea of invest for forever must at least be tempered into something like 20% of our investments exist to buffer the next 5 years, and the other 80% can be invested to the infinite horizon (maybe).  That’s a more realistic approach to endowment investing, akin to a speculator paying off his mortgage and having a year of savings in the bank before beginning a trading career with capital beyond that.

Alternative Investments are not Alternative Anymore

There is another reason, though, to be cautious about illiquid investments.  With any new alternative investment class, the best deals get done first, and wow, don’t they provide a thundering return!  Trouble is, knowledge travels, and success breeds imitators.  The imitators typically bring deals that will have lower returns or higher risks than the original deals.  But the pressure of additional money into the alternative illiquid investments force progressively more marginal ideas to get done as deals.  Also, mark-to-market returns of earlier investments get marked up, giving them an even more impressive return, which attracts more capital to the investment class.

Eventually deals get done that make no sense, but the momentum of demand carries the asset class until returns of newer deals prove to be negative.  That  gets the mark-to-market process moving in reverse, and demand for the “no longer new” investment class declines.  In some cases, investors will try to get out of funding commitments, and even try to sell their interests to a third party, usually at a significant concession to the hard-to-define fair market value.

Eventually enough capital exits the class, inferior deals get written down, and the once new investment class might still be labeled “alternative,” but has entered the mainstream, because it has been around long enough to go through a failure cycle.  The now mainstream but still illiquid investment class is near a normal size versus the investment universe, and should possess forward-looking returns that embed a risk premium to reflect the disadvantages of illiquidity.  Also, the now mainstream investment becomes more correlated with risk assets generally, because the actions of institutional investors chasing past returns is common to much of what qualifies for asset allocation.

Summary

• Liquidity is valuable, and should not be surrendered without proper compensation.
• Alternative investment classes eventually go through a mania phase, and then go through a failure cycle.
• After failure, they tend to be more correlated with other risk assets.
• Endowments can indeed invest for a long horizon, but should keep sufficient liquid assets on hand to deal with significant market corrections.
• Harvard’s endowment would be vulnerable if we had a repeat in the near term of what happened in fiscal 2009 because of its low net liquidity.

Investing is a business where the smarter you are, the more it pays to be humble and recognize risk limits.  Major universities and colleges (and defined benefit plans) should review their asset allocations and stress-test them on scenarios where liquidity is in short supply.  Better safe than sorry.

Articles on the Harvard Endowment

• Harvard Endowment Corrects Course With Return to the Past
• Harvard endowment posted 27 percent loss
• Harvard alters financial strategy
• In-house shift
• Chart of the day: Harvard donations
• 2009 Endowment Report (pdf)
• 2008 John Harvard letter (pdf — happier times)
• Harvard Endowment, Largest in Higher Education, Plummets by 27%
• Recession drags Harvard and Yale endowments down news
• Harvard University’s endowment fund grows to $36.9 billion (contrasting 2008)
• Harvard University financial report fiscal year 2008 (pdf)

6:46 PM Update — So I write this, and Morningstar comes out with a good piece like this one.  So it goes.

Since the first time I read him, I have been a fan of James Grant.  He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.  Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.  When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”  For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.  This book followed the same format, reprinting the best of old columns, with modest commentary.  In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?  Isn’t that a waste of time? That depends.  Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?  Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

• How does monetary policy affect the financial economy?
• Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
• Why do value (and other) investors need to be extra careful when investing in leveraged firms?
• What is risk?  Variation of total return or likelihood of loss and its severity?
• Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
• Why great technologies may make lousy investments.
• Why does neoclassical economics fail us when trying to understand the financial economy?
• How does one recognize a speculative mania?
• And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.  Being too early means you eventually get disregarded.  The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.  That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.  You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

• Those that have assumed that neoclassical economics adequately explains the way our economy works.
• Those that want to understand how monetary policy really works, or doesn’t.
• Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
• Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,  but your costs don’t go up.   Also, thanks to Axios Press for the free review copy.  I read the whole thing, and enjoyed it all.

Animal Spirits: A notion of Keynes that implied that the willingness of businessmen to take risk was unpredictable and somewhat irrational, leading to booms and busts.  I don’t agree, at least not entirely, but first a word about rationality and economics.

Thinking hurts, at least for most people.  It takes effort, which is why people conserve on doing it.  Instead, they substitute “shortcuts” for thinking that may have some plausibility.

• This has worked in the recent past, so it should work in the near future.
• My friend Fred has done this, and it has worked for him, so it should work for me.
• James Cramer (or Warren Buffett, or fill in your favorite expert, even me) thinks this will work wonderfully, so I will do it as well.
• Everyone is doing this and doing well.  I have missed out on it in the past, so I better get going now.
• The academics say you can’t succeed at beating the market, so I won’t try to do so.
• I’ve read some books on investing, and there is a really simple formula for beating the market.  I’ll follow that method.
• No one hedges that risk, so I won’t either.  The risk can’t be that large.
• The government has always been capable of dealing with economic troubles; they should be capable of dealing with this one as well.

Though my examples come from investing, they apply to other areas of business, finance, and life generally.  Few people like to go back to first principles to think through a problem.  Many follow the crowd, or so-called experts.

As an aside, because people don’t like to think hard, they don’t optimize, as the neoclassical economists posit.  Instead, they choose solutions that they deem to be “pretty good,” and stop their searching.  Searching is a cost.  But neoclassical economists insist  that consumers maximize utility and producers maximize profit anyway.  Why?  If they don’t assume that the math doesn’t work, and they can’t publish something that looks semi-scientific.

Crowd-following is common to humanity.  It takes a lot to stand apart from highly correlated behavior.  I’ve told this story before, but in late 1999, I was talking with my mother (a very good self-taught investor), she told me about many of my cousins who were speculating in tech stocks.  I said to her, “They don’t know anything about investing!”  My mom replied, “Oh, David.  You’re such a fuddy-duddy.  I just bought some Inktomi!”

Now, to set the record straight, that was just 1% (or less) of my mom’s assets, so an occasional flyer is acceptable.  Call it “Mad Money.”    For my cousins, it was most of their investable assets.  My mom is fine, and the fuddy-duddy did all right also, but the cousins swore off stock investing.

I saw the same thing with people in their 401(k)s and other DC plans in 2002 — no more investing in equities.  Real estate was the place to be. Buy what you know, and residential real estate always goes up.

Before I continue with the residential real estate example, here are two questions I ask in order to decide whether a course of action makes sense:

• What if everyone did this?
• What is the current risk-adjusted free cash flow yield?

The first point should make you remember that any smart strategy can be overdone.  Any business can be overlevered, etc.  We can ask questions about market size, profit capacity and other things to try to determine what a speculative stock or industry could potentially be worth in the long run.  The same thing is true on the bear side — almost everything has some value even in bear market phases.

The second point has value as well.  I use an equation like this:

Free Cash Flow Yield + Necessary Capital Gains Yield = Funding Yield

or:

Necessary Capital Gains Yield = Funding Yield – Free Cash Flow Yield

By necessary capital gains yield [NCGY], I mean what is needed to keep an asset whole.  During “normal times” the NCGY is negative by some amount that reflects the normal risk margin for the asset class.  Near the peaks of bull markets, NCGY goes positive.  Think of real estate investors having to feed their properties.  Rents less expenses are less than the mortgage payments.

At the depths of bear markets, both free cash flow yields and funding yields rise considerably, but the FCF yields more so.  Few are investing, because they are looking through the rear view mirror at the past losses.

Eventually, some enterprising sorts that don’t care about convention see the large negative NCGY, and start putting money to work.  The cycle starts to turn, and things begin to normalize, or at least, begin the next cycle.

-==–=-=-==–=-=-=-=-==–==–=-=-=-=-=-=

By believing in limited rationality for men, and recognizing the boom-bust cycle, do I come to the conclusion that Keynes did about animal spirits?  No, I don’t.  Businessmen may follow trends, but enough of them pay attention to the NCGY of their businesses that they know when future opportunities are good or bad.

In that same sense, if our government is trying to get economic behvavior to “normalize,” perhaps it should look at the constraints that businesses/consumers live under, and ask what could be done to change things.  It is not so much a question of animal spirits, as where people find that they have an advantage.

At this point, where so many find themselves hemmed in by debt, demand falls, and the economy suffers.  Perhaps an approach similar to what Barry Ritholtz has proposed would be useful.  Give each household a voucher that can only be applied against debts.  The indebtedness of the private sector will decline.  Their willingness to spend will rise.  Overleveraged households delever; underleveraged households spend more; the US is that much more indebted.

Though it may seem unduly populist, giving money to each household solves two problems: it reduces household debt problems, and it also reduces credit stress at the banks.  What could be better in this environment?

Time for another break from “All crisis, all of the time.”  I have long been fascinated by momentum anomalies, and this is an initial attempt to under stand them better.  My contentions have been that:

• Sharp moves mean-revert, gradual moves persist.
• In the short-run momentum persists, in the intermediate-term, it mean-reverts, and in the long-run, oddly, it persists.

Let’s see how well my default views stack up against the evidence.  I used Professor Shiller’s augmented S&P 500 data from 1871 to mid-2008 to ask the following question: given the performance of the last year and the last month, what can that tell us about the likely returns for the next year and next month?

I divided performance into ten deciles for the past year and the past month.  Here are the monthly and annual returns by decile:

For purposes of completeness, I also calculated the number of observations by decile:

Note the correlation.  The main diagonal elements support the idea that monthly and yearly returns are correlated.  Not too surprising.

Returns Over the Next Year

So, how do returns over the next year relate to returns over the last month and year?

Okay, the R-squared is low on this calculation, but the drift from the regression is that there is mean reversion from the past year’s return, and momentum from the monthly returns.  Oddly, some of the worst return occurred when yearly returns were pretty average.

Returns Over the Next Month

So, how do returns over the next month relate to returns over the last month and year?

The R-squared is a little better here, and the main result is that the past year’s returns do not impact the next month’s returns much, but the past month’s returns do.  There may be some evidence for when monthly momentum is strong, if annual momentum is strongly positive or negative, there will be outperformance.

So, what do I conclude here?

• Monthly momentum persists over the next month and year.
• Annual momentum might persist over the next month, and with a lesser tendency might revert over the next year.

One constant I have observed in financial economics: mean-reversion exists, but the tendency is weak.

PS — where are we now?  Lowest deciles for both monthly and annual returns, which indicates bad performance for the next month , but good performance for the next year.  Buckle in, it will be volatile.

Let’s take a short break from “all credit crisis, all the time.”  I want to talk about an issue that troubles us in a number of ways.  The legal doctrine of “insurable interest” [II] is critical to the life insurance industry.  II states that only those with a direct economic or (sometimes) sentimental interest can seek to buy life insurance on another person.  The sentimental interest is limited to close family, and sometimes friends, if approved by the insured.

This protection exists for several reasons:

• Insurance exists to reduce risk, not promote gambling.
• The tax-favored nature of life insurance relies on the idea that it is helping people who would be harmed by the death of the insured.  Absent that, the IRS will eliminate those favors.
• We don’t want to raise the risk of murder by allowing anyone to take out insurance on another person.  Even though murder by the policyholder would invalidate the claim, that can be hard to catch.

Now, those who know me as a life actuary know where I am going next.  I’m going to complain about stranger-owned life insurance, viatical settlements, premium financing and the like.  Good guess; I’ve written about those before.  I’ve turned down job offers in that area for ethical reasons.  You only get one reputation in the business, so you better guard it carefully.

But, that’s not what I am going to write about, much as I think that many of those practices should be outlawed.  I’m going to write about credit default swaps.

Wait.  What do credit default swaps have to do with insurable interest?  Legally, nothing at present.  This article will suggest that there should be a link.

Insurable interest exists to protect the insured, a natural person, against increased risk of death from policyholders seeking to do him harm.  Corporations are corporate persons under the legal code.  Should they not get the same protection?

Credit default swaps pay off when a corporation “dies.”  I know there are additional complexities here, but play along with me for now.  There are parties that get hurt when a corporation dies:

• Suppliers
• Employees
• Sponsored pension funds
• Debt/loan holders
• Stockholders
• And maybe more…

They have an insurable interest in the continued well-being of the corporation.  They should be allowed to issue credit default swaps to the degree that it allows them to hedge their exposure, and no more.  Any excess exposure is gambling, not insurance, and should be forbidden by law.

Yes, like Charlie Munger, I believe that gambling should not be legal on public policy grounds.  Credit default swaps are not insurance as the regulators define today, but they should be regulated as insurance, and only financial guarantee insurers should be allowed to insure it, and those seeking insurance should prove insurable interest, or the contract is null and void.

Now, if you see my logic, forward this article to your Senators and Congressmen.  Let’s change the dynamic that has introduced so much speculation into the bond markets, where there is more credit default swaps than there are bonds available.

At a time like this, when many things are coming unhinged, this is just one more thing to set right, so that we can have a more stable financial system.

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.

I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion  — yes, residential real estate was near its top.  My friends, being bearish, and grizzly housing bears, heartily approved.

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.

		David Merkel
		Housing Bubblettes, Redux
		10/27/2005 4:43 PM EDT

From my piece, “Real Estate’s Top Looms“:

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.

For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.  In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.  Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.  Fortunately, the piece I wrote was generic, and can benefit investors anywhere.

Notes on Stocks and the Fed

On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.  It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.  This wasn’t just true of the US, but of most global equity markets.

So, if we are going down further, the market will have to rest a while.  That said, valuations are more compelling than they were, especially compared to Treasuries.  Compared to BBB corporate yields, they are still attractive.  I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.

One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.

Finishing off the presentation proved to be harder than I estimated, together with all of my other duties.  Well, it’s done now, and available for your review here.  For those looking at one of the non-PDF versions, you might be able to see the notes for my talk as well.

I’m writing this before I give the talk.  If I had it to do all over again, I would have made the talk less ambitious.  Then again, of the four topics that I offered them, they picked the most ambitious one.  When you look at the talk, you’ll see that it is a summary of the macroeconomic views that frame my investment decisions.  The presentation will run 40 minutes or so, plus Q&A.  Reading it is faster.

Enjoy it, give me feedback, and I’ll be back to normal blogging Monday evening.

Recently Bill Rempel posed the following question to me:

Could you compare the total return of a 10-yr Treasury bought fresh and new anywhere from 1976-1980, and held to maturity (sending the coupons to cash) — to the total return from an equal-sized basket of stocks or residential real estate over the same time period? Please use “risk-adjusted returns” in the previous comment, re: returns on bonds. As a non-institutional investor who doesn’t care as much about the “mark to model” on any bonds I would hold, I would view double-digit Treasuries as free money, especially in light of long-term returns on stocks barely cracking the DD with divvies included …

He also made this recent post to further elucidate his views. So, let’s do a thought experiment. Suppose you knew where real interest rates and inflation would be ten years from now. How would that affect your investment policy?

The easy answer would be that you would know what to do with bonds. After all if rates are higher in the future, you would shorten your bond holdings to preserve your capital, and vice-versa if rates were lower.

But what do you do with your stocks? How is their performance impacted by future real interest rates and inflation rates? Before I answer that, let’s consider the difference between the yield of a bond, and its realized return from reinvesting the coupons. The following graph shows the coupon rate on a ten year Treasury note, and the realized return from investing the coupons at money market rates until the bond matured. The realized return is higher than the coupon when the average money market rate was higher than the coupon, and vice versa. But the difference is rarely very large. Most bond income comes from coupons.

Now, let’s consider how the ten year Treasury yield, inflation and real rates have varied over my study period, 1954-1997.

And look at how the ten year Treasury yield, the real rate of interest, and the inflation rate would change over the next ten years.

Looking at these graphs, you can guess that future equity returns are affected by changes in inflation and real interest rates, but here’s proof:

Or, another way of looking at it, future equity returns depend on future real interest rates and inflation rates. Note that bonds only beat stocks for ten-year investments beginning during the period 1964-1973, and not all of the time even then.

I ran a regression on the difference between ten-year stock returns and ten-year realized Treasury note returns, with the regressors being the current inflation and real interest rate, and the inflation and real interest rates 10 years from then. The R-squared was 57% (good in my opinion), and the coefficients were:

• Current inflation: +22%
• Current real interest rate: -12%
• Inflation 10 years from then: -121%
• Real interest rates 10 years from then: -46%

There was some autocorrelation of the residuals, indicating that periods of under- and out-performance of equities over bonds tends to persist:

All were statistically significant at a 95% two-sided level. What the regression tells us is that of the four variables considered, the most important one is future inflation rates. If future inflation rises, the value of future cash flow declines. It gets even worse if the Federal Reserve tries to squeeze out inflation by raising real interest rates high enough to overcome the inflation. Oddly, higher current inflation is a modest plus — maybe that indicates pricing power? Perhaps it is useful to think of equities as ultra-long bonds, with rising coupons. Rising rates would hurt those considerably.

Upshots

1. Note that it was a bullish period, and that stocks did not lose nominal money over a ten-year period to any appreciable extent.
2. Stocks almost always beat bonds over a ten-year period, except when inflation and real interest rates 10 years from now are high.
3. Investing in stocks during low interest rate environments can be hazardous to your wealth.
4. Watch for inflation pressures to protect your portfolio. Stocks get hurt worse than bonds from rising inflation.
5. Inflation and real rate cycles tend to persist, so when you see a change, be willing to act. Buy stocks when inflation is cresting, and buy short-term bonds when inflation is rising.