Rereading old articles is bittersweet.  I get a variety of internal reactions:

• You wrote about that again?! Who cared about that?
  
• Boy, you really blew that one!
• Another news post?! How many links can you cram into a post?  Anyone who reads all of that will learn a lot, but who has that much time?  (At least you summarized it, so some could avoid reading it…)
• Nice job!

Well, onto the fifth quarter of the Aleph Blog, February through April 2008:

All or Nothing at All

I had some “down time” today (taking my third child to junior college), when I could sit and think about some of the issues in the markets, when all of a sudden, a weird correlation hit me.  Similarities between:

• The near bankruptcy of the Equitable back in the early 90s.
• Neomercantilism
• The relationship of Moody’s and S&P to MBIA and Ambac.

This was a creative post that connected the dangers of the overextension of credit — debts growing at an unsustainable rate.  It doesn’t end well for the creditor and debtor, but the creditor typically gets the worst of it.

The Boom-Bust Cycle, Applied to Many Markets

The funny story of making money by resisting trends.  Main point: use your head and look through the windshield, not the rear-view mirror.

That’s my thought for the evening.  Analyze the motives of other players in your markets, and don’t assume that the current state of the market is an equilibrium.  Equilibria in economics are phantoms.  They exist in theory, but not reality.  Better to ask where new entrants or exits will come from.

Split the Financial Guarantors in Two? You Can’t Do That.

This was the first of many pieces arguing against fraudulent conveyance, which was attempted, but thwarted in the courts.  Someone send Sean Dilweg to a course in contract law.

In Some Ways, The Municipal Bond Market Was Asking For It

This was another case of asset-liability mismatch.  Lenders want to lend short, and borrowers want to borrow long. In this case, auction rate preferreds internalized the mismatch, subject to auction failure, which never happens, right?  There were also hedge funds that tried to exploit the yield differential, borrowing short and lending long.

A disaster waiting to happen…

A Small Victory Lap on CPDOs

I fought these since their initial issuance.  They did not make economic sense, and the rating agencies had never previously allowed for a martingale strategy to be a safety factor.  Oh, and things got much worse from here.  Losses were large.

Is the PEG Ratio a Valid Concept?

I expected the answer to be no, but it was yes.  I learned a lot in the process; encourages me to be more open-minded.

The Problem of Publishing in the Social Sciences

There are many reasons research in social science tends to be skewed and this article hits many of them.

Micro-stability versus Macro-instability

Greenspan was famous for suggesting that derivatives made the markets safer.  He missed that most derivatives are risk-shifters, not risk-eliminators.  Derivatives stabilized companies at a price of adding basis ans counterparty risks.

Buy Muni Bonds

Great call, when the market was dislocated.

What Should the Spread on a Corporate Bond Be?

Humorous piece on bond pricing, with six blind men analyzing the elephant, and one sighted guy reluctant to explain why they are right sometimes, but wrong most of the time.

The Value of a Balance Sheet

Humiliation, but I turn it into an opportunity to learn, and avoid future errors.

Investment Banks Are Priced Like Bermuda Reinsurers

A quick comparison between an industry that is usually admired, and one that is always despised.  The similarities will surprise!

A Social View of the FOMC

This piece took a lot of work, and got a lot of attention.  Someday, I’d like to put out another.  Enjoy the easy comparisons from one large table that explains in detail the accomplishments and foibles of FOMC members.

Dissent at the FOMC

After a rare double dissent, I analyzed how common dissents are at the FOMC.  Note to Bernanke: your power has grown since then.

Federal Office for Oversight of Leverage [FOOL]

Well, what could you expect from a post on April 1st? The sad thing is, it came into being, and is staffed with people who really don’t get the concept of systemic risk, or where it comes from.  Worst yet, they don’t control the Fed, which creates most of our systemic risk.

The Financings of Last Resort

Your firm needs money, but conditions for financing are unappealing.  What can you do?

Nerds and Barbarians

Understanding two stereotypes for hedge fund managers.

Problems with Tax Reform

A really important piece that argues that tax rates aren’t the important factor, it is the definition of income.

Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost

Two excellent books that everyone should read.

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That’s all for now.  Hope you enjoy a few of the articles.

The period from November 2007 through January 2008 was challenging, but I did say a lot of good things.  Here’s a sample of the best:

Contemplating Life Without the Guarantors

Markets always beat governments, unless governments get so determined as to subvert markets.  Guarantors provide “thought insurance” so you don’t have to analyze the bond that they guarantee.  But what if the solvency of the guarantor is questioned?

The US Dollar and the Five Stages of Grieving

An important article that explains why currency interventions almost never work.  Required reading for Treasury Departments and Central Banks.

Why Did I Name This Site “The Aleph Blog?”

Cogent explanation for the odd name.  But I have gotten the question a few times as to whether I named my site after Jorge Luis Borges short story, “The Aleph.”  The answer is no, but after reading “The Aleph,” I would say that it folds into reason number four for why this is called The Aleph Blog.  Aleph is big.  Very, very big.

On the Value of Secondary and Primary Markets

They are valuable for different reasons, but they are related.

In Defense of the Ratings Agencies

The original piece, pointing out how the regulators have abandoned their responsibility, having outsourced it to the rating agencies.

Personal Finance, Part 6 — The First Question

How much are you willing to learn, and how much work do you want to do? For people who ask my advice, that is usually the first question that I ask.

Booyah for Brainy Buybacks! (But not Brain-dead Buybacks.)

There is no simple answer to whether a buyback is the right strategy or not.  It depends on the price of the stock versus its value.

Options as an Asset Class

You can own/short options, but you can’t own/short volatility per se, at least not back in 2007.

Municipal Tensions

We are experiencing the front end of the woes now.  This won’t be over for 20 years.

How to Read the Whole Bible, and Survive the Experience

A simple way to read the whole of the Bible, and avoid getting bored, as so many do who try to read it straight through, and give up when 10-50% done.

In Defense of the Rating Agencies — II

Anyone can criticize, but who can offer a system that is better than the present one on a comprehensive basis?

The Beauty of Broken Moats

Berky had an opportunity with almost all of the financial guarantors kicked to the curb.  It never worked out because Berky would not take modest risks.  In foresight today, those modest risks don’t seem so modest, so salute Mr. Buffett, who has forgotten more than most of us will ever know.

What Did Buffett Know about the Gen Re Finite Reinsurance Deal with AIG?

Odds are, Buffett knew a lot more than he confessed to know.  Buffett is a maven on insurance issues.

On Benchmarking

Benchmarking enforces conformity on managers, and the shorter-term the horizon, the more it makes them closet indexers.

Pandora and the Fair Value Accounting Rules

There are really tough issues here.  Everyone wants to be accurate, but over what time horizon, and how to adjust over time?  Bright investors will build in provisions for adverse deviation, and be conservative.

Unstable Value Funds?

This didn’t prove to be an issue, in this credit cycle, though form what I heard from insiders, it got close.  If the Fed hadn’t done 0% and QE, my dire predictions might have come true.  They still might in the future.  Be wary.

Meet Some of my Friends

Though the videos have disappeared, the story of how President George W. Bush, Jr. came to visit the factory of a friend of mine (of which I own 1.4%) is an interesting tale.  I was proud of my friend, who is a humble, but a great guy.

A Bonus from MoneySense Magazine

A free version of what Canadian magazine buyers had to pay for. How to earn more while taking less risk.

Personal Finance, Part 11 — Your Personal Required Investment Earnings Rate

The intuitive explanation of what you need to earn in order to achieve all of your life goals.  It’s probably higher than you think.

With 401(k)s and Other Defined Contribution Plans, Watch Your Wallet

An important article — from the article:

If you are paying more than 1% of assets per year, then something is wrong, unless the asset classes are esoteric, which should not be the case for DC plans.  Remember, you have to be your own guardian with defined contribution plans.  No one will do it for you.  And, if a few of your colleagues complain at the same time, you will be amazed at how quickly it will be taken seriously, because the administrative staff of the plan sponsor usually doesn’t get that much feedback.

In general, high costs are closely correlated with low performance.  Keep a close hand on your wallet, and leave those who are charging you more than 1%, unless they are doing something special for you.

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I think I gave good advice in that era.  As the bubble deflated, investors needed to be more careful, and I highlighted that.  Not that I will always get it right…

In hindsight, I’m not happy about what I wrote August-October 2007.  As the bubble built I criticized it in fainter ways than it deserved.  Given the implosion of money markets, I should have been more bearish.  Part of that faintness stemmed from the stigma that came to bears in that era.  But here are articles from that era:

More Slick VIX Tricks

Attempts to explain the relationships between implied volatility and equity, and also corporate bonds.

Speculation Away From Subprime, Compendium

Subprime was getting blamed, but there were many areas where markets were very speculative at the time.  I call them out here, and I was not often wrong.

The FOMC as a Social Institution

I got a lot of publicity over this one.  I may do another one in 2011.  It is important to understand that those on the FOMC are not geniuses.  They are bright, but slaves to a view of the world that is not accurate.  The Fed drinks their own Kool-aid.

The Current Market Morass

As the markets declined, there were a lot of signs of the oncoming trouble that were ignored.  Following market liquidity was an aid to avoiding some of the crisis that was to come.

The Collapse of Fixed Commitments

I anticipate a lot of what will happen in the next 18 months, while not taking that much action.

A Moment of Minsky?

I get some publicity for being a little ahead of the crowd in suggesting that Minsky was correct in the way he viewed economic cycles.  I also anticipate what will happen one year later.

Sticking with the Short End, or, The Short End of the Stick

In the midst of the money market panic, the Fed added liquidity, whether it was right to do so, or not.

The Four Rules of Currency Intervention

These are the rules regarding currency interventions, ignored by hubristic governments that go their own way, and lose value as a result.

Ten Years From Now

In this article, I attempted to estimate what variable drove stock market performance in aggregate ten years out.  I discovered:

My 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

If Hedge Funds, Then Investment Banks

I argued that if many hedge funds had mismarked assets, then many investment banks would as well.  Definitely worked out that way, but bigger than I expected.

Society of Actuaries Presentation

This was a forty minute talk that I gave to the Society of Actuaries at their Annual Meeting.  Very big picture, and very prescient.  Worth a look if you have 15 minutes sometime.  I put a lot of work into this one.

Stocks Don’t Care Who Owns Them; Social Insurance and Private Markets Do Not Mix

Every now and then, some crank like Bill Clinton comes up with the idea that “all we gotta do is invest the Social Security trust funds in the stock market, and the funding problem will go away.”  This is the antidote to that malarkey.

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But, as the markets approached their recent highs during this period, I was skeptical, but insufficiently skeptical.  Further, I blew it on Deerfield, National Atlantic, and my view of how FOMC policy would evolve.  So for this era of my blogging, I have my regrets — I should have done better, even though I got some interesting things right.

This second period goes from May to July 2007.  Here we go!

A Modest Proposal to Raise Taxes on Mr. Buffett (and me)

Points out how the problems with the tax code are really more about defining income rather than tax rates.  It is easy for the rich to defer/shelter income — far better to tax increases in net wealth, and tax all people like traders, who are marked-to-market at the end of each fiscal year.

Talking to Management

One of my “labor of love” pieces written for RealMoney — five parts, dealing with how to interrogate management teams.  A lot of the game is asking the wrong questions, and seeing how management answers them.

Back From Bermuda

Uh, this post made me persona non grata in Bermuda for 2-3 years.  I think I could return now.  Part of the difficulty was that I was not told that sessions were supposed to be “off the record.” That said, my blog was the most popular blog in Bermuda for a day.  Apologies, HF, and thanks for inviting me; sorry to embarrass you.

Thinking About What Might Blow Up

Fascinating to see all of the markets that were going to blow up within 15 months trotted out for display.  Also, the basics of my theory on how one detects bubbles.

What Brings Maturity to a Market

Failure brings maturity to a market; risk-based pricing follows the realization of risk.

PIMCO in Theory and Practice

Important piece, because people watch PIMCO on the tube, and think that they make money off of their economic predictions, which are often wrong.  PIMCO is really a bunch of intelligent fixed income quants, who make their money off of mispriced out-of-the-money volatility.

Private Equity: Short Term versus Long Term Rationality

Analyzing comments of Cramer and others as to when the Private Equity bull market would end.

Speculation Gone Wrong, Or, Tops are a Process

I was commenting on how it is hard it is to call a top, because they are processes rather than events.  Who can tell how long foolish liquidity can last?

Trailing E/P as a Function of Treasury Yields and Corporate Spreads

Part one on my “Fed Model.”  Analyzing secondary factors in stock and bond performance.

Subprime Credit, Illiquidity, Leverage, Contagion and Concentration

I suggested that a small number of players would get hit by losses in subprime.  True enough, but what I did not know was how much risk was still being held by investment banks.

Efficient Markets Versus Adaptive Markets

A post I cite frequently, mainly for the joke at the end, but a post that tries to make the point that markets are not fully efficient, but they are somewhat efficient.

Quantitative Analysis is not Trivial — The Case of PB-ROE

In some environments, PB-ROE and low P/E investing will be similar, but that will not always be true. Do not accept a false simplification, even though it may be true at present. The PB-ROE model is richer, and works in more environments, after adjusting for the limitations listed above. PB-ROE is a very useful tool, and not “gobbledygook.”

Defends the PB-ROE model while admitting its limitations.

The “Fed Model”

Defends a version of the dividend discount model, and shows the simplifications that the “Fed Model” imposes are unrealistic, while showing that a more realistic model can add value over the long run.

A Fundamental Approach to Technical Analysis

Tries to explain how an intelligent fundamental investor would think about technicals, particularly in markets that are less liquid.

Twenty-Five Ways to Reduce Investment Risk

This article got me an invite to write an article for a Canadian business magazine.  But this article encapsulates the many ways I think about risk in investing.

Dissent on Dividends

Roger Nusbaum ably pointed out how demographics favors an increasing amount of dividends being paid to retiring Baby Boomers.  That is true.  We have ETNs being set up to do that (beware of Bear Stearns default risk), and hedge fund-of-funds crowding into strategies that synthetically create yield.  Beyond that, we have Wall Street creating funky yield vehicles that gyp facilitate the yield needs of buyers (while handing them capital losses).

My main point is this.  Approach yield the way a businessman would.  If you see an above average yield, say 4% or higher, ask what conditions could lead them to lower the yield. History is replete with situations where companies paid handsome dividends for longer than was advisable.

Back in 2002, I heard Peter Bernstein give an excellent talk on the value of dividends to the Baltimore Security Analysts Society.  At the end, privately, many scoffed, but I thought he was on the right track.  I still like dividends, but I like businesses that grow in value yet more.  Aim for good returns in cash generating businesses, and the dividends will follow.  Stretching for dividends is as bad as stretching for yield on bonds.  That extra bit of yield can be poisonous, leading to capital losses far greater than the incremental yield obtained.

Dividends are good, but they are a very imperfect way to approach the market.

Is the S&P 500 30% undervalued?

A somewhat whimsical piece that looked at implied equity volatility alone, and suggested that either the equity market was low, or equity volatility was high.  The truth was neither.  Equity volatility would blow out and go higher still, along with credit spreads.  Fortunately I was not dogmatic about my model’s conclusions.  I was more bearish in general in late July.

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So much for that era.  It was an interesting time as the bubble neared its apex.

We’re coming up on the fourth blogoversary for the Aleph Blog next month, so I wanted to do something a number of readers asked me to do — create a list of my best posts, with a little commentary.  I’m going to do it in segments of three months each, so that should be 16 posts by the time I am done.

Our first period goes from February-April 2007.  I wrote a lot on the panic after the Chinese market fell dramatically.  I also got Cemex and Deerfield Capital dreadfully wrong.  But here are the high points of that quarter:

What is Liquidity?

Liquidity is not a simple concept.  Depending on the situation, it can mean different things.

Helpfully, Martin Barnes, of BCA Research, an economic research firm, has laid out three ways of looking at liquidity. The first has to do with overall monetary conditions: money supply, official interest rates and the price of credit. The second is the state of balance sheets—the share of money, or things that can be exchanged for it in a hurry, in the assets of firms, households and financial institutions. The third, financial-market liquidity, is close to the textbook definition: the ability to buy and sell securities without triggering big changes in prices.

Pretty good, but it could be better. These are correlated phenomena. Times of high liquidity exist when parties are willing to take on fixed commitments for seemingly low rewards. Credit spreads are tight. Credit is growing more rapidly than the monetary base. Banks are willing to lend at relatively low spreads over Treasuries. Same for corporate bond investors. And, if you are trying to generate income by selling options, it almost doesn’t matter what market you are trading. Implied volatilities are low, so you realize less premium, while giving up flexibility (or, liquidity).

Yield = Poison

When everyone is grasping for yield, that is the time to avoid it, and aim for capital gains.  That is what I am doing now.

Bicycle Stability Versus Table Stability

A bicycle has to keep on moving to stay upright. A table does not have to move to stay upright, and only a severe event will upend a large table.

The main point there was to ask yourself what happens to your investments if the finance markets ever shut for a while.  Not that that scenario was likely to happen.

Getting Your Portfolio in Better Shape

Getting Your Portfolio in Better Shape, Part 2

Two part series on how I make changes to my portfolio.

Your Money or Your Job! (Or Both!)

Commentary on the buyout of Tribune.  Sadly, I was proven right on this one.  Sam Zell ended up making those at Tribune worse off.

Let Them Eat Yield!

More in the vein of Yield = Poison.  Sage words in a hot fixed income market that was about to blow.

Too Many Vultures, Too Little Carrion

I got it right that subprime auctions were not a sign of strength.

International Diversification

It’s a good thing, but it is not a free lunch.

Why Financial Stocks Are Harder to Analyze

The main problem is that the cash flow statement is meaningless, but I try to put a little more meat on the bones.

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So much for the first three months.  I hope you enjoy this series, as I highlight the best of the past.

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.