Two years ago I wrote at RealMoney:

		David Merkel
		In Bondage to Barclays plc
		6/21/2006 2:41 PM EDT

Roger, there is a reason to be aware the the ETNs issued by Barclays plc are notes. (or, bonds) If Barclays went bankrupt, the value of the notes would be impaired. From my limited glance through the prospectus:

The Securities are medium-term notes that are uncollateralized debt securities and are linked to the performance of the GSCI® Total Return Index (the “Index”).

and later…

The Securities are unsecured promises of Barclays Bank PLC and are not secured debt. The Securities are riskier than ordinary unsecured debt securities. The return on the Securities is linked to the performance of the Index. Investing in the Securities is not equivalent to investing directly in Index Components or the Index itself.

and much later…

USE OF PROCEEDS

Unless otherwise indicated in the applicable pricing supplement, the net proceeds from the offering of the notes will be applied for our hedging and general corporate purposes.

In essence, a holder of the ETN has bought a senior unsecured zero coupon bond from Barclays, with an ultimate payoff based off of the return on the commodities index less 0.75%/year. But unlike a bond, there is no floor on the implied interest at zero. If commodity indexes fall, the ETN would give a negative return.

I like Barclays. I own the stock. But there is more than one risk to the ETNs: commodity price risk (of course), and Barclays plc credit risk (surprise!).

Position: long BCS, and pondering the days when I used to read structured bond prospectuses regularly…

-=-=-=-

Now, today, I find it funny to see other retail investment commentators catching up with the credit risk angle of ETNs.  Perhaps it is my background in the Equity Indexed Annuity [EIA], Variable Annuity [VA], DC pension and GIC businesses — we had all sorts of guarantees and non-guarantees floating around, so we were used to analyzing the risks.

Now, what if the sponsors packaged the ETN with a default swap (written by third parties) to protect the investors if the company failed?  At that level, the ETN provider should buy Treasuries or Agencies, and layer on the futures or options as the case may be, creating an ETF, because all of the advantage from doing the ETN goes away.

Be wary of ETNs, at least to the level of asking how likely it will be for the sponsor to be in good shape when the ETNs mature.

Liquidity is like water. Is water a solid, a liquid, or a gas? Depending on the situation, water can be any or all of the three. When I started my blog, my first serious post was “What is Liquidity?” Given what was about to happen in Shanghai seven days later, and what that would do to liquidity, the post was ahead of its time.

Yesterday I saw two posts on liquidity:

• Liquidity isn’t apple pie
• Is Illiquidity Just Another Word for Uncertainty?

Both had a number of good points, though I like my piece better.  Let me borrow from Peter Bernstein, where he said something to the effect of “Liquidity is the ability to have a do-over.”  In other words, if you make an investment mistake, how much does it cost you to reverse it?

The three aspects of liquidity:

• What sort of premium does it take to get someone to lock into a long-term commitment?
• Slack assets available for deployment into new investments, and
• Bid-ask spreads

are correlated.  When there are few slack assets relative to investment needs, large premiums have to be offered to get investors to lock into a long-term investment, and bid-ask spreads tend to be wide as well.

But let’s consider the flip side of liquidity.  Liquidity is akin to holding a long option.  Rising volatility is the friend of one who has liquidity or a long option.  But, being long an option means someone else is short an option.  Having liquidity means that someone else has to provide cash should you choose to buy something.  If you liquidate shares in a money market fund, cash must come either from new investors in the fund who take your spot, or the fund has to raise liquidity internally, handing you some of the proceeds from not entering into an overnight loan.

Or, consider the bid-ask spread in stocks, or other securities.  When the bid-ask spread is tight, it means that the market maker (or specialist), is comfortable that short-term volatility is low enough, that he will be able to profit from the tight spread on average.  When there is severe uncertainty, as there often is in esoteric fixed income instruments during a panic period, the bid-ask spread disappears, and one is reduced to “price discovery, using a broker who is discreet about your intentions regarding buying or selling.  (My, but I got good at that during 2001-2003.   Ouch.)

I like my definition of liquidity, which is the willingness (price) to enter into or exit fixed commitments.  It covers all three aspects of liquidity, and helps explain why they are usually different manifestations of the same phenomenon.

As for now, versus mid-February 2007, the willingness to enter into fixed commitments has declined markedly, even though it has improved over the last seven weeks.  That is no guarantee that it will continue to improve linearly.  Bear markets have their rallies, and this current rally has been a good one.  It would be rare to have such a short bear market, or one that ended without clearing away most of the prior excess lending problems.  We still have a lot of wood to chop there.

1) Desperation and the Dollar. In mid-March, pessimism over the US economy and monetary policy were so thick that people were considering the old Greenspanian rate of 1% Fed funds as possible. Well, times change, at least for now. The orange line above is the 2-year Treasury yield which gives a fair read on expectations of monetary policy, which bottomed in mid-March. It took the Dollar a little longer to move along, but the present course of dollar is up in the short-term (consider the Euro). That doesn’t address the possibilities of a wider lending problem, or the overly aggressive fiscal policies that will be employed by the next President. (Deficits don’t matter, until they are big enough to matter.)

2) I’ve talked about the US Dollar and the five stages of grieving. I think the G7 got to the second stage, anger, in threatening action recently. I think they get a respite from fear because of the bounce in US monetary expectations. My guess is that they would intervene when the Dollar gets to $1.70/Euro. Neither the threats nor the intervention will have much impact in the long run, though. This will only change when foreigners stop buying our bonds, and start buying our goods and services.

3) Another thing that correlates with the shift in expectations of US monetary policy are yields in long government bonds around the world. Surprise, as the anticipated future financing rates rise, the willingness to try to clip a spread off of long bonds declines.

4) So what could replace the Dollar as the global reserve currency? The Euro, maybe? The Yen and Pound are too small, and everything else is smaller still. The Yuan might be ready in 15 years when their financial markets are developed. It takes a long time for the reserve currency to shift.

5) So, why not the Euro? I’m still a skeptic that the EU will hang together without political union. Also, a strong Euro is testing the monetary union in places where credit markets are weak, and export markets are weakening because the US is getting more competitive with the weak Dollar. That said a persistently weak dollar raises the incentives for other countries to look for a new reserve currency. Leaving aside the potential instability of the EU (unlikely in the short run) the Euro is probably the best alternative.

6) This piece by Felix Salmon helps point out why why Iceland is the canary in the coal mine. They are the smallest economy with a floating currency. It seems like they are successfully defending their currency at present, at the cost of 15% interest rates.

7) Is the UK economy just a miniature version of the US economy?

• Cutting Central Bank lending rates
• Bailout plans for the banks (and here)
• Many homeowners with negative equity, and all of the problems that brings

8 ) Why is Chinese inflation rising? Loose monetary policy, and an undervalued Yuan, at least versus the Dollar. Now, maybe the Chinese will start buying Euro-denominated bonds, and sell more to the EU than they buy. (Note that I am not the only skeptic on the Euro’s survival.)

9) What of the Gulf States? What will they do with all of the dollars that they have? Along with China, their huge depreciating Dollar reserves are fueling inflation. Personally, if I were in their shoes, I would buy US corporations quietly, perhaps through the purchase of ETFs. But the huge accumulation of dollars threatens to create the same “white elephant” development schemes that they experienced in the early 80s, when the socialist Gulf governments had too many Dollars, and too few places to use them.

10) Inflation is rising in the OECD. This is a “sea change” in terms of economics. Policymakers have enjoyed falling inflation rates for so long that perhaps they aren’t ready for the degree of monetary tightening necessary to squeeze out inflation.

11) Development isn’t easy after a point. It reveals shortages, as India is experiencing in semi-skilled and skilled labor. This will eventually work out, but in the short run, it makes infrastructure and construction projects difficult. Bodies aren’t enough; skills are needed, and many better skilled Indians work abroad, where they can make more.

12) A rice cartel? Everything old is new again. I remember in the 1970s when the US talked about a wheat/corn cartel, in response to the new strength of OPEC. Personally, I don’t think it would be effective. Agriculture is too flexible for cartel-like schemes to work in the intermediate-term. But, let them try. It will be interesting to see what happens.

In my blogging, in my other research and in investing, I gain some degree of comfort from being criticized by both bulls and bears. Worst of all would be no criticism; it would mean that I am not saying much. Criticism from both sides means that I am probably not blindly taking a partisan view, or talking my own book.

Briefly this evening, I want to point out some of the costs of our current monetary policies. Now, some things are going well, and the Fed might want to take some credit.  But the costs are soft costs, ones that are preferable to systemic financial collapse. That said, there are smarter and dumber ways to do bailouts. When I criticized the Bear Stearns bailout, I tried to point out how there have been better ways of doing bailouts from history, and that the Fed should have known this. I understand that the Fed may have felt rushed at the time, leading to a suboptimal decision, but they should be better read on economic history. Bailouts should be very painful for those bailed out, or else others line up for them.

Well, now that there has been one bailout, why not more? Other shaky areas of the economy could use a bailout… student lenders, homedebtors, home lenders, etc. Are they less worthy than Bear Stearns? Ignore the student lenders, because they pose little systemic risk. If housing prices fall another 20%, the systemic risk issues could be severe. Consider there two quotes from the article:

“There is no way to put the genie back in the bottle,” Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. “What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.”

and

Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. “The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,” they wrote. That “creates a potentially severe moral-hazard problem.”

We’re on that slippery slope now. Should the Fed bend monetary policy even more to compensate for areas of lending where they have inadequate control? To the extent that you believe in central banking, central banks should deal with the big issues, and leave the little ones alone. Lend at a penalty rate during a crisis; don’t try to make things normal. Where there is systemic risk, stand behind the core but not the fringe; defend debt claims, and wipe out equity claims.

Or, consider the second order effects that our monetary policy creates: the weak dollar and the responses that foreign governments must follow: let their export sector wither, or follow US policy down, and accept more inflation. It will take a long time for the US to lose its reserve currency status, but we are on that path. Here’s to the day when we have to borrow in the currencies of oil exporters, or China. (Please no. )

Or, consider the troubles that the states are in, since they have to run balanced budgets, unlike the Federal government, which can borrow in dollars, and inflate the currency as needed. I follow state tax revenues; it is an excellent coincident read on the economy. Well, sales tax revenues are falling. Also, some states are considering one of the “dumbest ideas ever” — pension bonds (borrowing to fund pension plans, relying on clever investing to beat the rate paid on the bonds). New Jersey lost big on their last attempt at pension bonds. Far better to consistently fund municipal pensions through general revenues. For those that have read me before on municipal pensions, their claim to fame is that they make private sector funding look good.

Finally, to end on a less sad note, is Iceland looking better, or , is it just part of an overall bear market rally?  (What of Argentina?)   My guess is the latter, but maybe they have successfully defended their currency. Then again, we can look at Brazil, which is now investment grade on one side (from S&P). Good news follow good policies, and Brazil has been on the right track — they have become a net creditor, unlike the US. Hey, maybe the Real should be a reserve currency.

Those who have read me for a long time know that my favorite insurance company is Assurant.  I’m not writing tonight about how they had great first quarter earnings, or how their investment portfolio suffered less than their competitors.  Rather, it springs from a Bloomberg article that is not available on the web.  It seems Assurant is talking to Countrywide about purchasing their Balboa Insurance Group.

What makes for an intelligent acquisition?  Two things: don’t overpay, or flub the integration.

On overpaying, it helps if you are buying:

• part of a business rather than the whole company
• a noncore asset of the target
• and offering noneconomic benefits (e.g. joining Berkshire Hathaway, because Warren doesn’t change the culture…)
• through a negotiation, not an auction (think of MetLife buying Traveler’s Life)
• something where you can get significant expense savings
• and you are known to be prudent and fair as an acquirer

On integrating, it helps if:

• you are integrating a business that differs from your business in at most one or two ways
• corporate cultures are similar
• the differences in technology are small
• you gain new markets or technologies that you can use in the rest of your business

Assurant has done very well through small in-fill acquisitions where they pick up a new line of business that they can grow organically.  They also have done well in occasionally buying scale in areas where they are already strong, for example, when they bought the pre-need (funeral) insurance business of Service Corp International (a very concentrated niche business line).

With Balboa Insurance Group, Assurant would deepen its penetration into lender placed homeowners insurance.  Assurant is #1, and Balboa I think is #2 because of its business with Countrywide.  Assurant has efficient systems — they will be able to take out costs, and deliver even better service to Countrywide / Bank of America.

Now, if Countrywide is interested in selling, it is likely that the best bid would come from Assurant, not because they will overpay, but because they can offer the best service, and take out the most in expenses.  Bank of America would likely find Balboa to be a small noncore asset, so their interest in retaining it would be low.

Here’s small excerpt from the Bloomberg piece:

“Certainly that is a business we would be interested in,” Assurant Chief Executive Officer Robert Pollock said today in a conference call with investors. “Until things between Bank of
America and Countrywide close, I don’t think that’s going to be a focus” for Bank of America.

Countrywide, based in Calabasas, California, reported a first-quarter loss of $893 million earlier this month, its third straight quarterly loss, as late mortgage payments and home
foreclosures rose. Bank of America said April 21 that its purchase, which would make the Charlotte, North Carolina-based bank the largest U.S. mortgage lender, remained on course forcompletion in the third quarter.

“Even in that case though, we still have to evaluate what we would have to pay for that business versus our ability to win” Balboa, Gene Mergelmeyer, president of Assurant’s specialty
property business, said in the call.

So, I look at this as a possible plus for both Bank of America and Assurant.  Balboa will be most valuable in Assurant’s hands.  Put it this way, why would another insurer want to buy Balboa when it is up against much superior competition?

PS — From the “don’t give a sucker an even break” file, Bank of America may not guarantee the debt of Countrywide.  This should not be a surprise.  They aren’t required to guarantee the debt, and Countrywide bondholders should just be grateful for the equity infusion.  If things get bad, though, Bank of America could walk away from Countrywide, and give it to the bondholders.

Full disclosure: long AIZ

1) The rating agencies have been running like crazy. They do that when they are behind the curve. Whether it is Moody’s on subprime, or S&P on Alt-A lending, the downgrades are coming in packs. Then there are difficulties with the debts of real estate partnerships, like LandSource Communities Development, which is likely to file for insolvency, together with some residential developers.

2) Now, there have been a few summary pieces on how the rating agencies changed as the housing boom moved on. Here is one from the New York Times, and one from the Wall Street Journal. As I had commented long before in my writings at RealMoney, the rating agencies were co-dependent with those that paid them. That said, it would be hard to construct a system that would not be that way. Buyers don’t have a concentrated interest in ratings. Issuers so.

3) If I were Ambac, I would be doing all that I could to allege fraud on contracts where representations and warranties were not upheld. Ambac is fighting to survive.

4) Mortgage insurers — it is the best of times, if you survive, because you are the almost the only game in town for those wanting to do low down payments, and rates for mortgage insurance are way up. But, it is the worst of times, housing prices are falling, rating agencies are downgrading, and defaults on insured mortgages are rising.

5) Foreclosures:

• An excellent summary and map of foreclosure activity.
• Maryland makes them take a little longer. (The article overstates the lengthening.)
• California is suffering.
• Desperate in Denver.
• Foreclosures and crime are correlated.
• Which leads the FHA to act, and the states to act as well, because Federal efforts are slow.

6) Gotta love OFHEO, which is trying to rein in the GSEs during a lending crisis. Even though they may have traction, I don’t see how they tighten the regulations during a crisis.

7) For that matter, consider the lenders. Countrywide seemed to purposely ignore the creditworthiness of borrowers as they jammed it out the door lent on mortgages. Even with all this, mortgage lenders are complaining that new regulations will make mortgages less affordable. What they mean is that they will issue fewer mortgages, and they will make less profit. Please, let’s stop making it easy for those that can’t afford a home to take the risk of buying one. Higher mortgage rates are bad in the short run, but good in the long run.

8 ) Dr. Jeff reluctantly asks what inning we are in on housing. I understand that it is an overused metric, but it is overused for a reason. Nine is an intuitive number — are we halfway through? Fifth inning. One-quarter? Third. Almost done? Eight or ninth. He also makes a simple request to those of us who opine on the housing slump, to be more definite in what we say, provide more data, and what will be signs that the troubles are turning.

I need to set up some housing recovery googlebots to scan for me, but my guess is that we are in the fifth inning of the troubles. When I get more definitive guesses/answers to the questions, I will post.

9) Delinquencies:

• Lenders, or better, servicers, are struggling with the load.
• That said, the growth in subprime delinquencies is slowing. Perhaps we are going through burnout, where most of those likely to default have done so, and a few incremental defaults remain.
• But home equity loan experience keeps getting worse. (My only surprise there is how slow this has been in arriving.)

10) Home prices continue to fall, and estimates to the nadir (cycle low) range between 0-50%, with 10-20% being the most common.

11) Falling home prices will lead to many more foreclosures in prime loans, and of course Alt-A and subprime. Foreclosures happen when a sale would result in a loss, and a negative life event hits — death, divorce, disaster, disability, and unemployment.

12) Second-order effects:

• Home remodeling expenditures fall
• (Commercial) Architecture Billings index falls. (Does not bode well for commercial real estate.)
• Low new housing sales.
• Tough total sales environment in the SF Bay Area. Sales fall before housing prices, and rise as housing bottoms. (Opinions on that last thought?)
• Allegations of fraud are thick among borrowers and lenders. A lotta smoke, but is there any fire?… Clearly, the servicing system was not designed for this level of failure, so I’m not surprised that things are moving slowly.
• Homeowner vacancy rates are at an all-time high. That should keep the pressure on prices, because there is a lot of competition if you want to sell, and there is a lot of dark supply waiting to emerge if prices get more favorable. Emergence from this set of troubles may be slow, much like a credit crisis in the corporate bond market often feels slow to unwind.

As we were driving down the highway Monday evening, back from our oldest daughter’s symphony concert at U-MD, my wife and I began talking about teaching children about money.  We homeschool, so we have to consider a lot in training our children for the real world.

Some of my children have an interest in the market, some don’t. Personalities differ, but you want to give them some core knowledge that everyone can use. There have been people in our home school get-togethers who when they find out I am an investor, they ask “Do you know of any good books on the stock market for kids?” Lamely, I suggest the out-of-print book by Ken Fisher’s son, Clayton, which is pretty good, but I didn’t think it was definitive.  One has complained to me about the Stock Market Game, which seems to teach speculation, not investment.

That’s true of most stock market contests — the only exception I can think of was the Value Line contest back in 1984 . I managed to place in the top 1%, but not high enough to win. That contest forced you to pick 10 stocks from ten different groups for six months. The stocks were sorted by price volatility deciles, so you had to pick some volatile stocks and tame stocks. The stocks were equal weighted, and there was no trading. Great contest — I would love to run something like that. I have suggested it to The Street.com, but no dice. Hey, maybe Seeking Alpha would like to try it! Nominal prize money, but there would be bragging rights!  (Abnormal Returns, this could work for you as well…)

My wife tells me to think about it. Well, today, as I’m going through my personal e-mail, I run across a note from the Home School Legal Defense Association promoting the National Financial Literacy Challenge. Timely, I think. They are having a competition based off of the national standards published in 2007 by the Jump$tart Coalition for Personal Finance.

So I look at the standards, and I think, “These are pretty detailed… how can you turn this into a usable curriculum?”  I print them out and read a little bit of them to my wife Ruth, who says, “Typical for those that set standards, and aren’t teachers; you can’t work with that stuff.”  My wife was a high school teacher, and despite that hindrance, she still homeschools well.  But she knows the troubles that come to public school teachers as mandates come down from on high.

She asked me, “What would you recommend, then?”  I thought about it and said that the personal finance book that I reviewed recently, Easy Money, would be a good book for high school seniors to read.  It’s not a complex book at all.  Afterward I would discuss it with them.  She asked me why I hadn’t done that for our older two children and I said, “It was published after they went to college.  I’ll ask them to read it this summer.”

For investing, I still think that Buffett’s Annual Reports are understandable to most teens.  Marty Whitman is easy to read as well.  But I always liked Ben Graham, and I think The Intelligent Investor is accessible to the average teenager.  Good investing is not complex… but often we make it so.

Full disclosure: if you enter Amazon from my links and buy anything, I get a small commission.  It is my substitute for the tip jar, and it doesn’t increase your costs at all.

One thing about Jim Cramer, he is quotable.  Take this short bit from his piece, Graybeards Get It Wrong on Financials.

One of the loudest and most pervasive themes by a lot of the graybeards is that there is still much more pain ahead in the financials.Let me explain why that is wrong. First, the group is down from a year ago. It’s been hammered mercilessly.

More important, every time the stock market rallies is another chance for these companies to refinance.

Remember, as they go up, the companies are in shape to tap the equity market again because those who bought lower are being rewarded, psyching others to take a chance. In fact, other than the monoline insurance faux bailouts, people who pony up are doing pretty well.

Now, he might be right, and me wrong on this point (with my gray beard, though I am younger than he is).  But let me point out what has to go right for his forecast to be correct.

1) The inventory of vacant homes has to start declining.  Still rising for now, another new record.  Beyond that, you have a lot of what I call lurking sellers around, waiting to put more inventory out onto the market, if prices rise a little.  They will have to wait a while, and many will lose patience and sell anyway.  There is still to much debt financing our housing stock, and though most of the subprime shock is gone, much of the shock from other non-subprime ARMs that will reset remains.  Will prices drop from here by 20%?  I think it will be more like 12%, but if it is 20% there will be many more foreclosures, absent some change in foreclosure laws.  Foreclosures happen when a sale would result in a loss, and a negative life event hits — death, divorce, disaster, disability, and unemployment.

2) We still have to reconcile a lot of junk corporate debt issued from 2004-2007, much of which is quite weak.  Credit bear markets don’t end before you take a lot of junk defaults, and we have barely been nicked.  Yes, we have had a sharp rally in credit spreads over the last five weeks, but bear market rallies in credit are typically short, sharp, and common, keeping the shorts/underweighters on their toes.  You typically get several of them before the real turn comes.

3) We have not rationalized a significant amount of the excess synthetic leverage in the derivatives market.  With derivatives for every loser, there is a winner, but the question is how good the confidence in creditworthiness between the major investment banks remains.  Away from that, Wall Street will be less profitable for some time as securitization, and other leveraged businesses will recover slowly.

4) Credit statistics for the US consumer continue to deteriorate — if not the first lien mortgages, look at the stats on home equity loans, auto loans, and credit cards.  All are doing worse.

5) Weakness in the real economy is increasing as a result of consumer stress.  Will real GDP growth remain positive?  I have tended to be more bullish than most here, but the economy is looking weaker.  Let’s watch the next few months of data, and see what wanders in… I don’t see a sharp move down, but measured move into very low growth in 2008.

6) What does the Fed do?  Perhaps they can take a page from Cramer, and look at the progress from private repair of the financial system through equity and debt issuance.  It’s a start, at least.  But the Fed has increasingly encumbered is balance sheet with lower quality paper.  Two issues: a) if there are more lending market crises, the Fed can’t do a lot more — maybe an amount equal to what they have currently done.  b) What happens when they begin to collapse the added leverage?  Okay, so they won’t do it, unless demand goes slack… that still leaves the first issue.  There are limits to the balance sheet of the Fed.

Beyond that, the Fed faces a weak economy, and rising inflation.  Again, what does the Fed do?

7) Much of the inflation pressures are global in nature, and there is increasing unwillingness to buy dollar denominated fixed income assets.  The books have to balance — our current account deficit must be balanced by a capital account surplus; the question is at what level of the dollar do they start buying US goods and services, rather than bonds?

8 ) Oh, almost forgot — more weakness is coming in commercial real estate, and little of that effect has been felt by the investment banks yet.

As a result, I see a need for more capital raising at the investment banks, and more true equity in the capital raised.  Debt can help in the short run, but can leave the bank more vulnerable when losses come.  The investment banks need to delever more, and prepare for more losses arising from junk corporates and loans, housing related securities, and the weak consumer.

The bond market has had quite a shift since the last Fed meeting. What are the common themes?

• Outperformance of credit, especially high yield.
• Return of the carry trade.
• Tax-free Munis have run.
• Underperformance of Treasuries (longer= worse), and foreign bonds, particularly carry trade currencies like the Yen and Swiss Franc.

The willingness to take risks in fixed income has returned, particularly in the last two weeks. I don’t want to tell you that this is a trend that won’t reverse… it might reverse. Remember that bear market rallies tend to be short and sharp, and that the credit bear market in 2000-2002 had several legs. Leg one may be over for this credit bear market, but that doesn’t mean the credit bear market is over; there are still too many unresolved credit issues in housing, builders and investment banks.

Now, to flesh out the changes, I looked at the total returns on 15 major ETFs in different sectors of the bond market. Here are the returns since 3/19:

• HYG — High yield Corporates + 4.47%
• DBV — Carry trade fund +2.83%
• MUB — National Municipals +1.10%
• LQD — Investment Grade Corporates +0.99%
• FXE — Euro currency Trust +0.29%
• BIL — Treasury Bills -.06% (Negative on T-bills?!)
• AGG — Lehman Aggregate -1.03%
• SHY — Short Treasuries -1.18%
• TIP — TIPS ETF -2.85%
• IEI — 3-7 yr Treasuries -3.41%
• FXF — Swiss Franc Currency Trust -3.44%
• BWX — Intl. Gov’t Bond Fund -3.49%
• IEF — 7-10 yr Treasuries -3.74%
• TLT — 20+ Treasuries - 4.87%
• FXY — Yen Currency Trust -5.30%

What a whipping for safe assets. Perhaps the Fed will be happy that they helped engineer the whacking. Then again, the TED spread is still high, and the change might just be a normal shift in sentiment after the panic leading up to the last FOMC meeting. Interesting to see both the return of the carry trade and credit spreads outperforming the move in Treasuries.

For those that follow my sector recommendations, I would be lightening, but not exiting credit positions in the near term. I’m in the midst of considering my other sector recommendations, and will report on this soon. For more on this topic, refer to:

• Its against my programming to call bottoms (and anything by Accrued Interest)
• RIP Bond Rally 2005-2008
• Signs of Improvement in the Credit Markets
• Debt Investors Show Signs Of Relief

Before I close, one large negative area where there is excess supply: preferred stock of financial companies.  There is a lot floating around from balance sheet repair efforts where they didn’t want to dilute the common.  (That’s the next act.)  I would stay away for now, but keep my eyes on selected floating rate trust preferreds, to leg into on the next leg down.

A word before I start: I’m averaging two book review requests a month at present. I tell the PR people that I don’t guarantee a review (though I have reviewed them all so far), or even a favorable review. They send the books anyway.

Included in every book is a 2-6 page summary of what a reviewer would want to know, so he can easily write a review. Catchy bits, crunchy quotes, outlines…

I don’t read those. I read or skim the book. If I skim the book, I note that in my review. Typically, I only skim a book when it is a topic that I know cold. Otherwise I read, and give you my unvarnished opinion. I’m not in the book selling business… I’m here to help investors. If you buy a few books (or anything else) through my Amazon links, that’s nice. Thanks for the tip. I hope you gain insight from me worth far more.

If I can keep you from buying a bad book, then I’ve done something useful for you. I have more than enough good books for readers to buy. Plus, I review older books that no one will push. I hope eventually to get all of my favorites written up for readers.

Enough about my review process; on with the review:

When the PR guy sent me the title of the book, I thought, “Oh, no. Another investing formula book. I probably won’t like it.” Well, I liked it, but with some reservations.

The authors are a father and son — Gerard Appel and Marvin Appel, Ph. D. They manage over $300 million of assets together. The father has written a bunch of books on technical analysis, and the son has written a book on ETFs.

Well, it is an investing formula book… it has a simple method for raising returns and reducing risks that has worked in the past. The ideas are simple enough that an investor could apply them in one hour or so every three months. I won’t give you the whole formula, because it wouldn’t be fair to the authors. The ideas, if spun down to their core, would fill up one long blog post of mine. But you would lose a lot of the explanations and graphs which are helpful to less experienced readers. The book is well-written, and I found it a breezy read at ~200 pages.

I will summarize the approach, though. They use a positive momentum strategy on three asset classes — domestic equities, international equities, and high yield bonds, and a buy-and-hold strategy on investment grade bonds. They apply these strategies to open- and closed-end mutual funds and ETFs. They then give you a weighting for the four asset classes to create a balanced portfolio that is close to what I would consider a reasonable allocation for a middle aged person.

Their backtests show that their balanced portfolio earned more than the S&P 500 from 1979-2007, with less risk, measured by maximum drawdown. Okay, so the formula works in reverse. What do we have to commend/discredit the formula from what I know tend to happen when formulas get applied to real markets?

Commend

• Momentum effects do tend to persist across equity styles.
• Momentum effects do tend to persist across international regional equity returns.
• Momentum effects do tend to persist on high yield returns in the short run.
• The investment grade buy-and-hold bond strategy is a reasonable one, if a bit quirky.
• Keeps investment expenses low.
• Gives you some more advanced strategies as well as simple ones.
• The last two chapters are there to motivate you to save, because they suggest the US Government won’t have the money they promised to pay you when you are old. (At least not in terms of current purchasing power…)

Discredit

• The time period of the backtest was unique 3/31/1979-3/31/2007. There are unique factors to that era: The beginning of that period had high interest rates, and low equity valuations. Interest rates fell over the period, and equity valuations rose. International investing was particularly profitable over the same period… no telling whether that will persist into the future.
• I could not tie back the numbers from their domestic equity and international equity strategies in the asset allocation portfolio to their individual component strategies.
• I suspect that might be because though the indexes existed over their test period, tradeable index funds may not have existed, so in the individual strategy components they might be done over shorter time horizons, and then used indexes for the backtest. This is just a hypothesis of mine, and it doesn’t destroy their overall thesis — just the degree that it outperforms in the past.
• They occasionally recommend fund managers, most of whom I think are good, but funds change over time, so I would be careful about being married to a fund just because it did well in the past.
• If style factors or international regional return factors get choppy, this would underperform. I don’t think that is likely, investors chase past performance, so momentum works in the short run.
• Though you only act four times a year, that’s enough to generate a lot of taxable events if you are not doing this in a tax-sheltered account.
• It looks like they reorganized the book at the end, because the one footnote for Chapter 9 references Chapter 10, when it really means chapter 8.

The Verdict

I think their strategy works, given what I know about momentum strategies. I don’t think it will work as relatively well in the future as in the past for 3 reasons:

• There is more momentum money in the market now than in the past… momentum strategies should still work but not to the same degree.
• International investing is more common than in the past… the payoff from it should be less. There aren’t that many more areas of the world to go capitalist remaining, and who knows? We could hit a new era of socialism abroad, or even in the US.
• Interest rates are low today, and equity valuations are not low.

Who might this book be good for? Someone who only invests in mutual funds, and wants to try to get a little more juice out of them. The rules on managing the portfolio are simple enough that they could be done in an hour or two once every three months. Just do it in a tax-sheltered account, and be aware that if too many people adopt momentum strategies (not likely), this could underperform.

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