Bonds – Page 120 – The Aleph Blog

Efficient Markets Versus Adaptive Markets

Posted on 2 July 200720 June 2017 by David Merkel

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

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

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

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

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

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

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

Scene One — Efficient Markets Hypothesis

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

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

Subprime Credit, Illiquidity, Leverage, Contagion and Concentration

Posted on 30 June 200720 June 2017 by David Merkel

There are two popular views that I am seeing among those that are in the media limelight at present regarding subprime mortgages. There may be more, but I will point at James Cramer’s assertions that this is an illiquidity event, and not a credit event, and the assertions of Bill Gross that this event heralds a wider credit event, and soon. Neither are correct in my opinion.

Cramer is in over his head on this topic; if you’ve never been a mortgage bond manager, but only an equity manager, you might view this in a way akin to a short squeeze. The hedge funds that got killed didn’t have enough equity to carry their positions through some market chicanery. There are no credit losses being allocated to the securities at present, and only the 2006 vintage stinks.

Plausible on the surface. My old boss at the Mt. Washington Investment Group would always say, “Liquidity follows credit quality.” Bonds with improving credit quality tend to become more liquid, and vice-versa for bonds with deteriorating credit quality.

One of my biggest professional investing mistakes was buying a gaggle of Manufactured Housing ABS bonds back in late 2001. I only bought bonds in vintages prior to mid-1997, because I knew later credit quality was horrid. I also stuck mainly to AA-quality mezzanine bonds. All of those bonds are still “money good” today, but when the market fell apart due to the horrid 1998 and after vintages, the bonds with relatively good underwriting got taken to the cleaners as well. Money good bonds trading in the 60s? It can happen.

Markets are discounting mechanisms; with asset-backed securities, if the projected losses make it virtually certain that a tranche of a securitization will lose principal, the tranche will quote like the losses have already happened. It doesn’t matter tht the losses won’t allocated for a few years; the tranche will trade at the discounted value of reduced future payments, at a high discount rate, if it trades at all.

The issues with the Bear Stearns funds are future credit issues, which produce present liquidity issues. It gets noticed there first because of the concentration of the risk in the fund, and the leverage employed. This is similar to what happened in 1994, when the prime mortgage market blew up over extension risk. There was no contagion there; many in the bond market absorbed losses from rising rates, but only a few notable players that took on the negative convexity risks in a big way got killed.

Derivatives are funny, or maybe I should say, people using derivatives are funny. Alan Greenspan thought that derivatives spread out the risk, making the system more stable. Nothing could be further from the truth, at least in terms of spreading out the risk. With derivatives, some market players, out of greed, concentrate the risk because they are trying to make a killing. When the negative part of the credit cycle hits, the speculators get destroyed. Contagion happens when the lenders to the speculators face major losses also. In 1998, that was the worry over LTCM.

With derivatives, speculators absorb the losses that previously might have been borne by the banking system. (Now, those speculators could be DB pension plans, endowments, or wealthy individuals, working through hedge funds.) If the banks overlend to these speculators, they can bear risk as well.

My view is that there are a small number of greedy players that hold most of the credit risk from subprime mortgages, and that their ultimate owners have enough capacity to bear losses that there is no significant contagion risk to the debt and equity markets, even if some players are wiped out, and the banks take modest losses.

That said, I would wait awhile to buy any subprime mortgage ABS, even at the AAA level. The market is dislocated, and has not fully realized the true level of losses that will be taken. The same goes for Alt-A loans, and make that a double!

In summary, this will not be a “piece of cake,” but the losses will be concentrated among a small set of investors. As for the CLO market, it will have its troubles, but not yet. Prudent investors will avoid it, but there may be some rallies there in the short run, away from subprime and Alt-A.

It was a Good Quarter; Also, my Favorite Managers

Posted on 30 June 200730 June 2007 by David Merkel

It’s good to be back home with my wife and kids. There truly is no place like home, particularly when things seem to be working well with my wife and kids.

Two quick notes, because I’m kind of tired:

I wondered at many points this quarter whether I would beat the S&P 500 or not. Not counting my unpaid dividends and interest, I can say that I was ahead by 110 basis points for the quarter, bringing the year-to-date figure to 590 basis points. I don’t expect to win every quarter, and not every year either, but the streak is at six years now, and I hope to prolong it. Let’s see how I do at the next portfolio reshaping, which should come this week.
One of my readers asked for my favorite mutual fund managers. Here they are: Marty Whitman at Third Avenue, Ron Muhlenkamp at the Muhlenkamp Fund, Don and Craig Hodges at the Hodges Fund, Ken Heebner at CGM, and Bob Rodriguez at FPA. (There are other value managers I like as well, Tweedy Browne, and Heartland Value, to name a few. I am a value guy, but I like rotating sectors.)

All of these managers are willing to look for cheap assets, and sectors that are undervalued. That’s what I do, and my record is comparable to theirs, though I run a lot less money.
Here’s to a great second half of the year. Let’s make some money together, or, at least not lose more than the market.

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

Posted on 27 June 200720 June 2017 by David Merkel

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

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

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

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

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

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

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

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

Eleven Articles on Residential Real Estate

Posted on 22 June 2007 by David Merkel

Those who have read me at RealMoney know that I have been bearish on residential real estate for the last 2-3 years, and on commercial real estate for the last year.? I have found it fascinating to see both markets move to situations where current income is exceeded by what can be earned in Treasury securities, much less mortgage funding costs.? Take it as a rule, when one must depend on rental growth and property appreciation to make a profit, it’s time to sell.? Anyway, here are the articles:

I guess I have to start with Bear Stearns’ hedge funds.? An ugly situation where Bear might have to tap $3.2 billion of liquidity to stem the crisis.? Bear can afford the money, but it might bite into their credit rating, and their ability to earn money off of their spare capital.? As I commented on RealMoney yesterday, it is not likely, but possible that this turns into a wider crisis.
Though this article is about Collateralized Debt Obligations [CDOs] generally, much of the excess yield that allowed the CDOs to be sold came from subprime CDOs.? Now who holds the risk?? From what I can tell, a bunch of hedge funds, hedge fund-of-funds, and pension plans.? The lure of easy yield beings out the worst in institutional investors stretching to make a certain total return target.? The low-paid managers of public funds are particularly drawn to these investments because of the political pressure to keep taxes low.
As an aside, the principal-protected versions are a sham; it is the same as investing a small amount in the volatile stuff, and a large amount in Treasuries.? That one can’t lose money on the package is meaningless; look at the two investments separately, and ask if they both make sense.? Lesson: don’t but investments that you don’t fully understand.
Little of the current troubles in residential real estate could have gone on without optimistic appraisals.? That’s putting it kindly; before the end of this crisis the appraisers are going to face some degree of additional regulation.? Will it be the right solution?? Probably not, but read the article, and watch a profession in need of tough ethical requirements, or perhaps, means of eliminating shady operators.
I’m not sure how one can rent out credit scores.? It would be fraud if done without the consent of the one whose score is borrowed.? With consent, it would be a stupid form of co-signing a loan.? I never recommend co-signing.? You have more protections loaning the person the money yourself, even if you have to take out a loan to do it.
I’ve followed this statistic for a while.? With a few conservative assumptions, it means that the average indebted homeowner has only 30% equity in his home.? Not a safe place to be.
Buying foreclosures?? Wait a year, okay?? Look, foreclosure, and other forms of distressed investing only work when the ratio of vultures to carrion is low.? It’s not low now.? Let the dumb vultures overspend now; come back when you hear of former vultures having to raise liquidity.
Barry Ritholtz and I have long been on the same page on residential real estate investing.? This article has some of the best charts I have seen in some time.
Here’s an alternative view of residential real estate pricing.? Rather than listen to the shills at the NAR, this might be a fairer take on the market.? Note that it has been lower and higher than NAR forecasts; I like that, because reality is almost aways more volatile than we would admit.
My view of the residential real estate markets is bifurcated.? The Midwest and the South suffered the worst initial foreclosures because housing prices did not rise much there, and refinancing was not an option.
? Tight finances + bad event = default.
But the pain will shift to the formerly hotter coastal markets, where subprime financing was more prevalent, as the ARM resets hit, and now prices are falling, and interest rates rising.
Excess supply is the rule; we have a little less than one year’s supply of housing vacant and ready to sell at present.? That is a record by almost double the long term average.? This will take years to clear up, particularly with the builders still constructing homes.? Perhaps we can solve the problem by selling all the excess homes to wealthy foreigners.? Kill two birds with one stone; fund the current account deficit, and reduce the the housing supply overhang in one fell swoop.
Interest rates are the silent killer here.? It would be wise for many people to refinance to prime fixed-rate loans, but with interest rates rising, the bar is getting raised for even creditworthy borrowers.

We are stopping at a butcher’s dozen here.? Not a great time to own residential real estate on leverage.? When I went to work for the hedge funds that employ me, I paid off my mortgage because my earnings would be less certain than what ai earned as a bond manager for an insurance company.? Would that more people were conservative with their finances in the same way.? As it is, I expect the residential real estate price slump to persist into 2009.

Speculation Gone Wrong, Or, Tops are a Process

Posted on 19 June 2007 by David Merkel

Tonight’s article is about speculation in the current market environment.? Let’s start with the front page of Wednesday’s Wall Street Journal.? Two medium-large hedge funds at Bear Stearn are likely to be closed down, and the collateral sold by Merrill Lynch, unless an alternative deal can be worked out.

Working out such a deal won’t be easy.? Debt-based hedge funds are frequently long and short credit obligations that are complex, and often unique.? The obligations are difficult to trade, partially because there are few who traffic in the securities, and there is often little trading in the securities to validate the pricing levels that the hedge fund use to calculate their valuations each evening.? Positions are not so much marked-to-market, but marked-to-model.? Illiquid as they are, an auction will test the markets to see how much of a discount is needed to move the securities.? How much slack assets do their competitors have to snap up debt obligations at a bargain?? When the liquidation is done, will there be anything left for the hedge fund investors?? Merrill just wants its money back, will they take their time to get the best price, or will they conclude that the market is decaying, and decide to sell as rapidly as possible?

Now there are a decent number of these investors, and reputedly bright, as this Bloomberg article points out.? There are lots of smart people on Wall Street, perhaps too many, and some always prove to be “too clever by half.”? What is the ratio of vultures to carrion?? So far, more vultures, which is bullish.? The results of any auction will be reflected in the prices, which may overshoot on the downside, if only because when too much liquidity is demanded at once, the prices of what is being sold will suffer.? But if there are a lot of vultures, that will not happen.

Part of this problem is the general willingness to extend credit at low incremental yields.? (Spreads were tight when the worst of the subprime mortgages were originated.) Fundamental bond investors (like me) have been worried for a while, but usually it takes a few years of lending at low spreads before something breaks.? Consider the following articles:

Spreads are too tight, particularly on riskier debt.? More subordinated debt is getting issued.? Covenants are weaker than before.? More CCC-rated debt is getting issued than ever before.? Private equity seeks more and more financing, substituting debt for equity, and making the overall financial system less flexible.? Liquidity is just another way of saying that risky lending takes place at low spreads versus safe debt.

The last two articles cited describe the problem, but also how it might end ugly.? In my opinion, it will take a few entities blowing up before the markets change.? In the fixed income markets there are players who fell that they must deploy cash to justify their existences; they only sell once a crisis is proven, and the client is complaining.? That is why the debt markets react more slowly to a crisis than the forward-looking fundamentals would indicate.? Men have lost their jobs for not grabbing enough yield in the bull phase; this leads others to invest in securities of dubious quality, but possessing stellar YTNJs [YTNJ = Yield To Next Job]. 8D

Part of this mess is a failure of the ratings agencies.? It’s tough to be proactive when most of your revenues come from those you rate.? The ratings agencies have been slow to downgrade through much of the last two years, as subprime creditworthiness deteriorated.? We faced the same problems in corporate credit back in 2001-2002.? The venue changes, but the conflicts of interest don’t.

This will not end well, which is not to say that the sky is falling.? These troubles could take years to unfold.? Tops are a process, not an event, and fundamantally driven investors almost always sell too soon, seeing the crisis well in advance, but not realizing that those in troubles have many ways of delaying the pain.? It is always amazing to see how resourceful some can be during a crisis.? So, be aware of the problems at hand, but don’t give in to imminent panic.? Before the a crisis occurs, the vultures will have to be glutted or scared to death, and we aren’t near that yet.

Supply and Demand Factors in the Equity Market

Posted on 18 June 2007 by David Merkel

My posting philosophy when doing commentary on the news is not to do “linkfests,” much as I like them, but to try to give a little more thought behind what has been written, and try to weave them into a greater coherent whole.? My career has been diverse; if I wanted to be mean I would say that I was a dabbler, a patzer, a dilettante.? A jack of all trades and a master of none.? The strength of my varied career is that I have insights into a wide number of areas in the markets, and how they interconnect.? I have always believed that understanding multiple markets helps shed light on each one individually.

So, when I comment on the news, it is my aim to give you a broader perspective on the major factors influencing our investment decisions.? That also means that I might not be commenting on what is breaking news, but on what trends are going on behind the scenes.? Today’s topic is supply and demand factors in the equity market… the true technical analysis. 😉

Let’s start with Jeff Miller at A Dash of Insight. He gives the classic case of why a management would buy back stock.? A management team is able to capture more of the excess returns that the business is earning by substituting cheaper debt for equity in their capital base.? In moderation, this is a decent strategy; it is a strategy increasingly employed because of high profit margins and low interest rates.

Now, as you go through this discussion, you will run into the term “Fed Model.”? The Fed model is a simplified version of a discounted cash flow model, where the earnings of an equity market are discounted using a common interest rate, frequently a long treasury rate, and compared to the current price, to see whether stocks are rich or cheap.? (Note: this calculation does not actually prove whether stocks are absolutely rich or cheap, but only rich or cheap relative to bonds.)? In practice, the calculation can come down to comparing the earnings yield of an index (earnings divided by market capitalization) to the yield on the long Treasury note.

Use of this model is controversial and can produce widely varying results depending on your assumptions.? Take for example, this article over at Trader’s Narrative. It draws the conclusion that the market is “extremely undervalued” at these levels.? This is true, if interest rates and credit spreads stay low, and profit margins stay high.? All three data series tend to mean revert, so how long these factors remain favorable is open to question.? Nonetheless, in the past, comparing treasury and earnings yields was a smart strategy.? Will that continue?

John Hussman ably argues that profit margins are mean-reverting, and that the relationship of earnings yield to bond yields has been spotty at best.? I agree with both of those ideas, but with some caveats:

Profit margins could remain high for a longer time than anticipated because of increased globalization, and increased willingness to lever up.
The relationship of earnings and bond yields has gone through eras where there has been extreme greed and fear.? That earnings and bond yields do not track perfectly is not a weakness, but a strength of the model.? If they tracked perfectly, there would be nothing to game here.? At extreme differences the yield differential produces signals that will make money, and reduce risk to investors.? (Personally, I like my models to explain half of the variation or so — a good balance between there being a signal, and having significant noise to exploit.)

I expect profit margins to mean-revert, but what if they don’t do so quickly?? As an example, consider the upside surprise delivered in the first quarter.? US corporations don’t just depend on the US economy anymore; they sell outside the US, and buy resources outside of the US, even labor (outsourcing).? With a weak dollar, earnings in dollar terms surprised on the upside.? Buybacks also increased earnings per share.

Ignore Shiller when he does the 10-year average earnings.? 10-year averages are less representative of future earnings than the current year’s earnings.? There has been a lot of earnings growth for sustainable reasons.? Could earnings pull back significantly?? Yes, but not to the 10-year average, unless we get a depression.

What of rising interest rates?? Will they derail the equity market?? Some think so.? Some think not.? My view is that at around 6.50% on the 10-year Treasury, bonds would present serious competition to stocks.? Down here around 5.15%, we will continue to have the substitution of debt for equity through LBOs and buybacks.? Despite the volatility, investment grade credit spreads are still tight, and the collateralized loan obligation market is still active, allowing LBOs to be more easily financed.? Further, there is a yield hunger on the part of buyers that allows corporations to sell debt, even subordinated debt cheaply.? This will eventually change, but we need some genuine failures of investment grade companies to demonstrate the real risks of borrowing too much.

In the short run, that IPOs are being well-received is a plus to the market.? There is demand for stock.? In the long run, buying at low P/Es is also a plus (ask David Dreman).? That’s not true now, except relative to bonds, which are providing little competition to stocks.

So where does that leave me?? My view is more complex than many of the caricatures being trotted out.? Let me give you the main ideas:

Comparing earnings yields to bond yields is useful, but must be done with discretion.
Profit margins will mean-revert, but given globalization, and its effect in restraining wages, that may be a while in coming.? How much do you want to leave on the table?
Demographic trends should keep real interest rates low.? The graying of the global Baby Boomers is one of the factors keeping interest rates low.? Retirees and near-retirees want income, and that is surpressing interest rates.
Also suppressing interest rates are those that have to recycle the US current account deficit.? Until we see large currency revaluations in countries that have large surpluses with the US, rates should stay low.
Until we get a significant set of defaults in the credit markets, credit spreads should stay low.? At present, there is too much vulture capital lurking, waiting to buy distressed assets.? The distressed investing community needs to be seriously scared; then maybe valuations will head south.

So, reluctantly, in the short run I carry on as a moderate bull.? That said, the valuations in my portfolio are cheap relative to the market, and the balance sheets are stronger than average.? The names are inclined more toward global growth than US growth.? Many companies in my portfolio have buybacks on, but none are doing it to the level where it compromises their credit quality.

Trends have a nasty tendency to persist longer than fundamental investors would anticipate.? So it is with the markets at present.? Honor the momentum, but keep one eye on shifts in interest rates and profit margins.

Nine Business Days Ago

Posted on 15 June 2007 by David Merkel

The most recent closing high in the S&P 500 was on June 4th.? Since then, we have been through a spin cycle where all that mattered were yields on the long end of the Treasury curve.? That’s why I wrote late on Thursday at the RM Columnist Conversation:

	David Merkel
	Bonds and Stocks Decoupling? They were only Together by Accident.
	6/14/2007 4:50 PM EDT

I was somewhat skeptical when I saw bonds and stocks trading in tandem. The relationship between bond and stock earnings yields is a tenuous one operating over the long haul and on average. Using the five-year Treasury as and the S&P 500 my proxies, bond yields have exceeded earnings yields by as much as 8% in the mid-’50s, while earnings yields have exceeded bond yields by more than 4% in 1981, 1984 and 1987. On average earnings yields are 32 basis points over bond yields. If there is mean reversion in the difference between the two yields, the effect is not a strong one. At present, the relationship between earnings and bond yields seems tighter because of the large substitution of debt for equity going on, but that’s not a normal thing in the long run.

Even with all the buybacks and LBOs, it isn’t normal for stocks and bonds to trade in a tight correlated way in the short run, so, take one of your eyes off of bonds, and look at the fundamentals of the companies that you own. You’ll make more money that way, and take less risk.

PS: if the ten-year crosses 5.50%, go ahead and look at bonds again, and maybe allocate some more money to fixed income. Repeat the process each 0.5% up, should we get there. Equilibrium for stocks and bonds on a valuation basis is a 6.50 10-year. We’re not there yet, so I expect the substitution of debt for equity to continue, albeit at a slower pace.

Sometimes I think investors and the media search for an easy target on which to pin their fears or hopes.? In this case, it was the bond market.? Don’t get me wrong, the bond market is important, and usually ignored by investors to their peril.? But using the bond market to make short term equity trading decisions is just plain silly.

Now, when actual volatility rises, my methods usually do well against the broad averages.? One of the things that I have tried to achieve in my adaptive approach to the markets is to create a system does does well in calm markets, but does relatively better in volatile markets.? Volatile markets scare inexperienced investors into making the wrong moves.? My methods are geared toward allowing ordinary investors to benefit from volatility in a rational way.? As I stated in the CC on Friday:

	David Merkel
	Rebalancing Trades
	6/15/2007 11:55 AM EDT

Wow. Nice rally over the last chunk of time, and it’s time to “ring the register” and lighten on a few names that have run nicely. I do this primarily for risk control purposes. Here are the names that I trimmed: Noble Corp (NE), Cemex (CE), Lyondell Chemicals (LYO), and Tsakos Energy Navigation (TNP). They are now back at their target weights in my portfolio. My rebalancing discipline is a way of:

Lowering risk on companies that are more expensive, and thus more risky than when I last bought them.
Raising exposure on names that are cheaper, and thus less risky than when I last bought or sold them.
Capturing swings in sentiment in industries, companies and the market as a whole, without becoming a momentum trader.
Lowering my market impact costs by leaning against the wind (selling into a rise, buying into a fall), and
Forcing a review process at certain price levels
Taking the emotion out of selling and buying
Making an additional 2% to 3% a year on my portfolio.

You can only do this with a high quality portfolio; don’t try this with companies that have a non-zero chance of a severe drop. For more information, review my “Smarter Seller” article series.

Position: long NE LYO TNP CX

Since 6/4, my broad market portfolio has outperformed the S&P 500 by roughly 1%.? My methods are designed to be able to cope with volatility and some back smiling.? Why can I go on business trips or vacation and not worry about the markets?? Why don’t I get scared by many of the negative macroeconomic situations out there?? First, I trust in Jesus; my life is not just the markets.? But beyond that, my eight rules are design to deal with the volatility that the market serves up, and adapt to what is undervalued in the present environment.

My plan for the next three weeks on the blog is to go through another portfolio reshaping.? You’ll get to see how I make choices in my portfolio.? Beyond that, I have one big article on the Fed Model coming, and continuing coverage of the major factors driving the markets.? Have a great weekend.

Full Disclosure: long CX TNP LYO NE

Private Equity: Short Term versus Long Term Rationality

Posted on 14 June 200720 June 2017 by David Merkel

Until you learn to accept it, it is painful for many fundamentally driven investors to accept trends that are short-term rational, but long-term irrational. (And, much as it hurts my fingers to type this, technicians don’t have that problem… they have other problems though.) 😉

Tonight’s topic is private equity. There has been a cascade of bits and bytes splattered across the web on this topic, so I thought I would try to give a well-rounded picture, together with my views on the topic. Let’s start with the bull case:

Who better to start with than my colleague Jim Cramer? Two articles:

Let’s take the latter article. What were his five reasons?

Funny; it [DM: the private equity wave] will end. But not before many things happen, including these five:

Interest rates on the long end going to at least 6%-7%. At that point, I believe it will get too risky.
The equity market being closed to the IPOs of the companies that need to be flipped. It’s wide open right now.
Not one, not two, but maybe three or four, or even five deals going bust. Can’t we wait for even one to go belly-up before we get too nervous?
Valuations ramping up more. With the S&P 500 selling for about 17.5 times next year’s earnings, there is plenty of room to keep buying.
Private equity funds running out of money. Very unlikely.

He has made the case exceptionally well as to why Private Equity should continue to be a factor in the market in the short-to-intermediate run. Here are two other pieces that make a similar case, which can be summarized like this: if there is a positive spread between the forecast earnings yield of a company, and the interest rate at which we can finance the purchase of the company, then it is rational to take the company private.
It’s at times like this that my inner actuary comes out and says, “Hey, what about a provision for adverse deviation?” That is, how much can go wrong, and still make this deal work? My inner financial analyst asks a slightly different question, “Will you need additional financing later, even if it is selling off the company? What if financing or selling is not available on today’s advantageous terms?”

The private equity folks will say that the high debt levels force success; there is no room for error, so we will work like crazy to make it work. As for financing, there are always windows of opportunity within a reasonable time span. There is no reason to worry.

Now not all deals work out, despite the best efforts of the new private owners. Most are marginal with a few celebrated home runs. During mania times, buyers definitely overpay. As an example, you can see how badly Daimler Benz did in its purchase of Chrysler. Will Cerberus do as well? I am not as bullish as the BW article, but it is clear the Cerberus does not have as much at risk as Daimler. Where I differ is that it will be harder to shed liabilities and reduce costs than the article implies.

At present there aren’t a lot of hot problems in private equity deals. There are financing difficulties, like KKR finding it hard to get additional private equity investors. Institutional investors like to be diversified, which always makes it tough for the biggest players in any asset class to get financing. Aside from that, the risks from doing deals are in the future.

At present, there is a lot of cash to finance private equity for both debt and equity commitments. Today it is rare to find assets that cannot be refinanced. There are more vultures than carrion. There have also been many articles pointing out that amid the flood of financing, the leverage has been going up, and the interest coverage down.

These are not the problems of today, so bulls ignore it and bears get frustrated. These will be problems, just not yet. What if real interest rise? Well, that will affect the ability to re-IPO the company, but it won’t absolutely stop a deal today. What if interest rates rise simply due a bond bear market, whether due to inflation, or global competition for capital? That will affect new deals, making it harder for them to get done, and sale multiples will fall on companies that the private equity folks try to sell.

Perhaps the effects are reversed here. Maybe private equity troubles will be a harbinger of the next junk bond bear market. Could be; after all, one weakness of being private is that tapping the public equity markets is not an easy option, much as that can be valuable when times are about to get tight.

Here’s my verdict. In the short run, almost anything can work. When debts go bad, it typically occurs because the company chokes on paying the interest, not the principal. Private companies that can pay the interest will likely survive to make some money for their private equity sponsors. But many will over-borrow, and in a recession, or in an industry or company downturn, will find that they no longer have enough cash to make the interest payments, and possess limited options for refinancing. Multiple defaults will happen then; think 2009, give or take a year.

But maybe it takes until 2012. If so, perhaps this letter from the future will seem prescient in hindsight. Private equity is not a bubble today; history may judge it to be a mania. To my readers I say be careful, and stick with higher quality bonds and stocks.

PIMCO in Theory and Practice

Posted on 13 June 200722 June 2017 by David Merkel

There’s been a certain amount of chatter lately over some of the comments made by Bill Gross regarding the long end of the market.? Others have discussed that; I’d like to bring up a different point.

Leaving aside the rumors that Bill Gross talks his book in order to create better entry and exit positions (many in the bond market believe it, I’m not so sure), I have criticized his (and PIMCO’s) forecasting abilities in the past.

Fortunately for PIMCO clients, Mr. Gross does not depend on his Macro forecasting to earn returns. Sitting on my desk next to me is a copy of the September/October 2005 Financial Analysts Journal. In it Mr Gross has an article, “Consistent Alpha Generation Through Structure.” That article encapsulates the core of PIMCO’s franchise. Essentially, they write unlevered out-of the money options on a variety of fixed income instruments, go short volatility through residential mortgages, and try to take advantage of the carry trade through the cheap float that their strategies generate.

So there’s a free lunch here? Well, not exactly. In a scenario where rates move very rapidly up or down, PIMCO will be hurt. But the move would have to be severe and very rapid. Even then, unlike LTCM, which had many of these same trades on but in a levered fashion, a bad year for PIMCO would ruin their track record, but most of their clients would deem the losses mild in comparison with whatever happened to the rest of the asset markets during a crisis that moved interest rates so severely.

That is the genius of Bill Gross, and I mean that sincerely. As for what he says on the tube, well, that’s just to aid marketing of the funds. He’s an entertaining guy, and on TV, those that invite you don’t care so much that you are right or wrong; they care that you say interesting things that keep the ratings up.

So, ignore Gross and McCulley on macroeconomic predictions, but their funds are generally worthy investments (leave aside for a moment that they are having a tough time this year). That said, if I’m buying an open end bond fund, I go to Vanguard. Low expenses win with bond investing, and it is a more durable advantage than advanced quantitative strategies.