Category: Pensions

Musings on the Fed and Yesterday’s Article

Musings on the Fed and Yesterday’s Article

Posted on by David Merkel

From Tuesday’s Columnist Conversation over at RealMoney.com:


 David Merkel
Thinking About the Fed
11/20/2007 1:51 PM EST

One of my maxims of the Fed is that it is better to watch what they do, and pay less attention to what they say. The markets are saying that they expect Fed funds at 3% sometime in 2008. The Fed governors see that also, and are being dragged there, kicking and screaming. They don’t want to do it; there is real risk to the US Dollar, and there are inflation risks as well. As they measure it, the economy is growing adequately, and labor employment is fairly full. But as Cramer and others point out, the financial system is under stress, manifesting most sharply in mortgage lenders and insurers. Secondary stress is in the investment banks and financial guarantors.

But what exactly has the Fed done so far? Most of the monetary easing has not come through growth in the monetary base, but from continued relaxation of reserve requirements. Given that the Fed is loosening, I would have expected a permanent injection of liquidity by now. As it is, the last one was May 3rd, when there was no hint of the loosenings coming.

So what then for future FOMC policy? The banks are increasingly incapable of levering up more. The monetary base will have to grow. With the Treasury-Eurodollar spread at over 170 basis points, the big banks don’t trust each other. Again, this measure points to 3.00-3.25% Fed funds sometime in 2008.

I see them getting dragged to cuts, kicking and screaming, until a combination of inflation and the dollar force them to change. Then the real fun begins.

Fed minutes out soon. Watch them make a fool out of me.

Okay, the FOMC minutes did not make a fool out of me.? Neither did the market action.? I’m in the weird spot of thinking that nominal economic activity is higher than expected, on both an inflation and real GDP basis.? I don’t like the mortgage and depositary financial sectors at present, two areas that are dear to the FOMC.? That’s where I stand.

One reader asked, what do you mean by, “Then the real fun begins.”?? Maybe I have to do a book review on James Grant’s, “The Trouble with Prosperity.”? James Grant is very often correct, but usually way too early, which is why it is hard to make money off of his insights.? The “real fun” is watching FOMC policymakers squirm as they balance off costs of inflation and economic growth on the negative side, as it was in the late 70s and early 80s.? It is also the fun of watching policymakers at the Treasury Department squirm as they realize that the the fiscal wind is in their face and not at their backs anymore, as the demographic winds spin 180 degrees.

Other readers e-mailed, asking the practical question of how to invest in such an environment.? First, don’t overdo it.? Invest for a normal market scenario, and then tweak it to add more short bonds, TIPS, Commodities, Foreign bonds, and stocks with good inflation pass-through.

I got a few questions asking me to justify my bearish view on the US Dollar.? On, a purchasing power parity basis, the US Dollar is fairly valued now.? (What goods can the Dollar buy versus other currencies?) Unfortunately, currencies react more to forward covered interest parity in the short run. (What will I be able to earn by investing my money in dollar denominated debt, instead of another currency?)? Low intermediate term interest rates in the US portend bad returns from investing in US Dollar denominated debt, so the US Dollar declines.? The rest of the world seems to be bracing for more inflation and more growth.? Because US policy is headed the other way, the US Dollar is weakening.

As for my longer-run negative view on US Bonds, US government policies are designed to undermine bonds.? They have made more future promises than they can keep.? Who will they renege on their promises?? Bond investors are the easiest target; they don’t vote in large numbers.? It will be harder to turn their backs to those receiving social insurance payments, at least in nominal terms.? They have a lot of votes.

That’s all for now.? More tomorrow.

The US Dollar and the Five Stages of Grieving

The US Dollar and the Five Stages of Grieving

Posted on by David Merkel

Recently I had dinner with a college friend of my oldest son.? It surprised me, but he was interested in how the US dollar was doing.? I likened the current situation to the five stages of grieving.

The first stage is denial.? As it respects the US Dollar, in the initial phases in the decline of the US Dollar, most foreign? finance ministers and central bankers are pretty happy.? After all, foreign exchange reserves are at an all time high.? Export industries are booming.? The government loves the exchange rate policy that keep the US Dollar artificially rich against the foreign currency.? The banks are flush, credit is booming… what could be better?? After all, you can’t have too much in the way of US Dollar reserves, can you?? (They never have to worry about a currency crisis again!)? The government is happy with them, especially since they are supported by the exporters.

Anger is the second stage.? The dollar reserves are worth less and less on a relative basis, and they keep coming in.? The wisdom of having a fixed rate, crawling peg, or dirty float against the dollar is questioned.? Goods inflation is rising in the foreign market, and credit creation is getting out of control.? The finance minister or central banker face the hard choice of revaluing the currency up versus the US Dollar, which slows the economy, particularly exports, or let the situation continue, and build up more US Dollar reserves.? (“What will we ever use all these Dollar reserves for?” they might ask in a moment of lucidity. “What if the US Dollar fell a lot further?? That would reduce the value backing our currency…? Why is the Fed loosening so much?? Don’t they care about the Dollar?”)

So, some of them revalue their currency upward versus the US Dollar, some reduce the basket weight of the Dollar, some let the peg crawl faster, and some do nothing… and the US Dollar predominantly falls in value.? Some finance ministers complain about the Dollar, and net exports to the US begin to decline.? This is where we are now, and I don’t know how long it will take to get to the next stage.

The third stage is bargaining.? The foreign finance ministers and central bankers are stuck.? They are getting pressure to lower the value of the currency against the dollar from exporters, and the politicians that they support.? They wonder if an intervention on the foreign exchange market might do it.? They call their opposite numbers around the globe, proposing an intervention to raise the value of the dollar.? Enough agree to do it, and the coalition of the willing does what they don’t want to do.? They sell their own foreign currencies, and buy more dollars.? The surprise works!? They caught the FX traders leaning the wrong way, on a day when economic news was going their way, they cooperated, and they did it BIG!? The US Dollar rises a full five percent. (“See you at the party tonight!”)

Only one problem, which is clear the next day to Finance ministers, Central bankers and FX traders alike.? (“What are we going to do with all the new US Dollar reserves that we bought?? We already have too much of that…”)? The FX traders pounce, and take the opposite side of the trade, and push the US Dollar lower.


Stage four is depression.? (“There’s no way out, and we got snookered by the neo-mercantilist exporters who got us to keep the currency too low versus the US Dollar.”)? The US Dollar is below the earlier intervention level, and there have been a few additional failed interventions, where the FX traders ate the central banks for lunch.? The US Dollar continues to fall.

Finally, stage five, acceptance.? The foreign currencies rise to sustainable levels versus the US dollar.? Inflation and real economic activity decline in the foreign countries.? They begin buying more goods and services from the US, and dollar claims are redeemed.? Inflation and interest rates rise in the US, as we have to produce more to pay off the dollar reserves now being redeemed by foreigners.? (Send us goods and it will pay off your debts!? Amazing how the US got good terms on both sides of the transaction.”)

Well, maybe.? It will take a while before all major trading parties in the world float/adjust their currencies to fair levels.? At? the time that happens, though, it will be obvious that the US is less important to the global economy.? The relative value of all US assets will be a smaller proportion of global assets, though it will still likely be the largest share in the world.? My view is this process to get to stage five will take no more than 10 years.? By that point, the hopelessness of Federal social insurance programs like Social Security and Medicare, plus underfunded Federal and state retirement plans, will force benefit reductions and tax increases on the US, and crimp borrowing capacity, unless they borrow in a currency other than dollars.? There are five stages of grieving for US social welfare programs as well, but I am afraid we are only in the first stage now, denial.

That is a topic for another day, and not one that I am excited to talk about.

Seven Observations From Barron’s

Seven Observations From Barron’s

Posted on by David Merkel
  1. Kinda weird, and it makes you wonder, but on the WSJ main page, I could not find a link to Barron’s. I know I’ve seen a link to Barron’s in the past there; I have used it, which is why I noticed its absence today.
  2. I found it amusing that the mutual fund that Barron’s would mention on their Blackrock interview, underperformed the Lehman Aggregate over 1, 3 and 5 years. Don’t get me wrong, Blackrock is a great shop, and I would work there if they offered me employment that didn’t change my location. Why did Barron’s pick that fund?
  3. I’m not worried about the effect of a financial guarantor downgrade on the creditworthiness of the muni market. Munis rarely fail. Most of those that do fail lacked a real economic purpose. What would be lost in a guarantor downgrade is liquidity. Muni bond insurance is a substitute for analysis. “AAA insured, I’ll buy that.” Truth, an index fund of uninsured munis would beat an index of insured munis, because default rates are so low. But the presence of insurance makes the bonds a lot more liquid, which makes portfolio management easier.
  4. I’ve been a US dollar bear for the last five years, and most of the last fifteen years. Though we have had a little bounce recently, the dollar has of late been at record lows against currencies that trade freely against the dollar. I expect the current bounce to persist in the short term and fail in the intermediate term. The path of the dollar is lower, unless the Fed decides to not loosen more. Balance needs to be restored in the global economy, such that the rest of the world purchases more goods and services, and fewer assets from the US.
  5. I don’t talk about it often, but when it comes up, I have to mention that municipal pensions in the US are generally in horrid shape. The Barron’s article focuses on teachers, but other municipal worker groups are equally bad off. The article comments on perverse incentives in teacher retirement, which leads older teachers to retire when it is feasible to do so. For older teachers, I would not begrudge them; they weren’t paid that well at the start, and the pension is their reward. Younger teachers have been paid pretty well. I would not expect them to get the same pension promises.
  6. I like Japan. I own shares in the Japan Smaller Capitalization Fund [JOF]; it’s my second-largest position.

    Japan is cheap, and small cap Japan is even cheaper. I would expect a modest bounce on Monday.

  7. We still need a 15-20% decline in housing prices to bring the system back to normal. There might be an undershoot in price from the sales that forced sellers must do. Hopefully it doesn’t turn into a self-reinforcing decline, but who can be sure about that? At that level of housing prices, man recent conforming loans will be in trouble, much less non-conforming loans.


Full disclosure: long JOF

Contemplating Life Without the Guarantors

Contemplating Life Without the Guarantors

Posted on by David Merkel

Here’s another recent post from RealMoney:


 David Merkel
Contemplating Life Without the Guarantors
11/1/2007 1:30 PM EDT

Hopefully this post marks a turning point for the Mortgage Insurers and the Financial Guarantee Insurers, but when I see Ambac trading within spitting distance of 50% of book, I cringe. I’ve never been a bull on these companies, but I had heard the bear case for so long that my opinion had become, “If it hasn’t happened already, why should it happen now?” Too many lost too much waiting for the event to come, and now, perhaps it has come. But, what are all of the fallout effects if we have a failure of a mortgage insurer? Fannie, Freddie, and a number of mortgage REITs would find their credit exposure to be considerably higher. The Feds would likely stand behind the agencies, because Fannie and Freddie aren’t that highly capitalized either. That said, I would be uncomfortable owning Fannie or Freddie here; just because the government might stand behind senior obligations doesn’t mean they would take care of the common and preferred stockholders, or even the subordinated debt.

Fortunately, the mortgage insurers don’t reinsure each other; there won’t be a cascade from one failure, though the same common factor, falling housing prices will affect all of them.

Other affected parties will include the homebuilders and the mortgage lenders, because buyers without significant down payments will be shut out of the market. Piggyback loans aren’t totally dead, but pricing and higher underwriting standards restrict availability. Third-order effects move onto suppliers, investment banks and the rating agencies. More on them in a moment… this will have to be a two-parter, if not three.

Position: none

And since then, the mortgage insurers have fallen a bit further.? On to part two, the financial guarantors:

Unfortunately, the financial guarantors have had a tendency to reinsure each other.? MBIA reinsures Ambac, and vice-versa. ? RAM Holdings reinsures all of them.? The guarantors provide a type of “branding” to obscure borrowers in the bond market.? Rather than put forth a costly effort to be known, it is cheaper to get the bonds wrapped by a well-known guarantor; not only does it increase perceived creditworthiness, it increases liquidity, because portfolio managers can skip a step in thinking.

Now, in simpler times, when munis were all that they insured, the risk profiles were low for the guarantors, because munis rarely defaulted, particularly those with economic necessity behind them.? In an era where they insure the AAA portions of CDOs and other asset-backed securities, the risk is higher.

Now, guarantors only have to pay principal and interest on a timely basis.? Mark to market losses don’t affect them, they can just pay along with cash flow.? The only trouble comes if they get downgraded, and new deals become more scarce.? Remember CAPMAC?? MBIA bought them out when their AAA rating was under threat.? Who will step up to buy MBIA or Ambac?? (Mr. Buffett! Here’s your chance to be a modern J. P. Morgan.? Buy out the guarantors! — Never mind, he’s much smarter than that.)

Well, at present the rating agencies are re-thinking the ratings of the guarantors.? This isn’t easy for them, because they make so much money off of the guarantors, and without the AAA, business suffers.? If the guarantors get downgraded, so do the business prospects of the ratings agencies (Moody’s and S&P).


Away from that, municipalities would suffer from lesser ability to issue debt inexpensively.? Also, stable value funds are big AAA paper buyers.? They would suffer from any guarantor getting downgraded, and particularly if Fannie or Freddie were under threat as well.?? All in all, this is not a fun time for AAA bond investors.? A lot of uncertainties are surfacing in areas that were previously regarded as safe.? (I haven’t even touched AAA RMBS whole loans…)

This is a time of significant uncertainty for areas that were previously regarded as certain.? Keep your eyes open, and evaluate guaranteed investments both ways.? I.e., ABC corp guaranteed by GUAR corp, or GUAR debt secured by an interest in ABC corp. This is a situation where simplicity is rewarded.

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

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

Posted on by David Merkel

Actuaries are bright people.? Okay, present writer excepted.? That’s a danger when you give a talk to a bunch of them.? Every now and then you will end up with a questioner who is a bit of a crank.? Now, I have a soft spot in my heart for actuarial cranks, because I have done more than my fair share to question other presenters over the years.

At my talk yesterday, one actuary suggested turning the Social Security system into a defined benefit plan, and having it invest in stocks, which would provide cheap capital to corporations.? The Social Security system gets better returns. Everyone wins, right?

Well, no.? Here is what is amiss with the idea:

  1. It would favor public companies over private companies.
  2. Active managers would be useless, because the fund would be too big.? They would have to index.
  3. Initially the stock market would shift up as the money began to be invested, but once fully invested, P/E multiples would be so high that future returns would be lousy.? Once the liquidation phase began, this fund would be so big that stocks would fall in advance of the liquidation, even if everything were indexed.
  4. Marginal companies with lousy profitability would come public to take advantage of the cheap funds.
  5. Corporate governance issues would be tough; how does the government vote its proxies?? How would activist investors get treated?? Which side would the government favor?? If they left this in the hands of active managers to take care of, could the managers stand up to all of the political pressure?
  6. Do we really want the Socialism associated with the government owning 20% of every corporation?? What additional regulations might be put on corporations that are owned or not owned by the government?
  7. Would we give the Fed a third mandate to try to improve corporate profitability, because it would have a greater effect on the economy?
  8. Why limit the asset classes invested in?? Why not other bonds, loans, commodities, real estate (commercial and residential) and perhaps international investments?? At least if we liquidate international investments, we don’t hurt our own economy.
  9. For that matter, the US government could contribute all of its property to a great big REIT, and use it to fund a small portion of Social Security.? Of course, the deficit would rise as the government made dividend payments.
  10. Medicare is the tougher issue to solve; Social Security is small compared to it.? Solve that one first.

My last reason is that for the most part, stocks don’t care who owns them.? In the long run, they are weighing machines, and not voting machines.? They will produce the stream of cash flows as a group that will be pretty invariant to who owns them.? Activist investors may have an effect in the short run, but on the whole, the effects of activism on the index returns as a whole will be paltry at best.

This tired idea of investing the Social Security trust funds in equities came up during the Clinton Administration (hopefully there will not be a second one).? I view it as the ultimate “dumb money” for the stock market.? If it were ever implemented, you would invest into the wave of new money, and create IPOs to sop up money.? Then once the money flow was largely deployed, you would sell along with other smart investors, and invest overseas.

My own view is that Social Security and Medicare should be wound down over a 80-year period.? They were bad ideas to begin with, but getting us out of that business with fairness to promises made would have to take two generations or so to complete.? I know, that’s a non-starter, but most reasonable ideas regarding social insurance programs are.? The eventual “solution” will come through higher ages for benefit receipt, lower benefits, higher taxes, limitation of inflation adjustments (already done, and quietly) and means-testing.? Not that I like it, but we will have to face realities eventually.

The same issues will apply to Medicare.? Eventually we will have a two-tier healthcare system (we won’t call it that), because we can’t afford the promises made to Medicare recipients.? It will be “The government pretends to pay us, and we pretend to treat you.”? It will be a mess, and that one should begin to come into clear focus within ten years.

PS — My talk went well yesterday.? If there is ever a recording of it on the web, I will put a link at my blog.

Society of Actuaries Presentation

Society of Actuaries Presentation

Posted on by David Merkel

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

 

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

 

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

Too Many Vultures, Too Much Liquidity

Too Many Vultures, Too Much Liquidity

Posted on by David Merkel

About a month ago, when the financial markets were more skittish, I saw a series of four articles on more interest in distressed debt investing (One, Two, Three, Four).? In this market, it didn’t surprise me much because we have too many smart people with too much money to invest.? It reminds me a bit of a RealMoney CC post that I made a year and a half ago:


 David Merkel
Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

We are still on the side of the demographic wave where net saving/investing is taking place, and that forces pension plan sponsors to find high-return areas to place additional monies.? Away from that, the current account deficit has to be recycled, and they aren’t buying US goods and services in size yet.? That’s why there will be vultures aplenty, outside of lower quality mortgages.? Even the debt market for new LBO debt is slowly perking up.? The banks pinned with the loan commitments may be able to get away with mere 5% losses.? Away from that, investment grade and junk grade corporate bonds are looking better as well.

Now, don’t take this as an “all clear.”? There are still significant problems to be digested, particularly in the residential real estate and mortgage markets.? CDOs still offer a bevy of credit issues.? There will be continued difficulties, and I don’t expect big returns.? But with so many willing to take risk at this point, I can’t see a big drop-off until they get whacked by worsening credit conditions.

The Longer View, Part 4

The Longer View, Part 4

Posted on by David Merkel

In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

 

1) Asset Allocation

 

  • Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.? An article on the web reminded me of this debate.? The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.? Security selection matters.
  • Two interesting papers on asset class correlation.? Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.? Value tends to march to its own drummer more than other equity styles in a crisis.? The effects on correlation in crises vary by crisis; no two are alike.? Natural resources and globa bonds tend to be good diversifiers.
  • In bull markets, risky asset classes all tend to do well.? Vice-versa in the bear markets.? My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
  • There are a few good states, but by and large, public pensions are a morass.? Most are underfunded, and rely on future taxation increases to support them.? When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.? This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

 

2) Insurance

 

 

3) Investment Abuse of the Elderly

 

It’s all too common, I’m afraid.? Senior citizens get convinced to buy inappropriate investments.? Even the SEC is looking into it.? This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.? The comment that a CEO doesn’t fully understand his own annuity products is telling.

 

Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

 

The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

 

4) Accounting

 

  • I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.? What is FASB’s main goal in life — to destroy comparability of financial statements?? We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
  • Congress moves from one ditch to the other.? This time it’s sale of subprime loans.? Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.? Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
  • As I’ve said before, I don’t like SFAS 159.? It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

 

5) Volatility

 

  • Earn 40%/year from naked put selling?? Possible, but with a lot of tail risk.? I remember how a lot of naked put sellers got smashed back in October 1987.? That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
  • Here’s an interesting graph of the various VIX phases over the past 20 years.? Interesting how the phases are multiyear in nature.? Makes me think higher implied volatility is coming.
  • I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.? If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

 

That’s all for now.? More coming in the next part of this series.

Fifteen Notes on the State of the Markets

Fifteen Notes on the State of the Markets

Posted on by David Merkel

1)? Start with the pessimists:


2)? Move to the optimists:

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at? “Splutter”).? I began toting up a list of notable losers, but it got too big.? One positive note, many of the large quant funds bounced back from their mid-August stress.

4)? When muni bonds get interesting, you know it’s a weird environment.? It starts with the fundamental mismatch of muni bonds.? Muni issuers want to lock in long term financing, but most investors want to invest shorter.? Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.? When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.? (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)? When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.? That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.? Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.? Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)? Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)? I would be more concerned about the first group.

7) Are global banks cheap?? Yes on an earnings basis, probably not on a book basis.? We need to see some writedowns here before the group gets interesting.

8) I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.? This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.? What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.? Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?? I would not have guessed that.? Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.? When I was a corporates manager, hedge funds weren’t a factor in trading.? Now they are 30% of the market.? Wow.? Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.? His call for outperformance of quality assets seems to be happening.? Now the question is whether the cost of capital is going up globally or not.? If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“? Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.? Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.? They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.? I’ve seen articles about bread prices rising.? Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.

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