More on speculation, while avoiding subprime which is still over-reported.

1. How much risk do hedge funds pose to the financial system?  My view is that the most severe risks of the financial system are being taken on by hedge funds.  If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.  The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
2. There is a tendency with hedge funds to hedge away “vanilla risks” (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.  I want to get a copy of Richard Bookstaber’s new book that makes this point.  Let’s face it.  Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.  Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
3. Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.  Inefficiencies are finite.  Now Renaissance Institutional is feeling the pain.  My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?  Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.  Asset growth is self-reinforcing to performance, until you pass the limit.
4. I have seen the statistic criticized, but it is still true that we are at a high for short interest.  When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.  The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.  Shorts are “side bets” that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
5. I’ve said it before, and I’ll say it again, there are too many vulture investors in the present environment.  It is difficult for distressed assets to fall too far in such an environment, barring overleveraged assets like the Bear Funds.  That said, Sowood benefits from the liquidity of Citadel.
6. Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.  This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
7. Should you be worried if you have an interest in the equity of CDOs?  (Your defined benefit pension plan, should you have one, may own some of those…)  At present the key factors are these… does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?  If so, you have reason to worry.  Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
8. There have been a lot of bits and bytes spilled over mark-to-model.  I want to raise a slightly different issue: mark-to-models.  There isn’t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.  This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.  For a one-sided example of this you can review Berky’s attempts to close out Gen Re’s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
9. If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.  Though the article doesn’t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
10. If you need still more proof, consider this article.  The problem for hedge fund managers gets worse when illiquid assets are financed by debt.  At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.

That’s all in this series.  I’ll take up other issues tomorrow, DV.  Until then, be aware of the games people play when there are illiquid assets and leverage… definitely a toxic mix.  In this cycle, might simplicity will come into vogue again?  Could balanced funds become the new orthodoxy?  I’m not holding my breath.

Liquidity, that ephemeral beast.  Much talked about, but little understood.  There are five pillars of liquidity in the present environment.  I used to talk about three of them, but I excluded two ordinary ones.  Here they are:

1. The bid for debt from CDO equity.
2. The Private Equity bid for cheap-ish assets with steady earnings streams.
3. The recycling of the US current account deficit.
4. The arbitrage of investment grade corporations buying back their own stock, or the stock of other corporations, because with investment grade yields so low, it makes sense to do it, at least in the short run.
5. The need of Baby Boomers globally to juice returns in the short run so that their retirements will be adequate.  With equities, higher returns; with bonds, more yield.  Make that money sweat, even if we have to outsource the labor that our children provide, because they are too expensive.

Numbers one and two are broken at present.  The only place in CDO-land that has some life is in investment grade assets.  We must lever up everything until it breaks.  But anything touched by subprime is damaged, and high yield, even high yield loans are damaged for now.

With private equity, it may just  be a matter of waiting a while for the banks to realize that they need yield, but i don’t think so.  Existing troubled deals will have to give up some of the profits to the lenders, or perhaps not get done.

Number three is the heavy hitter.  The current account deficit has to balance.  We have to send more goods, assets, or promises to pay more later.  The latter is what is favored at present, keeping our interest rates low, and making equity attractive relative to investment grade debt.  Until the majority of nations buying US debt revalue their currencies upward, this will continue; it doesn’t matter how much they raise their central bank’s target rate, if they don’t cool off their export sectors, they will continue to stimulate the US, and build up a bigger adjustment for later.

With private equity impaired, investment grade corporations can be rational buyers of assets, whether their own stock, or that of other corporations that fit their operating profiles. Until investment grade yields rise 1-2%, this will still be a factor in the markets, and more so for foreign corporations that have access to cheap US dollar financing (because of current account deficit claims that have to be recycled).

The last one is the one that can’t go away, at least not for another seven years as far as equities go, and maybe twenty years as far as debt goes.  There is incredible pressure to make the money do more than it should be able to under ordinary conditions, because the Baby Boomers and their intermediaries, pension plans and mutual funds, keep banging on the doors of companies asking for yet higher returns.  With debt, there is a voracious appetite for seemingly safe yet higher yielding debt.  The Boomers need it to live off of.

So where does that leave us, in terms of the equity and debt markets?  Investment grade corporates and munis should be fine on average; prime MBS at the Agency or AAA level should be fine.  Everything else is suspect.  As for equities, investment grade assets that are not likely acquirers look good.  The acquirers are less certain.  Even if acquisitions make sense in the short run, it is my guess that they won’t make sense in the long run. On net, the part of the equity markets with higher quality balance sheets should do well from here.  The rest of the equity markets… the less creditworthy their debt, the less well they should do.

With all of the concern in the present environment, it is good to be reminded of the actions one should take in order to reduce risk in the present, should the investment environment turn hostile in the future.

1. Diversify by industry, country, currency, inflation-sensitivity, yield, growth-sensitivity and market capitalization
2. Diversify by asset class. Make sure you have liquid safe assets to complement risky assets. This is true whether you are young (tactical reasons) or old (strategic reasons).
3. Diversify by advisors; don’t get all of your ideas from one source (and that includes me). In a multitude of counselors, there is wisdom, which is something to commend RealMoney for — there is no “house view.”
4. Diversify into enough companies: better to have smaller positions in 15-20 companies, than 5 larger ones. When I began investing in single stocks 15 years ago, I started with 15 positions of $2,000 each. That made each $15 commission bite, but the added safety was worth it.
5. Avoid explicit leverage; don’t use margin.
6. Avoid shorting as well, unless you’ve got a profound edge; few are constitutionally capable of doing it well. Are you the exception?
7. Avoid implicit leverage. How much does the company in question rely on the kindness of the financing markets in order to continue its operations? Highly indebted companies tend to underperform.
8. Avoid balance sheet complexity; it can be a cover for accounting chicanery.
9. Analyze cash flow relative to earnings; be wary of companies that produce earnings, but not cash flow from operations, or free cash flow.
10. Avoid owning popular companies; they tend to underperform.
11. Avoid serial acquirers; they tend to underperform. Instead, look at companies that do little in-fill acquisitions that they grow organically.
12. Analyze revenue recognition policies; they are the most common way that companies fuddle accounting.
13. Focus on industries that are out of favor, and look for strong players that can withstand market stress.
14. Focus on companies with valuations that are cheap relative to present fundamentals, particularly if there are low barriers against competition.
15. Take something off the table when the markets run, and edge back in when they fall.
16. Analyze how any new investment affects your total portfolio.
17. Don’t use any investment strategy that you don’t fully understand.
18. Understand where you have made errors in the past, so that you can understand your weaknesses, and avoid acting out of weakness.
19. Buy only the investments that you want to buy, and not what others want to sell you. Use only investment strategies with which you are fully comfortable.
20. Find ways to take the emotion out of buy and sell decisions; treat investing as a business.
21. Match your assets to the horizon over which you will need the proceeds. Risky assets should not get a heavy weight when the proceeds will be needed within five years.
22. When you get a new idea, and it seems like a “slam dunk,” sit on it for a month before acting on it. More often than not, if it is a good idea, you will still have time to act on it, but if it is a bad idea, you have a better chance of discovering that through waiting.
23. Prune your portfolio a few times a year. Are there new companies to swap into that are better than a few of your current holdings?
24. Size positions inversely to risk levels.
25. Finally, think about risk before you need to; make it a positive component of your strategies.

Remember, risk preparation begins today. That way, you will be capable to invest in the bargains that a real bear market will produce, and not leave the investment game disgusted at yourself for losing so much money.

If I had a dollar for every person that I knew who ignored risk in the late 90s, and dropped out of investing in 2002, just in time for the market to turn, I could buy a nice dinner for you and me in DC, near where I work. So, analyze the riskiness of your portfolio today, and prepare now for the bad times that will eventually come, whether this year, or four years from now.

I have a friend who works for the Williams Inference Service.  Those who work for WIS spend their time looking for deep trends in our world that are underappreciated.  I dedicate a little of my time to that as well, and try to draw investable conclusions from odd bits of data that come across my radar.  But even without explicit conclusions, it richens my knowledge of our world, and perhaps with other data, will yield some return for me.  If nothing else, I love reading and writing, so join with me on this tour of articles around the web.

1. I’m not sure if pollution problems in China are any worse than the problems faced by the US or the UK at similar points in their development.  That said, one major constraint on their ability to grow is pollution.  These articles from the Wall Street Journal are an excellent example of that: heavy metals in the food supply, and lead in jewelry that they sell domestically and export, with the lead coming from US scrap metal.  These practices may allow businesses to survive in the short run, but soon enough, jewelry will get tested in the US, and importers sued for liability.  In China, there will be increasing pressure for change, perhaps even violent change.  In Chinese history, there is a tendency for change not happen, or to happen rapidly when troubles for average people become too great.
2. Demographics is a favorite topic of mine, particularly as the world slowly heads into a shrinking population.  For the most part, national economies don’t work so well when population levels shrink, which leads to pressure to import low skilled laborers from nations with surplus workers.  One nation that is at the front of the problem is Japan, where the population is shrinking pretty rapidly today.  Japan is now seeing that its pension system will be hard to sustain because of the lack of children being born.  Europe will face this problem as well.  The US less so, because of the higher birth and immigration rates; for us, the foreign debt will be our problem.
3. Is war with Iran a done deal in a few years?  I hope not.  Given the mismanagement of the Iranian economy in the hands of the cronyist mullahs that run the joint, and the genuine difficulty of producing effective nuclear weapons without a strong academic/technical/manufacturing base, my guess is that there will be another revolution there before a significant bomb gets made.  (We’re still waiting on North Korea; what a joke.)  Economically, Iran is a basket case.  As I have mentioned before, they have mismanaged their oil resources.  What is less noticed is their coming demographic troubles.  Not all Muslims are fanatics, and many are having small families, which will generate it’s own old age crisis thirty years out.  That said, if Iran is provoked, it’s leaders will not give in; they iwill fight, as the second article i cited points out.  Better to quietly hem the current Iranian leadership in by supporting their enemies, than to risk another war that the US does not have the resources to fight.  Iran is weaker and more divided than it looks; its government will fall soon enough.
4. Memo to all quantitative investors: are you ready for IFRS?  IFRS, the European accounting standard, particularly for financials will change enough things that older formulas of calculating value and safety may need to be severely modified.  The larger the importance of accrual items to an industry, the worse the adjustment will be.  All I say is, watch this.  If it changes, it will affect the way that we numerically analyze investments.  We are definitely losing foreign economies on our exchanges, mainly due to Sarbox, not accounting rules, but I think we are rushing through a compromise with IFRS to protect the interests of our exchanges, and I think that is a mistake.
5. Then again, maybe we don’t need the Europeans to mess up our accounting rules; we can do just fine ourselves.  Our accounting standards are a hodgepodge between amortized cost and fair value standards… we keep moving more and more toward fair value, but will the auditors be able to keep up?  Auditing amortized cost is one thing; there are different skills required when fungible but not liquid assets can be written up on a balance sheet. (Think about real estate or mortgage derivatives.)  Accounting will become less reliable in my opinion.
6. I wish we had a harder currency; why else do I buy foreign bonds?  Anyway, I appreciated this short partial monetary history of the US, from the Civil War onward, from Elaine Meinel Supkis.
7. When you can’t deliver the underlying, typically futures markets don’t work well.  It is no surprise then that a derivatives market on economic indicators closed.  Futures markets exist to allow commercial interests to hedge.  Where there is nothing to hedge, it is akin to mere betting, and without the extra thrill of a sports contest, that rarely attracts enough interest to be economic.  That said, aren’t the VIX futures and options contracts catching on?
8. Not sure what the second order effects will be here, but a rule is finally coming that will require the trade execution occur at the best price.  It will be extra work for the exchanges, but it will probably centralize exchanges in the intermediate term.  If you have to share data, why not merge?
9. One reason that Buffett was/is that best was his ability to learn from mistakes.  He kept his mistakes small and eventually found ways out of many of them.  US Air?  Salomon Brothers?  He eventually gets cashed out.  General Re?  The earnings from investing float bails him out. The “Shoe Group” and World Book?  Small, and you can’t win them all.
10. What do you do when the market has passed you by?  You got burned 2000-2002, and moved to a more conservative posture, only to find that the market ran like wild while you weren’t there.  What do you do now?  My advice: do half of what you would do if the market hadn’t run.  If you are at 20% equities, and you know that in normal times you should be at 60% equities, raise your investment level to 40% equities.  If the market rallies, you have more on, if it falls, you will have the chance to reinvest another 20% into equities at more attractive prices.
11. I usually agree with Eddy Elfenbein; he’s very common sense.  But here I do not.  Get me right here, Eddy is correct in all that he says.  I frame the problem differently.  You have someone sitting on cash, and the market has appreciated to where valuations are high-ish.  You can  1) invest it all now, 2) dollar cost average, or 3) do nothing.  Eddy doesn’t consider that many will choose 3.  On average, 1 beats 2 by a small margin, but 2 beats 3 by a wide margin.  Dollar cost averaging is a way to get psychologically unprepared people into the market who would never risk putting it all in at once.  We use DCA to get inexperienced investors from a bad place to a “pretty good” place, because the best place is unimaginable to them.
12. Desalination is the wave of the future, even in the US.  Potable water is scarce globally (think of India and China), and the cost of potable water justifies the energy and other costs associated with desalination.  The article that I cited does not capture the environmental costs of desalination, in my opinion, but it gives a good taste of what the future will hold.

And, with that, that completes my tour of the periphery.  Next week, I hope to provide more color for you on our changing risk environment.

There are three great economic distortions in our world today that will eventually have to be unwound. All of them are temporarily self-reinforcing, so they will persist until something breaks. Here they are:

• Recycling the US current account deficit.
• Too much speculation in leveraged credit markets.
• Too much speculation from private equity investors.

I could add a fourth, willingness of institutions to invest in weakly funded structures, like hedge funds, and anything else with liquid liabilities and illiquid assets, but that is for another day. Tonight, I want to focus primarily on the first of those issues, the consequences of the US current account deficit. Here goes:

1. Almost all bond managers love positive carry. It is the lure of free money, and it works most of the time. Borrow cheaply and invest the money in something that yields more. That simple idea lies behind most of the excesses in our debt markets globally, and fuels the three excesses listed above. With currencies, market player borrow in yen and Swiss francs, and invest in higher yielding currencies like the New Zealand Dollar. Even major corporations like Citigroup borrow in yen, because the rates are low.
2. When a country sends more goods to the US than it receives back, there is a natural inflationary effect. The local population buys goods and services, not US bonds, yet as banks accumulate the bonds, considering them to be part of their reserves, the balance sheets of the banks expand, because increased capital allows them to make more loans, which adds to the buying power of individuals and corporation, and can lead to more inflation. To resist the inflation, a country can let its currency rise versus the dollar, making exports less competitive, and increasing the willingness to import. This has happened in Thailand, India, and South Korea. Once this happens in enough nations, interest rates will rise in the US. We will send more goods to balance the accounts, and fewer bonds.
3. Here you can get a look at the dollar reserve levels of many nations. China has been absorbing a lot of dollar claims.
4. Thinking about inflation, wages are rising in China, particularly for those that work in export-oriented sectors. That is leading to rising prices for exports to the US. That will eventually have an upward impact on US price inflation.
5. Now, inflation is not a serious concern yet in Japan or Switzerland. But if it did become an issue, the carry trade would end rapidly. Interest rates would be forced up rapidly, and the cost of loans denominated in those currencies would rise as well, making the borrowing uneconomic. Personally, I think the yen is 20% undervalued; in a few years, the yen will correct, if not more.
6. On a more positive note, Jim Griffin suggests that the economies of Europe and Japan may be heading into classical recoveries. If true, good for all of us, particularly if they buy US goods.
7. Now, imbalances are not forever. The emerging markets ten years ago were fragile because they ran current account deficits. Today many of them have the high quality problem of surpluses (and the inflation they can engender). They are in a stronger position to deal with crises. The US, though is does not know it yet, is ina weaker position to deal with crises.
8. On the “dark matter” debate, my position has been that the US has a big debt to the rest of the world, but that since the US invests in higher yielding investments abroad than foreigners do in the US, until recently, the US earned more from foreign investments than foreigners earned off of US investments. This WSJ blog post supports my contention. On net, the US contains risk-takers, and the returns have been good so far, but the foreign debt has become so great, that the added yield is not enough to keep up with what we have to pay out.
9. The main thing that could go wrong here would be a trade war.  Now, one of those is not imminent, but the Doha round at the WTO has not been a success, and there is pressure in many nations to restrict trade, or foreign ownership of assets.  If one wants to destroy the gains from trade, that would be the way to go.
10. The 10-year Treasury yield has gotten jumpy in this environment, closing the week out at 5.18%.  I would expect the yield to muddle between 4.75 and 5.50% through the remainder of the year.  This is a finely balanced environment, with reason for rates to rise and fall.  Thus I expect the muddle.
11. Finally, three bits on debt and demographics.  The first is an article from the Wall Street Journal on how insurers are going after Baby Boomers.  This is just another factor in the yield seeking that I have been talking about.  Baby boomers want yield from their assets so that they can enjoy their retirement.  That yield-seeking is and will be a major force distorting the markets for years to come.  It is much easier to demand more yield from your assets than to save more.  In the long run, it is much harder to realize more yield from your assets than it is to save more.
12. Don’t trust US Government estimates of the deficit; instead, look at the change in net liabilities, the way a corporation might do it.  That would balloon the paltry $250 billion deficit to $1.3 trillion.  I have been writing about this since 1992.  The US government will not make good on all the promises it has made in money with today’s purchasing power.  The tipping point is not here yet for when this becomes obvious, but I believe it will become clear within the next ten years.  Pity the next three presidents.
13. Partly as a result of this, and greater labor competition from abroad, we are finally seeing some evidence that the current generation of young adults is not doing as well as their parents did.  This may be a case of increasing income inequality, so that the average can increase while the median decreases.  From my angle in society, this is happening.  A few motivated people are prospering, and many are muddling along.  Where my opinion differs here is that people are generally getting what they deserve; in a more competitive world, people have to compete harder than their parents did, in order to do better.  In general, people are not working harder, and so their results are falling behind those of their parents on an inflation adjusted basis.

Not to leave it on a down note, but that’s it for the evening.  Hope to write cheerier stuff next week.

Bond investors and value investors tend to be cautious in investing. It is possible to be too cautious, though, and so sometimes it pays to lay out the bull case. Indirectly, I learned this after several years of sitting next to the high yield manager at Dwight Asset Management (a very good firm that few know about). He wasn’t unconcerned about negative developments, but knew that fewer bad things happen than get talked about, and that they tend to take longer to happen than most imagine. He knew that he had to take some risks, because if you wait for the market to correct before you enter, you will miss profits while waiting, and the correction could be a long time in coming.

Also, I fondly remember our weekly economic conference calls in 2002, where the high yield manager and I would take the bull side in the discussions. For me it was fun, because it was so unlike me (I tend to be a bear), and it helped me to learn to balance the risks, and not be a perma-bull or a perma-bear.

So with that, here’s my quick list on what is going right in this environment:

1. Earnings yields are higher than bond yields, particularly among many investment grade companies, fostering buybacks and occasional LBOs. Profit margins may mean-revert eventually, but it might be a while for that to happen, given the global pressures that are keeping wage rates low.
2. The financing of the US current account deficit is still primarily being done through the purchase of US dollar denominated debt securities, keeping interest rates low in the US. This may shift if enough countries experience inflation from the buildup of US dollar reserves that they do not need, and allow their currencies to appreciate versus the US dollar. That hasn’t happened in size yet.
3. ECRI’s weekly leading index continues to make new highs.
4. Money supplies are growing rapidly around the world. Most of the paper is creating asset inflation, rather than goods inflation so far.
5. Bond yields have moderated since the yield peak in mid-June. Spreads on corporate investment grade debt have not widened much. Financing is cheap for the creditworthy.
6. Short sales are at a record at the NYSE. Part of that is just the influence of hedge funds.
7. Vulture investors have a lot of capital to deploy. Marginal assets are finding homes at prices that don’t involve too much of a haircut. (I’m not talking about subprime here.)
8. On a P/E basis, stocks are 45% cheaper than when the market peaked in March 2000.
9. Sell-side analysts are more bearish than they ever have been.
10. Investment grade companies still have a lot of cash sitting around. The washout from 2000-2002 made a lot of companies skittish, and led them to hold extra cash. Much of the cash has been deployed, but there is still more to go.
11. The FOMC is unlikely to tighten before it loosens.
12. Yield-seeking on the part of older investors is helping to keep interest rates low, and the prices of yield-sensitive stocks high.
13. DB Pension plans and endowments are still willing to make allocations to private equity.
14. The emerging markets countries are in aggregate in better fiscal shape than they ever have been.
15. Trade is now a global phenomenon, and not simply US/Europe/Japan-centric.
16. The current difficulties in subprime are likely to be localized in their effects, and a variety of hedge funds and fund-of-funds should get hit, but not do major damage to the financial system.

Now, behind each of these positives is a negative. (Every silver cloud has a dark lining?) What happens when these conditions shift? Profit margins fall, interest rates rise, inflation roars, risk appetites decrease, etc?

These are real risks, and I do not mean to minimize them. There are more risks as well that I haven’t mentioned. I continue to act as a nervous bull in this environment, making money where I can, and realizing that over a full cycle, my risk control disciplines will protect me in relative, but not absolute terms. So I play on, not knowing when a real disaster will strike.

Editing note — my apologies.  The second paragraph omitted the word “not” in the original publication.  What a word to omit, not.   

Two years ago in the RealMoney Columnist Conversation, I wrote the following:

Yield curve be nimble, yield curve be quick, yield curve go under limbo stick.Okay, no great allusion in the song there, but I sit watching the long end of the yield curve rally as the short end falls slightly. Is the FOMC back in play that fast after yesterday? I don’t think anything has shifted, but Mr. Market is manic.

It’s times like this that make me want to review the full set of reasons why the long end is rallying:

1. The supply of long bonds is shrinking, and the Treasury hasn’t decided to reissue the 30-year bond yet.
2. Pension Reform is happening in Europe, and some Europeans are buying long U.S. debt together with currency swaps.
3. Pension reform might happen in the U.S. as well.
4. The PBGC is buying long investment grade debt (it likes to immunize, because it’s risk-averse), particularly Treasuries and Agencies like a madman, and it just got a new slug of cash in with the takeover of the UAL (UALAQ:OTC BB) plans.
5. Mortgage refinancing tends to depress rates as originators hedge.
6. Speculators that were previously short longer bonds are now long. (uh oh)
7. An aging population wants income and increasingly favors bonds.
8. Neomercantilistic economies buy U.S. bonds because they can’t find anything better to do with their export earnings.
9. Market players trust the FOMC (however misguidedly) to control inflation in the long run.
   
10. There aren’t a lot of other places to get incremental yield, so extending maturities is a temptation for bond investors.
11. The U.S. economy is anticipated to be growing at a slower rate.
12. The marginal efficiency of new capital is falling because of the introduction (in principle) of 2 billion laborers to the global capitalist labor pool.

This last point I covered in parts of the articles, “Implications of a Low-Nominal World,” and “The Economy, Seen From Many Angles.” When labor is abundant, more capital isn’t needed to produce a greater output, until labor is scarce again. The returns to the employment of additional capital fall, which leads market players to bid up the prices of fixed claims on the economic system, i.e., bonds, because they can’t find better places to assure a return for the future.

This also explains the increase in buybacks and debt reduction on the part of corporations, relative to increases in plant and equipment. That said, it’s a tough environment, but on the bright side, previously poor areas of the world are developing, and that bodes well for those countries, and the global economy 20 years out, once the labor that is new to the capitalist world is productively deployed.

What a difference two years makes. The above post was meant to justify low rates, and it did a fair job of making the case. Later I added a reason 13, that suggested that there was no other currency that could serve as the world’s reserve currency. Unless we move to a gold or commodity standard, that is probably still true.

So what among the above reasons are still valid? Let’s go through them:

1. 30-year bonds are being issued now, though not in great abundance.
2. Still a factor, but small because the initial surge has worn off.
3. Only 40% complete in the US, but FASB may fix that within a year, which would intensify demand for long bonds as defined benefit plans attempt to match liability cash flows.
4. The bankruptcy wave is past. Not a factor now.
5. With rates higher, the mortgage hedging flows favor higher rates.
6. Kind of a wash. Speculators are long the 10-year and short the 30-year. Not a factor on rates now.
7. Still a factor. Yield seeking on the part of retirees is big, and Wall Street i catering to that search. (Hold onto your wallets.)
8. Still true.
9. Still true.
10. False; can’t get much incremental yield at all through extension of durations now.
11. True, but the degree of the slowdown is open to question, and foreign financial flows are a bigger factor.
12. Still true, though the marginal effect at present is probably smaller.

So where does that leave us on interest rates? Muddled. Most of the big demographic and international effects on rates still favor lower rates. A new factor that was only partially understood by me two years ago has become a bigger factor: rising inflation in countries that fund the US current account deficit. That favors higher rates, both here and abroad. The question is whether foreign countries bite the bullet and allow their currencies to rise against the dollar or not. To the extent that they allow their currencies to rise, so will rates in the US. But if they keep their currencies artificially weak by buying US dollar bonds with their own currencies, it will continue to depress US long interest rates.

Human nature being what it is, I would expect that most countries continue their policies of buying US fixed income until a crisis forces them to change. Those don’t come on schedule, so I will not try to predict timing. I continue to keep a large portion of my fixed income investments in foreign currencies, which has not been a winner in the last month, but has served me well over the last two years.

Some housekeeping before I start. My post yesterday was meant to be a “when the credit/liquidity cycle turns” post, not a “the sky is falling” post. Picking up on point number 4 from what could go wrong, I would refer you to today’s Wall Street Journal for two articles on LBOs that are not going so well, and the sustainability of private equity in the current changing environment. Please put on your peril-sensitive sunglasses before reviewing the credit metrics.

In the early 90s, as 401(k)s came onto the scene, savings options were the hot sellers to an unsophisticated marketplace. Because of the accounting rules, insurance contracts could be valued at book, not market, and so Guaranteed Investment Contracts [GICs] were sold to 401(k) and other DC plans.

The difficulty came when companies that issued contracts failed, like Executive Life, Mutual Benefit, Confederation, and The Equitable (well, almost). A market that treated all contracts equally was now exposed to the concept that there is such a thing as credit risk, and that the highest yielding contract is not necessarily the one that should be bought.

In the mid-90s, that was my first example of market maturation, and it was painful for me. I was running the Guaranteed Investment Contract desk at Provident Mutual, and making good money for the firm. We survived as other insurance companies went under or exited the business, but as more companies failed, the credit quality bar kept getting raised higher, until we were marginal to the market. Confederation’s failure was the last nail in my coffin. I asked my bosses whether I could synthetically enhance my GICs by giving a priority interest to the GIC-holders in an insolvency, but they turned me down, and I closed down an otherwise profitable line of business.
Failure brings maturity to markets, and market mechanisms. When a concept is new, the riskiness of it is not apparent until a series of defaults occurs, showing a difference between more risky and less risk ways of doing business. Let me give some more examples:

Stock Market Leverage: How much margin debt is too much, that it helps create systemic risk? In the 20s leverage could be 10x, and the volatility that that policy induced helped magnify the boom in the 20s, and the bust 1929-1932. Today the ability to lever up 2x (with some exceptions) is deemed reasonable. If it is not reasonable, another failure will teach us.

Dynamic Hedging: In the mid-80s, shorting stock futures to dynamically hedge stock portfolios was the rage. After all, wasn’t it a free way to replicate a costly put option?

When it was first thought up, it probably was cheap, but as it became more common the trading costs became visible. For small price changes, it worked well. Who could predict the magnitude of price changes it would be forced to try and unsuccessfully hedge? After Black Monday, the cost of a put option as an insurance policy was better appreciated.

Lending to Hedge Funds: I’m not convinced that this lesson has been learned, but if it has been learned, the crisis from LTCM started that process. After LTCM failed, counterparties insisted more closely on understanding the creditworthiness of those that they expected future payments from.

Negative Convexity: Through late 1993, structurers of residential mortgage securities were very creative, making tranches in mortgage securitizations that bore a disproportionate amount of risk, particularly compared to the yield received. In 1994 to early 1995, that illusion was destroyed as the bond market was dragged to higher yields by the Fed plus mortgage bond managers who tried to limit their interest rate risks individually, leading to a more general crisis. That created the worst bond market since 1926.
There are other examples, and if I had more time, I would list them all. What I want to finish with are a few areas today that have not experienced failure yet:

1. the credit default swap market.
2. the synthetic CDO market (related to #1, I know)
3. nonprime commercial paper
4. covenant-lite commercial loans, particularly to LBOs.

There is nothing new under the sun. Human behavior, including fear and greed, do not change. In order to stay safe in one’s investments, one must understand where undue risk is being taken, and avoid those investments. You will make more money in the long run avoiding foolish risks, than through cleverness in taking obscure risks ordinarily. Risk control triumphs over cleverness in the long run.

Perhaps for blogging, I should not do this. My editors at RealMoney told me that they liked my “Notes and Comments” posts in the Columnist Conversation, but they wished that I could give it a greater title. Titles are meant to give a common theme. Often with my “Miscellaneous Notes” posts, there is no common theme. Unlike other writers at RealMoney, I cover a lot more ground. I like to think of myself as a generalist in investing. I know at least a little about most topics.

Now, I have to be careful not to overestimate what I know, but the advantage that I have in being a generalist is that I can sometimes see interlinkages among the markets that generalists miss. Anyway, onto my unrelated comments…

1) So many arguments over at RealMoney over what market capitalization is better, small or large? Personally, I like midcaps, but market capitalization is largely a fallout of my processes. If one group of capitalizations looks cheap, I’ll will predominantly be buying them, subject to my rule #4, “Purchase companies appropriately sized to serve their market niches.” Analyze the competitive position. Sometimes scale matters, and sometimes it doesn’t.

2) My oscillator says to me that the market is now overbought. We can rise further from here, but the market needs to digest its gains. We should not see a rapid rise from here over the next two weeks, and we might see a pullback.

3) My, but the dollar has been weak. Good thing I have enough international bonds to support my balanced mandates. I am long the Yen, Swissie, and Loony.

4) Sold a little Tsakos today, just to rebalance after the nice run. Cleared out of Fresh Del Monte. Cash flow looks weak. Suggestions for a replacement candidate are solicited.
5) Roger Nusbaum is an underrated columnist at RealMoney in my opinion. Today, he had a great article dealing with understanding strategy. He asked the following two questions:

• If you had to pick one overriding philosophy for your investment management, what would it be?
• If you had to pick four of your strategies or tactics to accomplish this philosophy, what would they be?

Good questions that will focus anyone’s investment efforts.

6) In the “Good News is Bad News” department, there is an article from the WSJ describing how the SEC may eliminate the FASB by allowing US companies to ditch GAAP, and optionally use international accounting standards [IFRS]. If it happens, this is just the first move. Eventually all companies will follow an international standard, that is, if Congress in its infinite wisdom can restrain itself from meddling in the management of accounting. The private sector does well enough, thank you. Please limit your scope to tax accounting (or not).

7) Also from the WSJ, an article on how employers are grabbing back control of 401(k) plans. Good idea, since most people don’t know how to save or invest. But why not go all the way, and set up a defined benefit plan or a trustee-directed defined contribution plan? The latter idea is cheap to do; we have one at my current employer. Expenses are close to nil, because I mange the money in-house. Even with an external manager, it would be cheap.Would there be people who complain, saying they want more freedom? Of course, but they are the exception, not the rule, and of those who complain, maybe one in five can do better than an index fund over the long haul. I am for paternalism here; most ordinary people can’t save and invest wisely. Someone must do it for them.

Finally, the “hooey alert.” The concept of using custom indexes to analyze outperformance smacks of the inanity of “returns-based style analysis.” I wrote extensively on this topic in the mid-90s. Anytime one uses constrained optimization to calculate a benchmark using a bunch of equity indexes, the result is often spurious, because the indexes are highly correlated. Most differentiation between them is typically the overinterpretation of a random difference between the indexes. Typically, these calculations predict well in the past, but predict the future badly.

That’s all for now.

Full Disclosure: long TNP FXY FXF FXC