Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns.  As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated.  Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide.  But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk.  I look at the individual risks and ask whether they are overpriced or underpriced.  Here is my current assessment:

• Equities — slightly undervalued at present, particularly high quality stocks.  (US and foreign)
• Credit — Investment grade credit and high yield are fairly valued at present.
  
• Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
• Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
• Inflation — Low, but future inflation is probably underestimated.
• Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
• Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
• Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present.  I would leave more in money market funds than most would as a part of capital preservation.  I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars.  I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc.  (The least of those worries is the US Dollar itself.)

We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into.  My view here is to play it safe when conditions are not crazy bad, and take a lot of risk whe credit markets are in the tank.

As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds.  Commodities and companies that produce them should play a small role as well.

Dear readers, I am now on Twitter — AlephBlog is my moniker if you want to follow me.

I have been somewhat reluctant to do this, but tonight’s post stems from a file on nonlinear dynamics on my computer that I developed between 1999 and 2003 for the most part.  Not so humbly, I called it “The Rules.”   This is the first in a series of what will likely be long set of irregular posts about what I call “The Rules.”  Please understand that I don’t want to make grandiose claims here.  After all, as I once said to Cramer (yes, that one): “The rules work 70% of the time, the rules don’t work 25% of the time, and the opposite of the rules works 5% of the time.”

My best recent example of the rules not working was when the formulas of the quants were blowing up in August 2007.  There were too many quants following the same strategy, and they had overbid the stocks that their models loved, and oversold the ones that they hated.  For a while, the quant models were poison.  Every investment strategy has a limited carrying capacity, and those that exceed the strategy’s capacity are prone for a comeuppance.

Here is today’s rule: There is no net hedging in the market.  At the end of the day, the world is 100% net long with itself.  Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

There are many people, particularly dumb politicians, who think that derivatives are magic.  To them, derivatives create something out of nothing, and that something is strong enough to smash innocent companies/governments that have been behaving themselves, but have somehow found themselves caught in the crossfire.

First, if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.  You have the upper hand.  But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.  Even without derivatives, that is a tough place to be.

With derivatives, for every winner, there is a loser.  It is a zero-sum game.  Yes, as crises arise there are always those that look for a way to make money off of the crisis.  And there are some parties willing to risk that the crisis will not be so bad, at a price.  Derivatives don’t exist in a vacuum.  Same thing for shorting — there is a party that wins, and a party that loses.  So long as a hard locate is enforced, it is only a side bet that does not affect the company whose securities are being played with.

When there are troubles, it is because a company or government has overstretched its limits.  You can’t cheat an honest man (or country).  You can take advantage of countries and companies that have overreached on their balance sheets and cash flow statements.

Cash on the Sidelines, Market is Oversold/Overbought, Money is Moving into or out of…

Every bit of cash on the sidelines is matched by a short term debt obligation somewhere.  Now, that’s not totally neutral, as we learned in the money markets crises in the summers of 2007 and 2008.  If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.  It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.  CIT did die.  Mexico in 1994.  When you can’t roll over your short term debts, it gets really ugly, and fast.  Think of the way we messed up housing finance in the mid-2000s; one of the chief signs that we were in a bubble was that so much of it was being financed on floating rates, or contingent floating rates with short refinance dates.  Initially, that gave people a lot more buying power, at a price of higher unaffordable rates later.  “The phrase, “You can always refinance,” is a lie.  There is never a guarantee that financing will be available on terms that you will like.

This is also a good reason to go for debt that fully amortizes (i.e., when you get to the end of the loan, the payments haven’t risen, and the loan pays off in full).  I’ve never been crazy about the way commercial mortgage loans don’t fully amortize.  I know why it happened this way.  A) in the late ’80s and early ’90s, insurance companies were issuing GICs by the truckload, and needed higher yielding debt with a 5-year maturity.  Voila, 5-year mortgage loans with a balloon payment.  For the real estate developers, the loans were cheaper, but they had to trust that they could refinance — an assumption sorely tested in the early ’90s.  After the death of many S&Ls, a few insurers and developers, and the embarrassment of a more, borrowers and lenders became a little more circumspect.

But the loss of the S&Ls left a void in the market.  The Resolution Trust Company created some of the first Commercial Mortgage Backed Securities [CMBS], that Wall Street then imitated, filling in the void left by the S&Ls.  But to make the securitizations more bond-like, for easy sale the loans were 10-year maturities with a balloon payment at the end.  That way the deals would closer at the end of ten years.  Maybe some of the junk-grade certificates would be stuck at the end with a some ugly loans to work out, but surely the investment grade certificates would all pay off on time.

And that is a big assumption that we are going to be testing for the next five years.  Will developers be able to refinance or not?

This has gotten long, and have more to say, but I’m going to a wedding of a friend, and must cut this off.  Let me close by saying there is a corollary to the rule above, and it is this:

Long-dated assets should be financed by non-putable long-dated liabilities or equity.  Don’t cheat and finance shorter than the life of the assets involved.  There is never an assurance that you will be able to get financing on terms that you will like later.

When I was a corporate bond manager, I often dealt in less liquid bonds.  Why?  They had more yield, I only bought those that my credit analysts liked, and I had a balance sheet that could hold them.  I had the option of holding those bonds, but not the obligation of holding those bonds.  As credit conditions improved in early 2003, to leave my successor with a simpler portfolio, I decided to lighten my holdings of bonds issued by a private bank.  I held 35% of the issue, and bought most of it near the height of the panic.

I told my secretary, “The phone will start ringing off the hook in 30 seconds.”  She gave me that usual sweet smile and said, “Okay, David.”  I offered a chunk of the bonds 0.2% below the last trade in spread terms, without guaranteeing the level.  To my surprise, I got a lot of bids rapidly, to the point where I said “whoa! there are too many that want these bonds.”  I recalibrated my levels and offered a “supply curve” of bonds, where I offered more the higher the price went.  I ended up selling 2/3rds of my holdings, and made significant gains for my client.  The final trade was 1/2% tighter than my initial proposed trade.

Having traded small and microcap stocks, and traded illiquid bonds, I am less afraid of illiquidity than many are.  Illiquidity is something that one can absorb, if he has a strong balance sheet and a patient disposition.

The great Peter Lynch would buy small cap stocks for Magellan, with strict orders on price.  Then he would let them sit, while they gained in value on average.  Marty Whitman buys in “safe and cheap” small cap stocks that are illiquid and holds them until their value is recognized.

If you have a strong balance sheet or patient investors, take advantage of it, and buy investments that are less liquid, where value may take a while to obtain.

But liquidity is not natural to all assets.  Most things in an average person’s life will not be liquid.  Your house and car are not liquid.  It will take a lot of effort to sell them and buy a different house and car.  So why should futures on property values be liquid, or residential mortgage-backed securities?

Well, debts that are very certain will always be liquid.  Debts that are less certain will be liquid during boom-phases, and illiquid during bust-phases.  In general, that is why AAA-rated asset-backed securities, which are usually “last loss” securities are fairly liquid, while lesser-rated securities trade rarely.

My point is that you can’t take illiquid assets and make them liquid.  Assets are liquid because they are short term, where one knows the cash flow to be received soon.

Are public stocks, like Exxon Mobil, liquid?  In one sense, yes.  During the day, when trading is in session, and there is
no news hitting the wire, then yes, quite liquid — one can get in and out of a position easily with little difference between the bid and ask.  But, when news hits, or from the closing price to the next day’s open, the price can move considerably.

Over a long period of time, the shares of two companies in identical businesses, one publicly traded, and one privately held, could deliver the same value over a long period of time.  The public company would have the ability to adjust its capital structure to buy in shares when they are cheap, and sell when they are dear, unlikely as that behavior is.  The public company would adjust its debt levels more frequently, while the private company would likely keep debt high and equity low, to keep taxes low.  The private company could act quietly and think longer term, subject to the constraints of their loan agreements.  The public company would have more bumps to its seeming value from news events, including earnings releases.

For the holder of shares in the public company, though liquidity is available, the value of the shares will vary.  For the public and private companies alike, liquidity for any large amount of the shares would be an event.  And, aside from successful maturity dates, the same would be true of large amounts of debt — there might be a public market available for small amounts of it, but just try to buy or sell a big amount, and pricing conditions are rarely favorable.  My example at the start of the post, where I sold 20% of the total issued amount for a favorable price, only happened because the willingness of investors to take risk increased dramatically since the last trade.  Yield greed had set in.

But that brings up the other definition of liquidity — what does it cost to enter/exit fixed commitments?  Tight credit spreads mean that corporations can (borrow) enter fixed commitments cheaply, and lenders, dearly.  The same applies to Fed policy — a wide Treasury curve means that it is expensive to borrow long, and cheap to borrow short — but borrowers want more security than to have a short maturity leash.

But when lenders are scared, they gravitate to short loans and high quality — cash equivalents lent to the Treasury.  If enough do that, short term yields get really low.  They can even go negative.

I remember arguing with a visiting professor at Wharton back in 1990 that negative interest rates were possible.  He told me I was nuts, people would sit on cash.  I replied, “what if you can’t keep the cash safe?”  Maybe I should have said, “What if it is inconvenient to transfer and guard several billion dollars in cash?  There are costs to that as well.”

In a liquidity trap like we are in, short-term money managers that must have US Treasury collateral must bid for it, no matter what.  They can’t move to cash.  Cash to them is very short-term debts of the most creditworthy entity that they know — their Government, the one that controls the Fed, sorta.

But the volume of lending, particularly to smaller business borrowers is light.  Is there really a lot of liquidity out there?  Or, is it being used primarily by the US Government and its affiliates while the economy is weak?  I think that is the case.

Liquidity is not magic; it can’t be created or destroyed — it just travels where it is needed.  During booms, liquidity appears abundant because of loose monetary policy and high willingness to take credit risk.  It seemingly disappears in the bust, as the marginal fixed income investor attempts to eliminate credit risk — liquidity then flows to the highest quality assets.

Liquidity is always around; it is only a question of where the marginal credit buyer has migrated.  In the current environment, it is short high-quality obligations that are still king, and lower-quality longer obligations that trail, though not as badly as last winter.

I am sure that I will write more on this topic, should I live so long.  My contentions are:

• Securitization does not create liquidity, it only redirects it.
• The Fed does not create liquidity, it only redirects it.
• The Treasury does not create liquidity, it only redirects it.

Liquidity is a function of human action.  We all have to work and trade to survive.  Liquidity is where people are transacting at any given moment toward that end.  Structural changes in the economy, whether by the government or through private channels will shift where liquidity goes, but it will not change the amount of liquidity, unless the changes are so severe that the economy itself becomes much less productive.

I have long been a fan of immediate annuities, particularly those that are inflation indexed, as retirement products for seniors.  Yet, they do not get bought by retirees.  Why?  Well, insurance products are sold, not bought, typically, and when the agent sells an immediate annuity, that is his last sale on that money.  They would rather sell a less suitable product that offers them another sale down the road.  And, people like having flexibility with and control over their investments, even if that leads to less money for them in the long run.  Annuitizing a portion of one’s lump sum lowers risk, and takes the place of investing in bonds in the asset allocation.

Most people like the reliability of their pensions, and Social Security, should it be paid, but do not seek the same thing when investing their private money.  One would think they would invest that money for growth if they had a strong stream of income elsewhere, but often that money is conservatively invested as well.

People get fooled by yield, and in an environment like this, more so.  People try to make their investments do more through targeting higher yields, while ignoring the possibility of capital losses.

Most people can budget, if pressed to do so.  Few can manage a lump sum of capital, and know what to invest it in, and how much to take from it per year.  Few have the discipline to buy an immediate annuity or limit their withdrawals to 4% of assets per year.

But where there is chaos and confusion, some in our government will seek to create a “solution.”  The ill-defined solution that sounds a bit like a Stable Value Fund is what is getting called “R Bonds.”  Here’s the idea: for those with 401(k)  or IRA balances, if they should retire, and not decide what to do with the money, the assets would get automatically get placed into a Retirement Bond, and for two years, the retiree would receive income.  They can opt out before that happens.  If after two years they still don’t decide, the income continues.  There is nothing mandatory about this program, should it come into existence; people who are asleep about their finances may find themselves trapped in it, at least for a time. [Note: there are scandalmongers alleging out-and-out theft being planned by the US Government.  From what I can see that is not true for anyone that keeps his wits about him.  All the proposals allow people to "opt out."]

But let me go further.  Scrap the idea of “R bonds.”  Issue a limited number of Trills for retirees to use, or create a special variant of TIPS that pays until someone dies.  These are easy solutions that do not require a lot of changes to the legal codes, or changes in investment behavior.

Now, there is not just one proposal out there.  Let me give the two most comprehensive:

• Increasing Annuitization in 401(k) Plans with Automatic Trial Income
• Guaranteed Retirement Accounts Toward retirement income security — less desirable.  People should not be coerced into investments for retirement.  People should have a right to choose or not choose.

With interest rates so low on the short end, I don’t see how the returns could be that great from “R Bonds.”   I would play for higher returns given the risk of inflation.  Today that would mean safe stuff that yields little, while waiting for a correction in the fixed income markets, and high quality common stocks with some yield.  And, annuitization at present?  I would wait for higher rates.

Other posts on the topic worthy of your consideration:

• Americans Oppose Proposals to Limit 401(k)s, ICI Says
• Administration explores ‘R bond’ as option for retirement accounts
• Rating the Idea of R Bonds
• Retiree Annuities May Be Promoted by Obama Aides
• Obama Administration Wants to Annuitize 401k’s and IRA’s – Mandatory “R Bonds”

Now, all that said, there is a reason to be politically aware here.  Governments have in the past forced people to convert assets that were more valuable for those that were less valuable.  And, we have the example of Argentina doing it in the present with pension assets, and also when their currency blew up — most debtors faced a forced conversion to less valuable bonds.  With the pension nationalization, it was done in the name of protecting people’s pensions, but ended up benefiting the finances of the Argentine Government.

So, be aware.  R Bonds, as currently proposed, are a bad idea.  But there are worse ideas not yet proposed that might be proposed in the guise of protecting your future.  Let us work to make sure they never get implemented.

I like Roger Lowenstein; he is a bright guy.  I have reviewed several of his books, and would recommend to readers that they are worth buying.

But, I disagree with Lowenstein in some ways regarding defaulting on home mortgages.  I want to give some credit to my wife here.  My dear wife of 23 years, who I thought about many times while we were attending a wedding today (I could not sit with her because I was leading the singing), and who does not have an economic bone in her body, helped me think about the issues around defaulting on home mortgages.

There is a false notion that because firms default when it is in their economic interest to do so, so should homeowners whose mortgages are greater than the underlying house value.

First, firms can’t so easily enter Chapter 11.  How does Chapter 11 work for firms?  Two things must be true — a firm must not be able to raise cash to make a debt payment, and the assets of the firm are worth less than the liabilities.  If a firm can’t pass both tests, the bankruptcy court should refuse the filing, forcing the firm to sell assets to make a payment.

To use this analogy for defaulting on a home mortgage, it is one thing to take out a mortgage in buying a home, having reasonable margins for error, and then disaster hits, and the mortgage payment can’t be made.  It is quite another thing to have the capacity to make the mortgage payment, and default.  Corporations usually can’t get away with that (please ignore KMart); if they can make payments on the debt, they can’t go into Chapter 11 bankruptcy.

Bankruptcy primarily exists as a protection for borrowers who have suffered loss, leading to inability to pay their debts.  It does not exist to allow people with the capacity to pay to slip out of contracts, simply because the creditor won’t go after them because it is not worth their effort, or, they don’t want the negative PR.

Would you borrow from a relative and default, because you know they would never sue you?  Would that be ethical?  Taking advantage of the extreme kindness of others may be legal, but it is never ethical.

If you can pay, you should pay.  That the mortgage lender will not enforce their rights does not mean that the one who can pay but defaults is ethical.

Imagine a society where any can default at their pleasure.  My, but the interest rates should get high to reflect the possibility of loss from borrowers that could pay but won’t.

If you can keep your word, and make your payments, do so.  You entered into the mortgage agreement with no assurance of where housing prices would go.  That they turned against you is no reason to default; but if your ability to pay has declined, well, that is another thing — default if you must.

1) There is a new blog that I recommend: Macroeconomic Resilience.  I have commented there recently, and I think that he understands the complexity of markets in ways that most Ph. D. economists don’t.  Here is a recent post, and my comment.

http://www.macroresilience.com/2010/01/01/moral-hazard-a-wide-definition/comment-page-1/#comment-6

One job ago, at a hedge fund that was bearish on financials, we would talk about this all the time.  Regulators could have stopped the crisis in the early 2000s had they simply enforced lending standards.  The banks would have screamed and ROEs would have gone into the single digits, but the crisis could have been prevented.

But, regulators are to a degree subject to politicians.  Politicians, in the absence of any moral compass aside from re-election, are mainly beholden to those that fund their campaigns, when the electorate is without education, or a moral compass as well.  Thus, regulations were neutered.

After that, how many businessmen would watch out for the companies they served, instead of what would maximize their pay?  There were some bankers that did so and got shown the door.  There were other banks owned privately, were conservative, and missed the crisis.  It could be done, but the management team or owners had to deliberately sacrifice the short run in favor of missing an uncertain crisis.

Chuck Prince said something to the effect of “When the music is playing, you gotta get up and dance.” to justify doing business in the face of bad credit metrics.  Well, yes, in a place where no one cares for the long-run health of the firms, or of society as a whole.

Someone has to care for the long run.  Better it be free individuals rather than the government.  But if free individuals will not do it, eventually the government will.

2) I have been a fan of Michael Pettis for many years, from his publication of his book, The Volatility Machine.  Here is a comment that I posted at his blog, which I highly recommend:

http://mpettis.com/2010/01/china-new-year-and-one-more-vote-for-gdp-adjusted-bonds/

Michael, I ordinarily agree with you on almost everything economic, but I can’t agree on the trills. I believe in asset-liability matching, even at the government level. Try to match term risk and liquidity risk to what is being funded.

I have argued that the debt structure of the US government has been getting too short, and recommended that the US Treasury lengthen its funding policies — I even said that to the Treasury officials that I met with in November.

http://alephblog.com/2008/11/25/issuing-debt-for-as-long-as-our-republic-will-last/
http://alephblog.com/2009/11/04/my-visit-to-the-us-treasury-part-2/ (2 of 7)

But trills have exceedingly long duration — the remind me of some structured settlements that I have had to model, but these are perpetuities — even longer for the coupon to grow. Duration looks like it would be north of 40 — it depends on the assumptions used.

A perpetuity growing at GDP rates saddles our posterity with debts that they cannot bear. Cheap debt up front — really costly on the back end.

http://alephblog.com/2009/12/27/not-so-cheap-trills/

But, thanks ever so much for your blogging. I learn so much from you. Keep it up.

3)  Insurance for those dropping out of school?  Sounds really dumb:

http://blogs.wsj.com/economics/2009/12/31/would-insurance-for-college-failure-keep-more-students-enrolled/

This sounds like a product that only dumb insurers would write. Never write insurance where the insured has better knowledge and more control than the insurance company.

4) Many are crying over auction rate preferred securities.  But most of the assets that were harmed were owned by corporations, who had investment professionals that chose auction rate preferred securities because they yielded significantly more than money market funds, but with seemingly little risk, and the system worked for around 20 years.

They took above average risks, and now they expect to be bailed out?  I have read through many ARPS prospectuses.  For those that read them, the risks were clearly disclosed.  I do not have a lot of sympathy for those that did not do their job.

5) From the “bitter taste” zone, we learn that foreign investors in US debt lost the most versus investing in the debt of other developed nations in 2009.  Should that surprise us when demands for loans accelerated dramatically in 2009?  I don’t think so, and most reasonable analysts would agree.

My first real post at the blog was Yield = Poison.  In late February 2007, prior to the blowup in the Shanghai market, I felt frustrated and wanted to simply say that every fixed income class seemed overvalued.  Short and safe seemed best.

It reminded me of a discussion that I had with a colleague two jobs ago, where in mid-2002, the theme was “yield is poison.”  I did the largest credit upgrade trade that I could in the second quarter of 2002, prior to the blowup of Worldcom.  Moved the whole portfolio up three notches in four months.  Give away yield; preserve capital for another day.

I feel much the same, but not as intensely in the present environment.  Spreads could come in further if the government keeps providing low cost liquidity to those who make money on the spread they earn on financial assets.  But most fixed income assets do not reflect likely default costs.  Perhaps the long end of the Treasury curve is worth a little allocation of assets here, if only as a deflation hedge, but if the Fed is going to start lightening up on their QE, and the Treasury will be having high issuance, I might want to stand back for a while  while supply will be high, and try to buy near the end of the quarterly refunding.

There is another sense in which I say “yield = poison,” though.  When rates for safe assets are low, retail and professional investors are both tempted to stretch for yield.   Wall Street is more than happy to deliver on your desire for yield.  It is their top illusion, in my opinion.

Two examples from my bond trading days: the first was some local brokers asking to buy a small amount relatively highly-rated junk bonds from us.  They were offering a full dollar over the usual market price.  They called me, since I ran the office, but I handed them over to the high yield manager, who said, “Jamming retail, are we?”  [DM: placing overpriced bonds in customer accounts.]  After a lame reply which amounted to,”Look, don’t ask us about what we are doing, we’re offering you a good deal, do you want to sell your bonds or not?”  the high yield manager sold them a small amount of the bonds, and we didn’t hear from them again.

The second example was when a bulge bracket firm called me and asked me if I owned a certain very long duration bond.  I said yes, and he made me an offer several dollars above what I thought they were worth.  With a bid that desperate, I said I could offer a few there, and more a little back, but for the block he would have to pay more still.  He offered something close to the “more still” price, and I sold the block to him there.

As we were settling the trade, I asked him, “Why the great bid?”  He said, “We need the bonds for retail trusts.  They get an above average yield, but if rates fall, after five years, we buy them out at par, and keep the bonds.  If rates rise, they take the loss.”

Even on Wall Street, if you have a good relationship, you get an honest answer.  That said, it made me sorry that I sold the bonds, even though it was the best thing for my client.

There are many ways to frame the yield question at present, here are two:

• You are on a fixed income, and you are having a hard time making ends meet.  Should you lend longer to earn more, go for lower rated credits, or do nothing?
• You are earning almost nothing on your money market fund.  You need liquidity, but where else could you invest it?

I would be inclined to buy a mix of foreign-denominated bonds, but most people can’t deal with that.  So, I would advise them to build a “bond ladder” where they have high quality issues maturing every year for the next 10 years.  As each bond matures, I would use the proceeds to buy bonds ten years out, re-establishing the 10-year ladder.

But don’t reach for yield.  Odds are, you will get capital losses great than the excess yield you hoped to receive.  And remember this, don’t buy products someone else wants to sell you.  Specifically, don’t buy high yielding investment products that Wall Street sells to enhance your income.  They prey upon those who want more money, and are weak in their knowledge of how the markets work.

To professionals: don’t reach for yield now; long-run, you are not getting paid for the risks.  You have seen how illiquid structured products can be in the face of credit uncertainty, and impaired balance sheets of holders and likely purchasers.  You have seen how spreads can blow out (bond prices fall), and roar back in (prices rise again) in the absence of safe places to invest money.

I’ll give the Treasury and the Fed this: they have created an environment where savers are punished, and have to take significant risks to get yield.  They have created a situation where the markets are dependent on subsidized credit, and speculation dominates over lending to the real economy.  They are pushing us deeper into a liquidity trap, as low-to-negative return investments in autos, homes, and banks get supported by cheap public credit, rather than getting reconciled in bankruptcy, so that capital can be redeployed to higher returning projects.

Anyway, enough for now — more later.

Before I start, I would like to toss out the idea of an Aleph Blog Lunch to be hosted sometime in January 2010 @ 1PM, somewhere between DC and Baltimore.  Everyone pays for their own lunch, but I would bring along the review copies of many of the books that I have reviewed for attendees to take home, first come, first served.  Maybe Eddy at Crossing Wall Street would like to join in, or Accrued Interest. If you are an active economic/financial blogger in the DC/Baltimore Area, who knows, maybe we could have a panel discussion, or something else.   Just tossing out the idea, but if you think you would like to come, send me an e-mail.

Onto the comments.  I try to keep up with comments and e-mails, but I am forever falling behind.  Here is a sampling of comments that I wanted to give responses on.  Sorry if I did not pick yours.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=–==-=–==-

Blog comments are in italics, my comments are in regular type.

http://alephblog.com/2009/12/16/notes-on-fed-policy-and-financial-regulation/#comments

Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov’t would could happen – seeing that result all but solidified the ‘too big to fail’ mantra.

2. Second, they will be forced to raise rates – that’s right folks, 0% – 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road – perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed’s paid interest on excess reserves – the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.

Thoughts????

UD, I think you have the Fed’s Order of Battle right.  The questions will come from:

1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up.  Bank profits have become very reliant on low short term funding.  I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

http://alephblog.com/2009/12/15/book-reviews-of-two-very-different-books/#comments

David,
A few years back you mentioned to me in an e-mail that Fabozzi was a good source for understanding bonds (thank you for that advice by the way, he is a very accessible author for what can be very complex material.)  In the review of Domash’s book you mention that he does not do a good job with financials. I was wondering, is there an author who is as accessible and clear as Fabozzi, when it comes to financials, who you would recommend.

Regards,
TDL

TDL, no, I have not run across a good book for analyzing financial stocks.  Most of the specialist shops like KBW, Sandler O’Neill and Hovde have their own proprietary ways of analyzing financials.  I have summarized the main ideas in this article here.

http://alephblog.com/2007/04/28/why-financial-stocks-are-harder-to-analyze/

http://alephblog.com/2009/12/05/the-return-of-my-money-not-the-return-on-my-money/#comments

Sorry to be a bit late to this post, but I really like this thread (bond investing with particular regard to sovereign risk). One thing I’m trying to figure out is the set of tools an individual investor needs to invest in bonds globally. In comparison to the US equities market, for which there are countless platforms, data feeds, blogs, etc., I am having trouble finding good sources of analysis, pricing, and access to product for international bonds, so here is my vote for a primer on selecting, pricing, and purchasing international bonds.

K1, there aren’t many choices to the average investor, which I why I have a post in the works on foreign and global bond funds.  There aren’t a lot of good choices that are cheap.  It is expensive to diversify out of the US dollar and maintain significant liquidity.

A couple of suggested topics that I think you could do a job with:  1) Quantitative view of how to evaluate closed end funds trading at a discount to NAV with a given NAV and discount history, fee/cost structure, and dividend history;   2) How to evaluate the fundamentals of the return of capital distributions from MLPs – e.g. what fraction of them is true dividend and what fraction is true return of capital and how should one arrive at a reasonable profile of the future to put a DCF value on it?

Josh, I think I can do #1, but I don’t understand enough about #2.  I’m adding #1 to my list.

http://alephblog.com/2009/12/05/book-review-the-ten-roads-to-riches/#comments

I see that Fisher’s list reveals his blind spot–how about being born the child of wealthy parents. . .

BWDIK, Fisher is talking about “roads” to riches.  None of us can get on that “road” unless a wealthy person decided to adopt one of us.  And, that is his road #3, attach yourself to a wealthy person and do his bidding.

I am not a Ken Fisher fan, but I am a David merkel fan—so what was the advice he gave you in 2000?

Jay, what he told me was to throw away all of my models, including the CFA Syllabus, and strike out on my own, analyzing companies in ways that other people do not.  Find my competitive advantage and pursue it.

That led me to analyzing industries first, buying quality companies in industries in a cyclical slump, and the rest of my eight rules.

http://alephblog.com/2009/11/28/the-right-reform-for-the-fed/#comments

“The Fed has been anything but independent.  An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

This seems completely wrong to me.  First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power.  Perhaps they will in the future, but it is a bit early to assert that, I think.

Matt, even in their mandates for full employment and stable prices, the Fed should have no mandate to do bailouts, and sacrifice the credit of the nation for special interests.  No one should have special privileges, whether the seeming effect of purchasing power has diminished or not.  It is monetary and credit inflation, even if it does not result in price inflation.

¨Make the Fed tighten policy when Debt/GDP goes above 200%.  We’re over 350% on that ratio now.  We need to save to bring down debt.¨

David, I fully agree (as with your other points).
However, I do not see it happening.

I´d appreciate your, and other readers´, take on this.

Carol, you are right.  I don’t see a limitation on Debt to GDP happening.

As to nations rolling over each other’s debts for 10 more years, I find that unlikely.  There will be a reason at some point to game the system on the part of those that are worst off on a cash flow basis to default.

The rollover problem for the US Treasury will get pretty severe by the mid-2010s.

http://alephblog.com/2009/11/13/the-forever-fund/#comments

Any chance of you doing portfolio updates going forward? I’d be curious to see if you still like investment grade fixed incomes, given the rally.

Matt, I would be underweighting investment grade and high yield credit at present.

As for railroads, I own Canadian National – unlike US railroads, it goes coast to coast, and slowly they are picking up more business in the US as well.

Long CNI

http://alephblog.com/2009/11/10/my-visit-to-the-us-treasury-part-7-final/#comments

Did none of the bloggers raise the question of the GSEs? I can understand Treasury not wishing to tip their hands as to their future, but I would have expected their status to be a hot topic among the bloggers.

I also don’t buy the idea that the sufferings of the middle class were inevitable. Over the past 15 or so years the financial sector has grown due to the vast amount of money that it has been able to extract. Where would we be if all of those bright hard working people and capital spending had gone to the real economy? I’m not suggesting a command economy, but senior policymakers decided to let leverage and risk run to dangerous levels. Your comment seem to indicate that this was simply the landscape of the world, but it seems more to be the product of a deliberate policy from the Federal government.

Chris, no, nothing on the GSEs.  There was a lot to talk about, and little time.

I believe there have been policy errors made by our government – one the biggest being favoring debt finance over equity finance, but most bad policies of our government stem from a short-sighted culture that elects those that govern us.  That same short-sightedness has helped make us less competitive as a nation versus the rest of the world.  We rob the future to fund the present.

http://alephblog.com/2009/11/07/my-visit-to-the-us-treasury-part-6/#comments

it’s not clear from your writing whether the treasury officials talked to you about the GSEs or whether your comments (in the paragraph beginning with “When I look at the bailouts,”) are your own. could you clarify?

q, That is my view of how the Treasury seems to be using the GSEs, based on what they are doing, not what they have said.

http://alephblog.com/2009/10/31/book-review-nerds-on-wall-street/

“There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.”
David, take a look at equilcurrency.com.

Jesse, I looked at it, it seems rather fanciful.

http://alephblog.com/2009/10/27/book-review-the-predictioneers-game/#comments

David,
Just wondering if there’s an omission in this line:

“The last will pay for the book on its own. I have used the technique twice before, and it works. That said, that I have used it twice before means it is not unique to the author.”

Did you mean to write “that I have used it doesn’t mean it is not unique….”

In the event it is, I’ll look it up in the book, which I intend to buy anyway.
Otherwise, may I request a post that details, a la your used car post,your approach to buying new cars?

Saloner, no omission.  I said what I meant.  I’ll try to put together a post on new car purchases.

http://alephblog.com/2009/10/22/book-review-the-bogleheads-guide-to-retirement-planning/

thanks for the book review. it sounds like something that i could use to get the conversation started with my wife as she is generally smart but has little tolerance for this sort of thing.

> unhedged foreign bonds are a core part of asset allocation

i agree in principle — it would be really helpful though to have a roadmap for this. how can i know what is what?

I second that request for help in accessing unhedged foreign bonds – Maybe a post topic?

JK, q, I’ll try to get a post out on this.

http://alephblog.com/2009/10/20/toward-a-new-theory-of-the-cost-of-equity-capital-part-2/#comments

to the point above, basically just an IRR right?

JRH, I don’t think it is the IRR.  The IRR is a measure of the return off of the assets, not a rate for the discount of the asset cash flows.

When I was an undergraduate (after already having been in business for a long time), I realized that M-M was erroneous, because of all the things they CP’d (ceteris paribus) away. For my own consumption, I went a long way to demonstrating that quantitatively, but children, work and family intervened, and who was I to argue with Nobel winners.

But time, experience and events convince me that I was right then and you are right now. As you’ve noted the market does not price risk well. In large part this is due to a fundamental misunderstanding of value. The professional appraisal community has a far better handle on this, exemplified by drawing the formal distinction between “fair market value as a going concern”, “investment value”, “fair market value in a orderly liquidation”, “fair market value in a forced liquidation” and so on. One corollary to the foregoing is one of those lessons that stick from sit-down education, that “Book Value” is not a standard of value but rather a mathematical identity.

Without going into a long involved academic tome, the cost of capital (and from which results the mathematical determination of value per the income approach) has a shape more approaching that of a an asymmetric parabola (if one graphs return on the y axis and equity debt weight on the x.).

If I was coming up with a new theorem, risk would be an independent variable. So for example:

WAAC = wgt avg cost of equity + wgt avg cost of debt + risk premium

You’ll note the difference that in standard WAAC formulation risk is a component of the both the equity and debt variable – and practically impossible to consistently and logically quantify. Yes, one can look to Ibbottson for historical risk premia, or leave one to the individual decision making of lenders, butt it complicates and obscures the analysis.

In the formulation above, cost of equity and cost of debt are very straightforward and can be drawn from readily available market metrics. But what does risk look like? Again if you plot risk as a % cost of capital on the y axis and on the x axis the increasing debt weight, on a absolute basis risk is lowest @ 100% equity. From there is upwards slopes. However, risk however is not linear, but rather follows a power law.

The reason risk follows a power law is that while equity is prepared to lose 100%, debt is not. Also, debt weight increases IRR to equity (in the real world) contrary to MM. Again, debt is never priced well, because issuers don’t understand orderly and forced liquidation, whereby in “orderly”, e.g. say Chapter 11,recoveries may be 80 cents on the dollar, and forced, e.g., Chapter 7, 10 cents on the dollar. One really doesn’t begin to understand the foregoing until you’ve been through it more than a few times.

So in the real world, as debt increases, equity is far more easily “playing with house money.” A recent poster child for this phenomena is the Simmons Mattress story. In the most recent go round equity was pulling cash out (playing with house money) and the bankers were either (depending on one’s POV) incredibly stupid for letting equity do so, or incredibly smart, because they got their fees and left someone else holding the bag. I’m seen some commentators say that ‘Oh it was OK because rates were so low, the debt service (the I component only) was manageable.’ Poppycock; sometime it’s the dollar value and sometimes it’s the percentage weight and sometimes it is both.

But you’ve already said that: “company specific risk is significant and varies a great deal.” I would also add that – or amplify – that in any appraisal assignment the first thing that must be set is the appraisal date. Everything drives off that and what is ‘known or knowable’ at the time.

Gaffer, thanks for your comments.  I appreciate the time and efforts you put into them.  This is an area where finance theory needs to change.

http://alephblog.com/2009/10/10/pension-apprehension/

I have a DB plan with Safeway Stores-UFCW, which I’ve been collecting for a few years. I’m cooked?

Craig, not necessarily.  Ask for the form 5500, and see how underfunded the firm is.  Safeway is a solid firm, in my opinion.

Long SWY

http://alephblog.com/2009/09/29/recent-portfolio-actions/#comments

David, I am curious about your rebalancing threshold. Do you calculate this 20% threshold using a formula like this:

= Target Size / Current Size – 1

I have a small portfolio of twenty securities. A full position size in the portfolio is 8% (position size would be 1 for an 8% holding). The position size targets are based generally on .25 increments (so a position target of .25 is 2% of the portfolio and there are 12.5 slots “available”). I used that formula above for a while, but I found that it was biased towards smaller positions.

Instead I began using this formula:

= (Target – Current Size) / .25

So a .50 sized holding and a full sized holding may have both been 2% below the target (using the first formula), but using the second formula, they would be 8% and 16% below the target respectively. I found this showed me the true deviation from the portfolio target size and put my holdings on an equal footing for rebalancing.

I was curious how you calculated your threshold, or if it was less of an issue because you tended to have full sized positions. For me, I tend to start small and build positions over time. There are certain positions I hold that I know will stay in the .25-.50 range because they either carry more risk, they are funds/ETFs, or they are paired with a similar holding that together give me the weight I want in a particular sector.

Brian, you have my calculations right.  I originally backed into the figure because concentrated funds run with between 16-40 names.  Since I concentrate in industries, I have to run with more names for diversification.  I don’t scale, typically, though occasionally I have double weights, and rarely, triple weights.  The 20% band was borrowed from three asset managers that I admire.  After some thought, I did some work calculating the threshold in my Kelly criterion piece.

A fuller explanation of the rebalancing process is here in my smarter seller pieces.

http://alephblog.com/2009/09/04/tickers-for-the-latest-portfolio-reshaping/

Have you seen DEG instead of SWY?
Extremely able operator. Some currency diversification as well. I’d like to know your thougts.

MLS, I don’t have a strong idea about DEG – I know that back earlier in the decade, they had their share of execution issues.  It does look cheaper than SWY, though.

Long SWY

http://alephblog.com/2009/06/11/problems-with-constant-compound-interest-2/

I like your post and want to comment on a couple of items.  You point to the peak of the 1980’s inflation rates and the associated interest rates.

The reason that the yield spread exploded is well known.  Here is a snippet from Irving Fisher.  http://capitalvandalism.blogspot.com/2009/01/deflationary-spirals.html

CapVandal – Great comment.  A lot to learn from here.  I hope you come back to blogging; you have some good things to say.  Fear and greed drive correlated human behavior.

Tonight’s book reviews are of two very different, yet very similar books: Fire Your Stock Analyst!: Analyzing Stocks On Your Own (2nd Edition) and, Far from Random: Using Investor Behavior and Trend Analysis to Forecast Market Movement.

Why different?  Well, the first relies on fundamental analysis, and the second on technical analysis.  Why similar?  They are both very single-minded in the way they present how to win in investing.

There are other differences, though.  Fire Your Stock Analyst, by Harry Domash, is a very complete fundamental investing guide for both value and growth investors.  Very complete, to the degree that most average investors will not be able to do all that Harry recommends.  There is a lot to do, and not all of it is of highest importance in my opinion.  Many professional investment shops ignore steps that he prescribes.  I don’t do half of what he prescribes, and I do better than most.  Also, much of what he prescribes is not applicable to financial stocks, but he does not seem to realize that.

Far from Random has a different flaw.  It spends 75% of the book talking about what does not work, and only 25% on what he thinks works.  In the last quarter of the book, the author asserts that trend channel analysis works  through giving stylized examples.  There are no academic studies to prove the point, or, audited track records, as Michael Covel is fond of.  (This makes me want to recommend Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets; there is more logic behind it than Far from Random.)

Who could benefit from these books:

With Fire your Stock Analyst, someone who wants an introduction to fundamental analysis could benefit.  Far from Random, I’m not sure anyone could benefit.  There are much better books on technical analysis.

Full disclosure:  Publishers send me books for free.  I review some of them, the ones that I think are most interesting.  If you enter Amazon through my site and buy anything, I get a small commission.  Don’t buy anything you don’t want.  I do this as a service to readers, and am not looking for remuneration as much as tips for what I have written more generally.

Before I begin, I want to thank longtime readers, and ask them to give me some feedback.  I have a category entitled Best Articles; what would you nominate to be in there.  Also, what would you take out?  I’ve tagged a few articles from the early days, but since then, have not done much with it.  If you have ideas, please let me know.  Thanks again.

-==–=-==–==-=-=-=-=-=-=-=-=-=-=-=–==-=-==-=-=-=-=-=-=-=-=-=-

As bond investors go, I tend to focus on what can go wrong more than most, so when I looked at the cover of Barron’s today, I said, “Oh, no.  Pushing yield now?”

It’s no secret that most safe investment grade debt does not yield much now.  Many investors, hungry for yield, must look for other ways to earn income, even if it means greater hazard of capital loss.  That is another impact of the federal reserve flooding the debt markets with liquidity — the safe investments yield little, forcing those that want yield to take significant risks, whether those risks are lending long, high credit risk, operational risk (common stock and MLP dividends), or subordinated credit risk (preferred stocks).

The history of chasing yield is not promising.  In general, average retail investors reach for yield at the wrong time, and Wall Street is more than happy to facilitate that through structured notes and other high yielding investments where the risk is greater than the excess yield.

But wait — I can endorse some of the article.  I like utilities here.  I don’t own Verizon or AT&T, but I could imagine owning them.  MLPs in energy distribution?  Probably safe; consider their competitive positions and consider where things might go wrong.  I’m not jumping to buy them, though.

Where I can’t sign on is with preferred stocks and convertibles.  All of the preferred stocks that the article cites are financials with marginal investment grade ratings.  The convertibles are from a grab bag of low junk-rated securities.

How quickly we forget the ugliness of 2008.  If we have a second dip in the financial economy for whatever reason, the preferred and convertible securities will do the worst.  In order to get significant yields one must take credit risks in excess of average loss costs — it is safe to say at times like this, the purchase of risky securities is not rewarded.  Be wary with all purchases of risky debt at present.