If the gyrations of the equity market today were not enough, we are in a historically unusual situation where 3 of the last five business days have had moves on the S&P 500 of over 4% in absolute terms.? Since 1928, how many times has that happened?? 69 times.? Dig this:
So, on average, you make money investing during volatile times, but the possibility of moderate-to-severe loss is significant.? Those losses came in the Great Depression era (as did the huge gains), but for those that have read me a long time, you know that I believe that a second Great Depression is not impossible.? I don’t care how much policymakers say that they have learned, the system has an odd way of mutating to create the same result through a new process.? The market always has a new way to make a fool out of you.
Aside from the crash in 1987, only the depression era has had similar volatility, and they had it for a long time.? Even 1973-74 did not rate under that measure (though it resembled the Chinese water torture).
Take this with a grain of salt.? A salt shaker even.? Eddy Elfenbein and Bespoke often do analyses like these, and they have a certain wisdom most of the time.? But data-mining is always dangerous.? The question that must be asked is whether there is a mechanism to explain the results.? In this case, there is.? Volatile markets scare investors away, and drive prices down, in general.? This causes stock to move from weaker to stronger hands, i.e., from the weakly capitalized to the strongly capitalized (now I get to send my electricity check to Mr. Buffett).
So, ask yourself this: are we heading into a depression?? If not, buy some stock.? Personally, I’m not certain about whether we aren’t heading into a depression.? I view it as a 25% chance now.? Perhaps my next article will help explain.? As for me, I am continuing my normal policy of having 70% of my net worth in risk assets.
My friend Cody put out a piece today on not investing in the company that you work for.? 95% of the time, that is correct.? Since this blog is about reduction of risk, I advise all readers not to increase their risk by risking their retirement funds on the the company from which they derive their wages.? That said, here is the other 5%, from a RealMoney CC:
Roger is dead right when he says to diversify. My broad market strategy has 35 stocks in it. Biggest position is Allstate (boring, huh?) at 5%. Most of the rest are around 2.5%, with about 15% cash.
There have only been two times that my wife has suggested that I do something with respect to our investments. Both were when I let a position grow too big. The first was the St. Paul, when I worked there. The other is my only private equity holding: a company which makes the best commercial lawn mowers in the world (my opinion). She was right both times, in my opinion.
The secret to investing is risk control. Don’t make a move that could knock you out of the game, and over the long run, you can make decent money as you compound your gains.
If I compare my investing to baseball, I would say that I try to hit singles. Playing home run ball leads to too many strikeouts, and the strikeouts hurt more than the home runs help. Not only do you lose money, you lose confidence to stay in the game.
So, play the game with a margin of safety. Diversify broadly, and maybe, just maybe, buy some bonds too, to even out the ride. (I have an article coming on my bond holdings in the next month…)
Position: long ALL
There are exceptions, though, and I will point three of them out.? 1) Executives often have to buy company stock; but they are beiong paid to take risk for the good of the shareholders.? 2)? Occasionally, when your company is out of favor, and you know it has a strong balance sheet, it may be time to buy.? That’s what I did with the St. Paul back in 2000, and it paid off well.? 3) If you understand your business better than anyone else (very rare), and you are in a fast growing industry, the stock of your company can be a good deal if the general market has not discovered it yet, and bid the stock price to high P/E ratios.
Aside from that, do not invest in the stock of your company.? Why put your retirement at risk?
This article was posted at The Big Picture this morning as I was guest-blogging for Barry.? That’s a first for me, and there is no better site to do it at.? I present the article here for those that did not see it at The Big Picture.
This piece completes the series for now, and asks whether we are at the bottom for RRE prices. If not, when, and how much more pain?
Before I start this piece, I have to deal with the issue of why RRE market tops and bottoms are different.? The signals for a bottom are not automatically the inverse of those for a top. Tops and bottoms for RRE are different primarily because of debt investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? There is a sense of invincibility for the RRE market, and the financing markets reflect that. Bottoms are more jagged, with debt financing expensive to non-existent.
As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? The same is true of RRE and that is what differentiates tops from bottoms.? At tops, no one cares about the level of debt or financing terms.? The rare insolvencies that happen then are often due to fraud.? But at bottoms, the only thing that investors care about is the level of debt or financing terms.
Why Do RRE Defaults Happen?
It costs money to sell a home ? around 5-10% of the sales price. In a RRE bear market, those costs fall entirely on the seller. That?s why economic incentives for the owners of RRE decline once their equity on a mark-to-market basis declines below that threshold. They no longer have equity so much as an option on the equity of the home, should they continue to pay on their mortgage and prices rise.
As RRE prices have fallen, a larger percentage of the housing stock has fallen below the 10% equity threshold. Near the peak in October 2005, maybe 5% of all houses were below the threshold. Recently, I estimated that that figure was closer to 12%. It may go as high as 20% by the time we reach bottom.
Defaults occur in RRE when there would be negative equity in a sale, and a negative life event occurs:
Unemployment
Death
Disability
Disaster
Divorce
Large mortgage payment rise from a reset or a recast
The negative life events, which, aside from changes in mortgage payments, can?t be expected, cause the borrower to give up and default. During a RRE bear market, most people in a negative equity on sale position don?t have a lot of extra assets to fall back on, so anything that interrupts the normal flow of income raises the odds of default. So long as there are a large number of homes in a negative equity on sale position, a certain percentage will keep sliding into foreclosure when negative life events hit. For any individual, it is random, but for the US as a whole, a predictable flow of foreclosures occur.
Examining Economic Actors as We near the Bottom
Starting at the bottom of the housing ?food chain,? I?m going to consider how various parties act as we get near the RRE price bottom. At the bottom, typically Federal Reserve policy is loose, and the yield curve is very steep. Financial companies, if they are in good shape, can profit from lending against their inexpensive deposit bases.
This presumes that the remaining banks are in good shape, with adequate capacity to lend. That?s not true at present. Regulation has moved into triage mode, where the regulators divide the institutions into healthy, questionable, and dead. The bottom typically is not reached until the number of questionable institutions starts to shrink. Right now that figure is growing for banks, thrifts, and credit unions.
The Fed?s monetary policy can only stimulate the healthy institutions. Over time, many of the questionable will slow growth, and build up enough free assets to write off bad debts. Those free assets will come through capital raises and modest profitability. Others will fail, and their assets will be taken over by stronger institutions, and losses realized by the FDIC, etc. The FDIC, and other insurance funds, will have their own balancing act, as they will need to raise premiums, but not so much that it harms borderline institutions.
Another tricky issue is the Treasury-Eurodollar [TED] Spread. Near the bottom, there should be significant uncertainty about the banking system, and the willingness of banks to lend to each other. Spreads on corporate and trust preferreds should be relatively high as well. Past the bottom, all of these spreads should be rallying for surviving institutions.
Financing for purchasing a house in a RRE bear market is expensive to nonexistent, but the underwriting is strong. At the bottom, volumes increase as enough buyers have built up sufficient earning power and savings to put a decent amount down, and be able to comfortably finance the balance at the new reduced housing prices, even with relatively high mortgage rates relative to where the government borrows.
Many other players in RRE financing will find themselves stretched, and some will be broken. Consider these players:
1) Home equity lenders will be greatly reduced, and won?t return in size until well after the bottom is passed.
2) Many unregulated and liberally regulated lenders are out of business. The virtue of a strong balance sheet and a deposit franchise speaks for itself.
3) Buyers of subordinated RMBS have been destroyed; same for many leveraged players in ?high quality? paper. Don?t even mention subprime; that game is over, and may even be turning up now as vultures pick through the rubble. This has implications for MBIA, Ambac, and other financial guarantors, since they guaranteed similar business. How big will their losses be?
4) Mortgage insurers are impaired. In earlier RRE bear markets, that meant earnings went negative for a while. In this case, one has failed, and some more might fail as well.
5) Do the GSEs continue to exist in their present form? That question never came up in prior bear markets, but it will have to be answered before the bottom comes. Will the FHLB take losses from their mortgage holdings? Will it be severe enough that it affects their creditworthiness? I doubt it, but anything is possible in this down cycle, and the FHLBs have absorbed a lot of RRE mortgage financing.
7) The losses have to go somewhere, which brings up one more player, the US Government. Through the institutions the US sponsors, and through whatever m?lange of programs the US uses to directly bail out financially broken individuals and institutions, a lot of the pain will get directed back to taxpayers, and, those who lend to the US government in its own currency. It is possible that foreign lenders to the US may rebel at some point, but if the OPEC nations in the Middle East or China haven?t blinked by now, I?m not sure what level of current account deficit would make them change their policy.
That said, the recent housing bill wasn?t that amazing. Look for the US Government to try again after the election.
A Few More Economic Actors to Consider
Now let?s consider the likely actions of parties that are closer to the building and buying of houses.
1) Toward the bottom, or shortly after that, we should see an increase in speculative buying from investors. These will be smarter speculators than the ones buying in 2005; they will not only not rely on capital gains in order to survive, but they require a risk premium. Renting the property will have to generate a very attractive return in order to get to buy the properties.
2) Renters will be doing the same math and will begin buying in volume when they can finance it prudently, and save money over renting.
3) At the bottom, only the best realtors are left. It?s no longer a seemingly ?easy money? profession.
4) At the bottom, only the best builders survive, and typically they trade for 50-125% of their written-down book value. Leverage declines significantly. Land gets written down. JVs get rationalized. Fewer homes get built, so that inventories of unsold homes finally decline.
As for current homeowners, the mortgage resets and recasts have to be past the peak at the bottom, with the end in sight. (In my piece on real estate market tops, I suggested that after the bubble popped ?Short rates would have to rally significantly to bail these borrowers out. We would need the fed funds target at around 2%.? Well, we are there, but I didn?t expect the TED spread to be so high.)
5) Defaults begin burning out, because the number of the number of properties in a negative equity on sale position begins to decline.
6) Places that had the biggest booms have the biggest busts, even if open property is scarce. Remember, a piece of land is not priceless, but is only worth the subjective present value of future services that can be derived from the land to the marginal buyer. When the marginal buyers are nonexistent, and lenders are skittish, prices can fall a long way, even in supply-constrained markets.
For a parallel, consider pricing in the art market. Many pieces of art are priceless, but the market as a whole tends to follow the liquidity of the rich marginal art buyer. When liquidity is scarce, prices tend to fall, though it is often masked by a lack of trading in an illiquid market.
When financing expands dramatically in any sector, there is a tendency for the assets being financed to appreciate in value in the short run. This was true of the Nasdaq in the late ’90s, commercial real estate in the mid-to-late 1980s, lesser-developed-country lending in the late ’70s, etc. Financing injects liquidity, and liquidity creates confidence in the short run, which can become self-reinforcing, until the cash flows can?t support the assets in question, and then the markets become self-reinforcing on the downside, as buying power collapses.
The Bottom Is Coming, But I Wouldn?t Get Too Happy Yet
There are reasons to think that we are at or near the bottom now:
The future of the GSEs, mortgage insurers, and financial guarantors are still up in the air.
The US Government will try some more policy ideas after the election.
We aren?t seeing a lot of speculative buying yet.
The biggest booms have had the biggest busts, but affordability is yet to be restored in what were the hottest markets.
My best guess is that we are two years away from a bottom in RRE prices, and that prices will have to fall around 10-20% from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse,Fitch is projecting a 25% decline.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and keep me in the game today. Avoiding the banks, homebuilders, and many related companies has helped my performance over the last three years. I hope that I ? and you ? can do well once the bottom nears. There will be bargains to be had in housing-related and financial stocks.
Full disclosure: no positions in companies mentioned
Buffett said something to the effect of: “I would rather be approximately right than precisely wrong.”? Everyone should agree with that maxim, but in the business world, many processes don’t work that way.
Take auditing as an example.? I’ve only experienced it as an actuary working in financial reporting, and it amazed me to see the detail work that they went through of checking cash flows (which should be done — how else do we detect fraud?), but with little to no attention on reserving assumptions.? Spending time on the “bigger picture” questions is important, and shouldn’t be neglected.
Or, consider earnings spreadsheets that analysts do.? They can be valuable, but I find it more valuable to look at the broader industry picture to see if an industry as a whole has a favorable economic picture, or, might be close to a turning point.
Then again, I think more like a portfolio manager, and less like an analyst.? That makes me better for some tasks, and not others.? My boss at Provident Mutual taught me the you need to identify the main 2-3 drivers of future profitability, and focus on them, because they will drive 80-90% of the results.? (I call this Cioffi’s Rule.)? If you get the main factors right, you will make more money than most investors.
Sometimes, I get labeled a lightweight because I don’t dig deep on certain issues.? I’m just trying to stay focused on the important issues.? Now, on financial stocks today, I own a bunch of insurers that put me over market weight for financials, but I own no credit-sensitive companies.? Even high-quality names are under stress.? (Consider the rate American Express had to pay to borrow money recently.? And I thought MetLife had it bad.? Ah, to be a corporate bond manager again… there are bargains to be had if one has an adequate balance sheet.)
What we don’t know is a significant factor.? I need to see some significant failures before the financial sector will be interesting.? I’m not investing to be courageous.? I’m here to make money over the cycle on a risk-adjusted basis.? It’s not that I avoid risk, it’s that I avoid taking it when I don’t see that I am paid to take it.
Also, even though my portfolio is concentrated, with 35 almost-equally-weighted companies, I avoid going “socks-and-underwear” (as my Dad would say playing Sheepshead) on any single company.? Even on industries, I try to be measured in my overweight positions.? But the objective is to take risk when you are being paid to do it, and avoid it otherwise.? Focusing is a popular strategy, and those who do well at it do very well.? Those who fail at it fail big.? On average, the strategy of focusing doesn’t of itself add value.
My eight rules help me be approximately right.? That doesn’t mean that I don’t make mistakes.? I make mistakes, and sometimes they are big.? But, my mistakes haven’t been frequent and big.
Consider this as you invest.? Focus on the big factors that affect profitability, and look for positive industry trends that are underdiscounted, and negative industry trends that are overdiscounted.? And, in the process, only buy companies that you know will survive.? More money is lost buying marginal companies than is gained.? Remember the margin of safety concept.? Your first job is not to lose money, so choose wisely.
Pensions are complicated.? Necessarily so, because of the wide numbers of parties involved, and the contingencies involved (mortality, morbidity, asset returns, insolvency) over a long period of time.? Anyone who has had a cursory look at the math (or regulations) behind setting pension liabilities, contributions, etc., knows how tough the issues are, and why real experts need to handle them.
I’ve worked at the edge of the pension business for much of my career.? I have designed defined contribution plans, created stable value products, done asset allocation for defined benefit [DB] plans, terminal funding, and other incidentals.? That said, I am a life actuary [FSA], not a pension actuary [EA].
Tonight’s main issue revolves around a good article by the estimable Matthew Goldstein of Business Week.? Steve Waldman, filling in at Naked Capitalism, commented on the article as well.
Here’s my take: it is legal today for companies to shift their pension liabilities to life insurance companies in the Terminal Funding business.? All they have to do is send a description of the liabilities of the plan to the dozen or so companies that are in the business with adequate claims paying ability ratings, and the companies will send back an estimate of what they would require as a single premium payment to take on the liabilities.? Low bidder wins (and loses — he mis-bid).
So, why don’t plan sponsors take the life insurers up on this?? Easy.? The cost of buying the annuities from the insurers is more expensive than the amount of assets in the trust.? For those companies that are overfunded, they don’t care to terminate — it is a great benefit for their employees.
Terminal funding was most common in the late 80s, when companies could terminate DB plans, and any excess assets would revert to the company.? Then the law changed, and most excess assets would be taken by the Federal Government.? Another reason why overfunded plans do not terminate — the excess assets are valuable to the plan sponsor, but are trapped assets.? They are valuable because they give flexibility, and reduce future contributions.
Why is it more expensive to buy annuities from insurance companies than the assets on hand in the trust?
The main reason is that the plan sponsor gets to assume the rates he will earn on plan assets (within reason).? That rate will almost always be higher than the rate that an insurance company can invest at after expenses.? Pension funding rules are significantly more liberal than life insurance reserving and risk-based capital rules.
Insurers must mainly invest in bonds, whereas pension funds can invest in any asset class, subject to the prudent man rule.
Insurers must keep surplus assets to keep the company sound through downturns.? Pension plans have no such requirement.
Insurance companies have profit margins and overhead that pension plans do not.
Often there are funky, hard-to-value benefits in the pension plan.? Subsidized early retirement is the simplest of those.? The insurance companies don’t have a good way of pricing them, so they toss out some guesses.? Often the winner is the one that ignored the cost of the odd ancillary benefits.
Now, for a proposal from the Treasury to be effective, they somehow have to wave their hands at the issues that I just put forth.? Even if they allow other regulated financial companies to take over pension plans, they have the following issues:
Who is responsible for shortfalls?
Does the company taking over the plan have to put in some subordinated capital to give them “skin in the game.”? (Essentially, the life insurers have to do that today.)
How do profit incentives work?? Do they accrue inside the plan as a buffer against shortfalls, or do excess earnings (however defined) get immediately? or over time paid to the buyer of the pension liabilities?? (You can guess what the liability buyers want.)
How do underfunded plans get transferred compared to adequately funded plans?? Hopefully the plan sponsors of the underfunded plans have to pony up to fund them at levels that are adequately funded, then they can transfer them.? It would be a sham to transfer underfunded plans to an entity that says that can fund the plans because they have an ultra-aggressive investment strategy.? The blow-up will leave behind even bigger deficits.
Call me a skeptic here, while I call the head of the PBGC a Pollyanna.? To Bradley Belt: If you think this will solve your underfunding/insolvency problems, think again.? Only through high risk investment strategies succeeding can all of the underfunding be invested away.? Ask this: how would you feel today if the plan sponsors of underfunded plans all adopted highly risky investment strategies?? You would worry.? Well, unless the liability buyers have skin in the game, you will worry just as much after the sale of liabilities.
Sometimes I think politicians/bureaucrats believe in magic.? Some little tweak, a loosening of regulations, and poof!? The problem goes away.? It is rarely that simple, particularly when you are dealing with the math and complexities of long term compound interest, which in my opinion are inexorable.? (Kind of the inverse of compound interest being Einstein’s eighth wonder of the world — it is a wonder when you are compounding assets looking forward, without liabilities to fund, but when your discounted liabilities are greater than your assets, my but that eighth wonder of the world fights you fiercely.)
Now, I’m not going to discuss this at length, because I am getting tired, but the Wall Street Journal had another pension article this week.? A good article, and I must say that I don’t get how the practices described are legal.? The anti-discrimination rules were put into place to deter this issue.? Why they are not enforced here is a mystery to me.? Regulated pension plans should not be able to invest in the debts of non-regulated pension plans.? To allow anything else, is to make a mockery of the regulations.? (Another reason why regulated and non-regulated financials should be separated.)? The Treasury has anti-abuse rules that they can invoke against such practices.? Why don’t they use them?
My guess is that the Bush administration doesn’t care about the issue.? Perhaps the next President will care more.? And, with respect to the sale of pension liabilities, my guess is that that gets left to the next President and Congress, who will not allow the practice as proposed.
PS — One last note: what would be fair, if pension liability buyouts are allowed, is to allow participants the option to roll their net assets into a rollover IRA.? Back in the 80s, many people got burned by less than creditworthy companies who bought their pension liabilities and went belly-up themselves.? It is a normal aspect of contract law that you can’t take a debt and transfer it to another party unilaterally, unless the creditor consents.? So it should be in pension liability transfers.
A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.
Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.
Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.
As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.
I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.
Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.
That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.
Position: none
I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?
The Investor Base Becomes Fundamentally-Driven
1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.
2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.
3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.
4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.
5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.
6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.
7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.
8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.
9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.
10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.
11) Value investors find no lack of promising ideas, only a lack of capital.
12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.
14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
8 ) High quality companies keep buying back stock, not aggresssively, but persistently.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
Over the last few trading days, I did rebalancing buys of Lincoln National, Gehl, Charlotte Russe, Group 1 Automotive and Anadarko Petroleum.? As the market has declined, so has my cash position, from 18% to 8%.
One reader has asked my opinion on stop loss orders, and I must admit, I have never used one.? I use the “economic sell rule,” which tries to look forward at the value of companies, rather than analyzing past price movements.? I sell when companies no longer offer me a good return on my money versus other investments.? I sell a little in rebalancing trades, because there is value in redeploying fundsafter quick moves up.
Do I take some losses from not having an automatic sell rule when prices fall?? Yes, but it is more than made up for from the gains on companies that I would have sold , but didn’t.
Don’t blindly adopt a sell rule, but use your head, and estimate the future value of the company, rather than agonizing over the paper loss.
1) Going back to one of my themes, be wary of companies that sell their best assets to bail out their worst assets.? Tonight’s poster child is GM.? How to get cash?? Borrow against the remainder of GMAC, foreign subsidiaries (most promising part of the corporation), etc.? Not a promising strategy.? As I have said many times before GM common is an eventual zero.? Same for Ford.? All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.
2) So where does GM cut expense?? White collar retiree medical care.? This is rarely guaranteed, except to unions, so it is legal to cancel it.? A word to those whose corporations or state/municipal employers presently have retiree medical care.? It is worth your while to find out whether there are guarantees of coverage or not.? If there aren’t, I can assure you that it will be terminated in the next ten years.? If there are guarantees, then you need to see whether there are standards of care guaranteed, and whether the plan sponsor has the wherewithal to make good on his promises.
One more prediction: many states and municipalities will devise clever ways to escape guarantees over the next 20 years.? That will include Chapter 9 of the bankruptcy code.
3) Note to the SEC, not that the powers-that-be read me: if you’re going to require a contract to borrow shares in order to short for a bunch of financial companies, then require it for every company, now.? Shorts are not the problem.? Failure to properly locate and borrow shares is a problem.? Let there be a level playing field in shorting, and let the investment banks that are lending out more than they have suffer.? (Ironic, huh, ‘cuz they are the ones complaining…)
4) Note to the new management of AIG: please do the following: a) locate lines of business with low ROAs and significant borrowing for funding in order to achieve high ROEs.? b) Close down those lines.? Possible areas include GIC-MTN programs, and life insurance generally.? c) Take a page out of Greenberg’s early playbook, and exit lines, or sell off divisions where it is impossible to achieve superior ROEs.? (I can see American General re-emerging, with SunAmerica in tow!)
First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don’t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.
Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn’t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO’ed it rather than spinning it off to shareholders…
But here’s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)
Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.
Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.
Position: none, and I have never understood the attraction to GE as a stock
6) One to think about: if US Bancorp is having a bad time of it, shouldn’t most large banks be having a worse time of it?? I spent a little time this evening reviewing the prices of junior debt securities of marginally investment grade banks (and a few mutual insurers, also).? The pressure on marginal financial institutions bearing credit risk is huge.
7) Speaking of junior debt securities, Moody’s gave the GSEs, and the US Government a shot across the bow when it downgraded the preferred stock ratings of Fannie and Freddie.? With the fall in the common and preferred stock prices, any possiblity of private capital raising fades.? The Administration and Congress should realize that whatever flexibility/help they grant the GSEs will be taken, and quickly.? Budget for the worst case scenario.
8) Then again, Ackman’s plan to restructure the GSEs, which is similar to mine (given in the last week), is reasonable.? Leverage is reduced and a market panic is avoided.
9) But even if neither plan is implemented, the dividends may be cut for the GSEs common stocks.? Shades of GM.? What is more significant, is if the GSEs feel they can’t issue preferred stock at acceptable yields, maybe they will omit those dividends as well.
10) Now, in the midst of expensive bailout talk, is there a cost imposed on the US?? Yes.? The dollar is weak, and default swaps on US government debt are rising in yield.? (Thought: how do swaps on US government debt pay off?? Hopefully not in dollars…? Also, what qualifies as an event of default?? Inflation doesn’t count, most likely, and yet that is one of the main ways for a government to try to escape debt.
11) Socialism!? Is the bailout socialism? Even for a libertarian like me, I can justify a bailout like Ackman’s, because it hurts those that tried to profit from the public/private oligopoly.? But no, I can’t justify what Paulson is trying to do, and maybe, just maybe, the market is sending him a message that half-measures won’t work.
12) More on preferred stocks.? They have been crushed.? This reinfirces why I rarely recommend preferred stocks, or junior debt securities: the payoff is low in success, and losses are high when things go wrong.
13) Let me get this straight.? You trusted Wall Street on an implicit guarantee?? You didn’t get a formal guarantee in writing?? Oh, my, it happens every decade… implied promises fail, and the cold, hard, printed text governs.? “Yes, that could technically be called, but don’t worry, they never do that.” “AAA insurance obligations never fail.”? “Portfolio insurance will protect you; you don’t have to buy puts.”? Never trust implicit promises of Wall Street, because in a real crisis, they go away.
14) Looking over some of my indicators, it looks like we are close to a bounce.? It feels a lot like January of 2008.? So, is it time to buy??? I’m not sure, but I am adding little by little to my stockholdings.? I’m probably going to up the equity percentage in some of my accounts where I have few options (old job Rabbi Trusts).
15) Not that I am likely to liquidate 401(k) assets, or anything like it.? That some are doing so is a sign of the stress that we are under.? Don’t do it, if you can avoid it.? Better, perhaps, to take in a boarder.? It increases cash flow on an underused asset, and optimally, increases community relations.
One thing that is different about me as a blogger — I not only write about the economy, but I am actively trying to apply my views through investing.? So, sometimes readers will get the micro-level aspects of investing.? This evening I got the unwelcome surprise of additional fees on some of my ADRs — It seems that the SEC has allowed for the passthrough of custody fees to shareholders.
Now, I know that there are implicit fees on sponsored ADRs, and both of the ADRs that I got hit with fees on are sponsored.? My question is this: did the banks sponsoring the ADRs give up their other fees in order to charge explicit fees to the shareholders?? I expect not.? I am considering writing to the companies whose shares I own, in order to get them to consider choosing another bank that will not charge fees to its ADR holders.
It is not just one bank — both BNY Mellon and JP Morgan took fees from me.? Particularly galling were the fees on SABESP, where since the dividend was taken in two parts, they took two equal fees, even though one dividend was tiny and the other big.
I don’t begrudge legitimate fees, but I really dislike fees that surprise me.? Consider this as you invest in ADRs, and contact the Investor Relations areas of those companies to choose banks that will not charge ADR holders.
This post will probably be too brief, but here goes.? The most important aspect of analysis is trying to gauge any sort of sustainable competitive advantage.? Qualitatively, do they really have something special going that other are unlikely to imitate?? Second, do they fit their paradigm?? If they are growth investors, do they use momentum?? If they are value investors, are they willing to be wrong for a while?
Third, how do they handle lesser questions like earnings quality?? Do they look at cash flow, free cash flow or earnings, and how do they justify their answers?? Do they have a decent decisionmaking process, given that managers that trade less tend to do better?
Finally, have they been successful?? Do they win, and do they win for the reasons that their methods would favor? Good track records that emerge for reasons other than managerial intentions are unlikely to be repeated.
Now what don’t I look at?? Sharpe ratios and other quantitative measures of risk.? The measures aren’t predictive of future performance, and the risk adjustment is too short term in nature.? These measures are backward looking, and not indicative of future performance.? Better to spend time sweating over how a manager chooses assets, limits risks, etc., than to focus on quantititive measures of risk that have no relation to long term performance.
.) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.