Category: Personal Finance

Personal Finance, Part 3 — Buy The Life Insurance You Need

Personal Finance, Part 3 — Buy The Life Insurance You Need

Posted on by David Merkel

Sorry that my posts have become more terse and less frequent.? A large part of that was recent computer troubles, which have largely been rectified.? I highly recommend the program and advice on this webpage if your computer is running slow.? Beyond that, I have had internet outages (thank you Verizon), and my efforts at obtaining long-term investors for my strategies have eaten up a lot of time.

Tonight’s post deals with life insurance.? My main advice: buy what you need, not what someone wants to sell you.? What most people need is protection for their loved ones from untimely death, which can be satisfied by term insurance.? Now, some wealthy people with complex estate planning needs can benefit more from other forms of life insurance, but that’s not common.? Also, people who aren’t so healthy can benefit from permanent insurance through an agent, because that may be the only way that they can obtain coverage on a reasonable basis.

Why do I favor term insurance?? It’s cheap.? It’s cheap because it is easy to compare the features of various policies against each other to find the best price.? But what if some company that is lower quality offers the best price?? The state guaranty funds stand behind the insurance companies, and no one has failed to receive a death benefit on a timely basis as a result.? (Note: agents are not allowed to tell you this, because the states don’t want lower quality companies to gain a marketing advantage by mentioning the guaranty funds.)

Term insurance offers another advantage: re-underwriting.? If after ten years, you are still in good shape, and you still need insurance, apply for a new policy at a lower rate over the same remaining term as your old one.? If you can get one, buy it and cancel the old policy.? If your health is not so good, keep paying premiums on the old policy.

Where do you buy the insurance, then?? Google the phrase “term insurance,” and a variety of comparison services will pop up.? Try a few of them, and buy from the cheapest.? The younger you are, the longer the term you should buy for, because the far-out years are cheaper.? The older you are, stick to ten years at most.

A few final points: don’t buy policy riders; they are an expensive way to obtain insurance.? Also, don’t buy convenience insurance policies that offer token amounts of insurance; they are expensive also.? Last, don’t scrimp on the amount of coverage.? Few people are overinsured when it comes to life insurance; 5-10x your salary is pretty standard, but analyze how much your loved ones will need in your absence, and buy that much coverage.

Personal Finance, Part 2 — Risks

Personal Finance, Part 2 — Risks

Posted on by David Merkel

I view personal finance through the prism of risk management. What can go wrong? Here are many of the threats that the average person faces:

  1. Die too soon
  2. Bad health
  3. Disability
  4. Inflation/Deflation
  5. Unemployment
  6. Property & Liability losses
  7. Live too long
  8. Not earn enough on investments


This list is not exhaustive; perhaps you can think of more. Each one reflects an aspect of life that we don’t fully control. ? Some of them can be fully or partially hedged through insurance (1, 2, 3, 6, 7), some can be fully or partially hedged through investment policy (4, 8 ), and some can’t be hedged at all (5).? My next few articles in the series will deal with the hedgeable risks, and what reasonable strategies can be for dealing with each one.

Personal Finance, Part 1

Personal Finance, Part 1

Posted on by David Merkel

This is the first in an irregular series of articles on personal finance issues.? I have only worked in two industries in my life — life insurance and asset management.? I have distinct opinions here, and ones that may prove to be controversial, because they will step on the toes of those who disproportionately benefit from how the system works at present.? All of that said, don’t take my word as gospel on these issues for your own personal situation.? Get personal, tailored advice from someone who knows your intimate financial details.

Tonight’s topic is on work.? Who drives your financial plan?? Either you can drive it, or, you can hire someone to drive it, or, you can let multiple parties take a “piece of the action” and end up with a crazy quilt.? The first option means that you have to work and learn.? The second option means that you have to learn enough to choose a good advisor.? The last option means that there is no organizing principle, but you end up with whoever successfully convinces you to part with money for a part of a financial plan on any given day.

I encourage the first two options.? They are cheaper, integrated, and you get better results.? When friends come to me for advice, my first question is “how much work do you want to do?”? It’s good to learn about financial topics.? Aside from the personal benefits, there are positive spillover effects into the rest of life.? It makes you more productive to those you serve, if you understand the basic economics behind the tasks that you do.

I understand enough about automobiles to be able to know whether my mechanic is likely lying to me.? The same is needed to be an intelligent user of financial professionals.? To not learn the modest amount needed to evaluate financial professionals is to invite financial salesmen to come and sell you on their product of the day, which may not be the best thing for you.

Twenty years ago, I? began spending an hour a day on average improving my knowledge of financial matters.? You don’t need to do that much, but you do need to learn about personal finance issues.? Future articles in this series will give my view of personal finance topics; I hope you can benefit from them.

Eight Notes on Insurance, Economics, and Value Investing

Eight Notes on Insurance, Economics, and Value Investing

Posted on by David Merkel
  1. Doug Kass over at RealMoney made the following comment: “The next shoe to drop will be the failure of a public homebuilder and a private mortgage insurer. The latter concerns me more than the former, as the markets are not aware of the economic implications of my view.”? An interesting comment to be sure.? Unlike other insurers that benefit from state guarantee funds, the mortgage insurers do not so benefit.? That said, in a concentrated sub-industry that has only seven players (MTG, RDN, PMI, TGIC, GNW, ORI, and AIG), one advantage that poses is that failure of one company will not lead to assessments on the rest of the companies, leading to cascading failures.? So who would be affected?? Fannie and Freddie would get a lot of credit risk back, as would any private lender that used the mortgage insurers to reduce risks.? Even some of the mortgage originators with captive mortgage reinsurers would take some degree of a hit (most of the top originators had these).
  2. Some younger friends of mine asked me for advice recently, and the question came up, “Should I invest in the market, or pay down debt?”? Now, we weren’t talking about credit card debt, which they paid off in full every month.? They did have a home equity loan at 8.5% fixed.? My view was this: with 10-year Treasuries yielding 4.4%, and marginal investment grade corporate bonds yielding 6.0% or so, a reasonable return expectation for the equity markets as a whole would be in the 8-9% region.? Add 2-3% to the BBB-bond yield, and that should be a reasonable guess, given that I think the market is somewhere between lightly undervalued and fairly valued.? My advice to them was to pay down the home equity loan, and once it was paid off, invest in an index fund, or a diversified mutual fund.? Until then, better to earn 8.5% with certainty, than 8-9% with uncertainty.
  3. As can be seen from my recent reshaping, yes, I do buy sectors of the market that look ugly.? Shoe retailers and mortgage REITs have not done well of late.? Am I predicting no recession by buying the retailers?? No; so long as the shoe retailers aren’t too trendy, demand for shoes is relatively stable, and these stocks are already discounting a recession.? I chose two that had virtually no debt, so I am on the safer side of the trade, maybe.
  4. Does buying a mortgage REIT mean that I am betting on further FOMC loosening?? No.? The mortgage REITs that I hold embed a pretty nasty set of assumptions for the riskiness of the safest parts of the mortgage bond markets.? While a FOMC loosening would probably help, I’m not counting on that.
  5. My value investing is different than most value investors, because I spend more time on industries, either buying quality companies in beaten-up sectors, or companies with pricing power, where that power is underdiscounted by the market.
  6. If we are trying to estimate the central tendency of inflation and eliminate volatility, it is better to use a trimmed mean, or median, rather than toss out volatile components like food and energy, particularly when those components have led inflation for the last 5-10 years.? The unadjusted CPI is a better predictor of the unadjusted CPI than is the core CPI.
  7. Personally, I think the next ten years will be kinder to “long only” equity managers than hedged managers.? There is only so much room for shorting, which is an artificial overlay on the system.? We aren’t at the limits of shorting yet, but we are getting closer to those limits.? It would not surprise me to see ten years from now to find that balanced fund managers beat hedge fund managers on average (after correcting for survivor bias, which is more severe with hedge funds).? It’s much easier and more effective to do risk management in a long only mode, and I believe that the virtues of long only management, and balanced funds, will become more apparent over the next ten years.
  8. I’m thinking of doing a personal finance post on what insurance to buy.? Is that something that readers would like to read about?
Book Review: Navigating the Financial Blogosphere

Book Review: Navigating the Financial Blogosphere

Posted on by David Merkel

Russell Bailyn is a Wealth manager who wrote a basic book on finances, but gave it a twist to emphasize what resources were available on the web, and at financial blogs specifically. He covers a wide number of areas in a basic way, sometimes giving answers where “one size fits all,” or almost all, and sometimes explaining to readers what the right questions are when answers are situation-dependent.

Some of the areas he covers are:

  • Banking, budgeting and credit.
  • Financial planning and tax-deferred savings/investment
  • Investment types
  • Life insurance and annuities
  • Retirement and portfolio management

The book isn’t long at 220 pages, so as you might imagine, this book is wide, but not deep. I would recommend this book for people who are getting started in managing their finances, and want to take a more active hand there. Alternatively, it could benefit those who want to hire a financial planner, because they would better learn how to choose a planner, and better evaluate the advice that their planner gives them.

Because I am aware of most of the areas in the book, this is a book that I skimmed. That said, as I looked at critical ideas in the book, I found that I largely agreed with his ideas. As a trivia note, Alephblog and I get featured on page 177, in the chapter on portfolio management. If I had to featured in any chapter, I’m glad it was that one, because managing risk through proper portfolio management is near and dear to my heart.

The Advantages of Being a Small Investor Amid Too Much Leverage

The Advantages of Being a Small Investor Amid Too Much Leverage

Posted on by David Merkel

Here’s a question from a reader a few weeks ago.

I consider myself to be a value investor and stick mainly to stocks
where I feel the asset to equity ratio is reasonable along with
consideration of other factors such as PE & share price to book value etc.
As a result, I am not panicking with the recent mkt downturn and expect
to hold most of my positions thru the major downturn when it happens.


Despite my resolve, I can’t help but feel uncomfortable with the recent
comments on subprime and liquidity etc. Again, I am a very inexperienced
amateur investor, but what I seem to be getting from the reports is that
there is so much leveraged investment in the markets these days that
even these mini downturns may force selling of stocks to cover leveraged
positions and could wash over the entire market. Reports of complete
funds being wiped out as a result of the necessity to cover leveraged
positions seem incredible to me. ?I personally feel leveraging should be
left to very skilled, specialized traders and will only consider it when
I have a portfolio of sufficient size that I would be able to use it as
insurance and in turn cover a position if required.

?

Having said all of this, I have several questions, if you would be so
kind as to consider.

?

Is there a way to assess the volume of leveraged positions relative to
the whole market and likelyhood to tip the whole market and the average
% the market will retreat based on the amount of leveraging in the
markets and the historical data on the effects?

?

Are there not rules that govern funds, in order to protect the investors
in the funds from complete liquidation due to leveraging by the managers
and at any rate doesn’t someone review the activities of the fund managers?

?

Is this leveraging in the marketplace so widespread and common now that
small investors like me are tilting at windmills if don’t participate?

?


I realize that these questions may be rather uninformed and somewhat
equivalent to “the meaning of life” scenerio, however I have been
reading your blog quite faithfully and with my limited understanding of
some of the technical jargon, find it very interesting.

Thanks for asking your question, and sorry I didn’t get to it earlier.? There are several things to write about here:

  • How serious are leverage problems in the market?
  • There are certain forms of leverage that are well measured, and some that are not.
  • Some institutions have leverage rules, and some don’t, sort of.
  • Am I at a disadvantage as a small investor, particularly if I stay unlevered?

Let’s go in order.? The leverage problems in the market today are significant, though none are urgent at present.? The furor over ABCP and SIVs and other bits of short-term lending have largely passed.? Good collateral got rolled over, bad collateral got picked up by stronger institutions.? That said, there are other important problems in the market that are not at a crisis point yet:

  • Falling residential real estate prices, and the effect on mortgage default, and the effect on those that hold mortgage securities.
  • Private Equity’s ability to repay debt on new acquisitions.
  • The willingness of the investment banks to takes losses on prior LBO lending commitments.
  • Losses in the CDO market, and who owns the certificates with the most exposure to loss.
  • Losses from high-yield lending to CCC, and single-B rated firms.
  • Are any significant financial institutions overexposed to the above items, such that they might be impaired?

Now, some of the leverage is well measured, and some is not. We really don’t know with derivatives what the total exposure is, and whether the investment banks have been clean with their counterparty management.? (That said, so far it looks like it is working.? There may be a Wall Street rule, that if someone is near the edge, find a way to kick them over the edge, so that you can foreclose with more collateral.)

We also don’t know about lending to or from hedge funds, and hedge fund-of-funds. ?? Non-bank lenders, we know about what they securitize publicly, and that’s most of it, but the rest, we don’t know.? Foreign lenders to the US — the Treasury collects some data on them, but the detail is lacking.

All of these are areas where reporting requirements are limited to non-existent.? Regulated domestic finance — we know a lot about that, and that’s a large part of the system; the open question there, is how much the regulated part of the system has lent to the non-regulated part of the system.? Difficult to tell, but given the slackness of bank exams over the past five years, it could be significant, but I doubt perilous to the system as a whole.

Banks, S&Ls, Mutual funds, Insurance companies, and margin accounts have leverage rules. ? Many non-regulated entities face leverage rules from the ratings agencies, which limit their ability to borrow and securitize.? Still other face limits on leverage from those who lend to them, in the form of debt covenants.? Almost everyone is limited in some way, but in a bull market, those limits often get compromised as a group.? The limits are not as wide as would be optimal for financial system stability.

So, there are some protections for those who lend to hedge funds and hedge fund of funds, but little protection to those who invest in them.? Hey, if you’re a big institution, and invest here, you are your only protector; no one is coming to rescue you in a crisis.

But onto the last question:? Am I at a disadvantage as a small investor, particularly if I stay unlevered??? You have many advantages as a small investor.? One? of the largest advantages is that no one can force you to be hyper-aggressive, except you yourself. If you are reasonable in your return goals, you can safely achieve better than your average levered competitor through a crisis.? An unlevered investor can’t be forced by anyone to take on or liquidate a position.? Levered investors, or those with return requirements from outside parties, do not fully control their own trades.

Second advantage: you can be more picky.? You can avoid trouble areas in entire if you want.? Many institutional investors face diversification or tracking error requirements, which force them to in vest some in areas that they don’t like.? As an example, I was one of the few investors that I knew that didn’t take some losses from the tech bubble popping.

Third advantage: you don’t have to take risk if you don’t want to.? If the market is too frothy, and shorting is not for you, just reduce exposure, and wait for a better entry point.? (Warning: that entry point may not come.)

A disciplined private investor may not have the same level of knowledge as the institutions, but he can have a longer time horizon, and play the out of favor ideas that might threaten job security of those who work inside institutional investors.? With that, I would advise you to take use your advantages, and invest accordingly.? Keep it up with the value investing!

For those with access to RealMoney, I advise reading these longish articles if you want more background on how I think here:

Managing Liability Affects Stocks, Pt. 1
Separating Weak Holders From the Strong
Get to Know the Holders? Hands, Part 1
Get to Know the Holders? Hands, Part 2

Buying Formerly Investment Grade Bonds of LBO Deals

Buying Formerly Investment Grade Bonds of LBO Deals

Posted on by David Merkel

Here was a reader question from yesterday:

I?ve been reading your blog for awhile, and I appreciate all the hard work you put into it. I especially like how you comment on intermarket relationships, and it?s helping to quicken my ever so slowly growing knowledge of the markets.

I read your comments that higher quality bonds should perform better than lower quality, because of a probable rising cost of capital for lower quality companies. In a different environment, or for financially secure companies, is it ever a good idea to make a leveraged buy of higher yielding bonds, where the bond sells at a discount and the coupon is greater than the margin interest rate?

I realize that junk bonds are called such for a reason, and that if reaching for yield was a no-brainer prospect then everyone would be doing this. But I notice that a company like Alltel with a 7/01/2012 maturity has a 7% coupon and 9.156 YTM, and a borderline investment grade rating. While a lot more research would need to go into a bond before buying, would something like this, in theory, be safely bought with any leverage?

Lastly, is debt issued by companies acquired by private-equity firms worth looking at, or is it to be avoided at all costs?

Thank you very much for any help you could provide, and I apologize for the long length of my email,

Yes, in a different environment, a leveraged purchase of lower quality bonds can be a great idea, though I tend to purchase the equity instead. Starting about the time of the Iraq war, we hit a period where low quality bonds outperformed for four years. Since then it has been tough; it goes in cycles. Typically, the time to buy low quality bonds is when everyone is scared to death, the VIX is over 40, and realized defaults are high. This scares everyone away.

Now, with Alltel, this reminds me of an ?Ask Our Pros? question that was asked of me on RealMoney, back when they had that feature. (I think I got asked the most, because of my unconventional skill set, but I don?t know that for sure?) A read asked about Toys ?R Us bonds. Here?s what I wrote back then:

Toys R Us Debt
4/4/05 7:26 AM EDT

Reader: What do you think of buying debt of Toys R Us (TOY:NYSE) now that they are being acquired, I don?t see KKR buying a company and defaulting on its debt. I am specifically looking at the 7 5/8 2011 trading at about 95. ? G.S.

David Merkel: I think you ought to be careful here. Buying the debt of a junk-rated company owned by private investors is not trivial.

Suppose you source the bonds at $95, for a yield to maturity in about 6 1/2 years of 8.66%. The best thing that could happen is that the private buyers turn around and sell Toys R Us to an investment-grade buyer who foolishly decides to guarantee the debt. Less good, but still good, is that the spread compression in the market continues, your bonds get bid up and you sell for a profit. Still less good is that it matures and you make your 8.66%. Now for the bad scenarios.

When the Toys R Us bond in question was issued, it was an investment-grade bond. Toys R Us won?t file financial statements. There are no covenants to protect you. In principle, the private buyers could sell a profitable division like Babies R Us and pay themselves a special dividend with the proceeds. You just lost security as a result. Granted, a case could be made for fraudulent conveyance, but try proving that in the courts against the private buyers? legal team. Also, you could be structurally subordinated by bank debt at Toys R Us. The private buyers could borrow at the bank with Toys R Us as the borrower and pay themselves a special dividend (if the bank lets them). You now have less security.

Or, they could use the money to grow the business. If things go well, they win big, and you get principal and interest. If things go badly, you both could end up with zeroes, but remember, they are private buyers; they probably got some level of dividends out of the deal. Their objective is to skate on a thin equity base to make the highest return on equity that they can. They don?t care about bondholders, unless they are selling bonds.

Their interests and yours are not perfectly aligned. The spread on the bond is weak single-B, which is fair in my opinion for the risks that you would be taking on relative to other securities like it in the market. Those risks are real, and not ones that I typically like to play.

No positions

With Alltel, you are similarly facing a private equity buyout, which will get done if the LBO debt market normalizes (not holding my breath). It is junk-rated by two agencies, and investment grade by two. Unless the deal fails, it is junk grade, with all of the problems listed in my note above for Toys ?R Us.

There is a time in the cycle to buy debts like this, but it is not now. The level of panic is too low. Wait until we see significant defaults in high yield borrowers, and then revisit this question. Spreads have widened on high yield names, but not as much as they will when defaults start coming through.

One final note, when the cycle turns, you don?t want to mess around with AT paper maturing in 2012. You would want the stuff maturing in 2029 or 2032. If you?re going to play it, play it to the hilt, but only once the cycle has turned.

Tickers mentioned: AT

Investing in a Stagflationary Environment

Investing in a Stagflationary Environment

Posted on by David Merkel

I intend to get back to answering more reader questions, and doing it through posts.? I’ve been somewhat derelict in responding to comments, and I want to do it, but time has been short.? Here is a start, because I think the answer would be relevant to a lot of readers.

From a reader in Canada:

I enjoy your writing as many of your comments generate a wider perspective than my own.? There is always something to learn.

I was too young to appreciate the last stagflationary period.? Yet, I need to manage my portfolio.? My approach is more ETF based, whereas, I see that you prefer specific stocks.

I struggle in anticipating the currency impact on my foreign holdings.? I’m a Canadian based investor.? The simple solution is to pull in my exposure and be more Canada centric.? This idea conflicts with my goal to have my portfolio weighted in similar fashion to the global markets (i.e., Canada is a very small percentage relative to the total).? I also do not subscribe to the excessive weighting in gold as a major investment theme.? To me, it’s insurance to help offset risk elsewhere.

I’m not asking for specifics as you are not familiar with my situation.? Do you have any recommended reading or suggestions to help me test my thoughts and to identify options, so that I can arrive at a better decision?

Well, I’m not that old either.? During the last stagflation, I was aged 13 to 22, from junior high through my Master’s Degree in Economics at Johns Hopkins.? That said, I have read a lot on economic history, so I understand the era reasonably.? I also spent many of my Friday evenings as a teenager watching Wall Street Week with my first teacher on investments.? (Hi, Mom! 🙂 )? Another thing I remember is being the student representative to the school board for two years 1977-1979, when our district in Brookfield, Wisconsin decided to do a wide number of capital improvements in order to save energy, at the peak of the “energy crisis.”? I remember that the payback periods were 15 years or so, not counting interest that they would have to pay on the munis that they issued.? No way that project saved money on a net present value basis.? (And it was depressing to see 2/3rds of the windows covered up.)

During the last Stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income.?? It paid to have your fixed income assets as short as possible.? Money market funds, a new invention at the time, were the optimal place to be until about 1982, when the cycle shifted, and the longest zero coupon bonds were the new best place to be.? Timing the shift between cycles is difficult, so don’t try to time it exactly, but add more longer bonds as long rates rise.? Right now, I would stay in money market funds, inflation protected bonds, and foreign currency denominated bonds.? You have enough Canadian exposure, so aside from you money market funds, consider bond investments in the yen, Swiss franc and Euro.

As for equities, pricing power is critical.? Who can raise prices more than the cost of their inputs?? Producers of global commodities like oil, metals, etc., typically do well here.? Financial companies with short duration assets or exposure to hard assets should do better here.? Staples should do better versus durables.? Growth investing should beat value investing (uh, oh, what do I do?? All of my processes are geared toward value investing).?? Cyclical names may beat them both.

If inflation really takes off, hard assets will offer some shelter though housing will lag until the inflation of real estate exceeds the deterioration of the debt.? I occasionally like gold, but it’s not a panacea.? I’d rather own the economically necessary commodities.

But what if stagflation does not become a reality?? That’s why we diversify.? I don’t tie my whole portfolio to one macroeconomic view.? Instead, I merely tilt it that way, leaving enough exposure elsewhere to compensateif my economic forecast is wrong.? I am a value investor, and almost always have a a few companies that will do well even if my economic forecast fails.

In summary: keep your domestic bonds short.? Diversify into foreign currency bonds.? Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation.

Eight Notes on a Distinctive Day

Eight Notes on a Distinctive Day

Posted on by David Merkel
  1. My broad market portfolio trailed the market a little today. I’ve been a little out of favor over the past three months; I’m not worried, because this happens every now and then. That said, we are coming up on another portfolio rebalancing, where I will swap out 2-3 stocks, and swap in 2-3 others. Watch for that in the next few weeks.
  2. Every group in the S&P 1500 was up today. I can’t remember when I have seen breadth like that before. Financials and Energy led the pace. Names like Deerfield Triarc flew on the Fed cut. They will benefit from cheaper repo rates, and the excess liquidity injected the system should eventually ease repo collateral terms.
  3. If the US dollar LIBOR fix at 6AM (Eastern) tomorrow follows the move in the US futures markets today, then we should see LIBOR drop by 27 basis points or so. Given the smaller move down in T-bill yields, 14 basis points, that would leave the TED spread at 132 basis points, which is still quite high, and higher than the 10-year swap spread. (LIBOR would still be higher than the 10 year swap yield.) This indicates that there is still a lack of confidence among banks to lend to each other on an unsecured basis. Things are better than they were two weeks ago, but still not good.
  4. The short term crunch from the rollover of CP, especially ABCP is largely over. The good programs have refinanced, the bad programs have found new ways to finance their assets, or have sold them, or used backup guarantors, etc.
  5. Watch the slope of the yield curve. It is my contention that the slope of the yield curve changes relatively consistently through loosening and tightening cycles. In the last tightening cycle, the curve flattened dramatically through the cycle, making the word “conundrum” popular. This is only one day, but the yield curve slope, measured by the difference in yields between 10-year and 2-year Treasuries, widened 10 basis points today. (The curve pivoted around the 7-year today.) If I were managing bonds at present, I would be giving up yield at present by selling my speculative long bond positions that served me well over the past few months in my model portfolio. I would be upping my yen and Swiss Franc positions.
  6. We learned some new things about the FOMC today: a) They don’t talk their book publicly, so don’t take their public comments too seriously. b) They are willing to risk more inflation for the sake of the non-bank financial system (which is under threat), or economic growth (which may not be under threat). c) They are flagging the Fed funds rate changes any more by letting rates drift nearer the new target in the days before the meeting. d) Beyond that, we really can’t say yet whether this is a “one and done” or not yet. We just don’t have enough data. e) The FOMC really isn’t interested in transparency.
  7. It would be historically unusual for this to be a “one and done.” Fed loosenings are like potato chips. It’s hard to stop at one. Just as there is a delay in the body saying, “that’s enough,” with the potato chips, the in the economy in reacting to monetary policy is slow as well, often leading policy to overshoot, as the FOMC reacts to political complaints to do more because things aren’t immediately getting better. It’s hard to sit in front of the short-term oriented Congress, or listen to the manic media, and say, “But the FOMC has done enough for the economy. It doesn’t look good now, but in 18 months, our policy will take effect and things will be better. Just trust us and wait.” That will not fly rhetorically; it will take a strong-headed man to not overshoot policy. On that Bernanke is an unknown.
  8. To me, it’s a fair assumption then that this cut will not be the last. Investment implications: in fixed income stay in the short to intermediate range, and remain high quality. Buy some TIPS, and have some foreign bonds as well. I like the Yen, Canadian Dollar, and the Swiss Franc. In equities, think of high quality sectors that can use cheap short-term credit, and sectors that benefit from inflation and a weaker dollar. So, what do I like? High quality insurers, mortgage REITs that have survived, (maybe trust banks?), basic materials, energy, goods transportation, staples, some areas in healthcare and (yes) information technology (if I can find any more cheap names there that I like).

Full disclosure: long DFR

Fifteen Notes on the State of the Markets

Fifteen Notes on the State of the Markets

Posted on by David Merkel

1)? Start with the pessimists:


2)? Move to the optimists:

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

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

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

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

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

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

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

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

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

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

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

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

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

With that, I bid you good night.

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