Jake at Econompic Data had a good post on credit and equity.  (He runs a good site generally.)  They are correlated, but not all of the time.  As I commented:

When yields are low, equities thrive because financing costs are low.

When the defaults come, future equity returns are low, because financing rates rise, killing some and wounding others.

When yield spreads are very high, future equity returns are high, because returns come as spreads tighten.

You can see more on pages 14-22 of this presentation that I gave:

http://alephblog.com/wp-content/uploads/2009/11/SEAC_Presentation.pdf

Though I promised some posts after my presentation to the Southeastern Actuaries Conference, I never followed up.  Here is part of my belated follow-up.

As I noted in my presentation:

• Credit and equity returns are closely correlated in bear markets.
• Illiquidity events become more common when equity prices are falling, and credit spreads rising.
• Complexity and structure raise illiquidity during crises.
• Bonds with negative credit optionality underperform in a crisis.

I would add that credit and equity returns are closely correlated coming out of a crisis as well.  But here are some examples, starting with 2007-2009

and then 1999-2004:

and then 1989-1993:

and then 1980-1983:

and then 1969-1975:

Finally, 1927-1944:

What I concluded:

• Credit booms are different – equities rise, while credit spreads stay low and stable.
• There are sometimes exceptions when selloffs are sharp, like 1987 or 1998.
• Ignore what the government says. It is impossible to eliminate the boom-bust cycle. The best a good businessman can do is try to understand where he is in the cycle, and be prepared.
• Building liquidity looks dumb after credit spreads have been tight for a few years, but can save a lot of performance. The same is true of an “up in credit trade.”
• During the bust phase, illiquid companies and investments get whacked. It is often good to “leg into” such investments during the panic. This is when credit analysis really pays off, because during the panic, everything gets hit.
• Equity risk shows up in insurance lines of business like Surety, D&O, E&O, Mortgage, Financial, etc.
• If you have equity risk in your liabilities, reduce credit risk in your assets. Same is true if you need to regularly buy equity options. When implied option volatility rises, credit spreads tend to rise as well.

Notes:

There are few corporate yield series that date prior to 1990.  Until computers became powerful enough, bonds traded on a dollar price basis, and yields, much less spreads, were not comprehensively recorded.  One of the few corporate yield series with a long history is Moody’s Corporate Bond Indexes, which goes back to 1919.  There are some oddities to that index, but there aren’t many choices if you go back a long way.  It composed of bonds in a given ratings category, 20-30 years long, unweighted average on yields.  The averages tend to yield more than most bond managers that I have talked with think they can get.

My credit spread variable was the yield on the Baa series less that on the Aaa series.  I think it is a really good proxy for credit conditions and overall market volatility.

Anyway, this was part of a talk that I gave to the Southeastern Actuaries Conference.  I’ll do a few more posts from that, but if you want to look at the report, you can find it here.

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.

Before I start tonight, a reminder, those that want to follow me on Twitter can do so here.  I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog.  I’m still working with it.  Thanks to all of those that tweeted and retweeted, and those that are following me now.

One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro.  If Greece defaulted, Greece would lose the low cost funding of the Euro.  The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line.  Tough love is the best policy; don’t bail others out if you care about the union as a whole.

On to tonight’s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.  There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.  In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.  There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can’t make good on his obligations.  As with many speculators, he overcommits.  He is short of funds because many trades are going against him at the same time.  It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.  The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.  After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip.  They were one of the main classes of marginal borrowers.

-=-=-==-=-=–==-

Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu.  There are trades that no one wants to take at any price that a seller could live with.  There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer.    Complexity is a minus.  We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them.  It is the price of creating safe securities.

No surprise: people pay a lot more for certainty, even if it is seeming certainty.  We see it in corporate bond spreads.  High quality borrowers borrow cheaply.  Low quality borrowers pay up. So what else is new?

What is new is the low-ish spreads for going down in quality.  This one could go either way; spreads are wide against history, but might be narrow against current difficulties.  The rebound has been rather sharp.

Note: this is reposted because of a system glitch.

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.

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.  Ready for how much they made?  Ta-da!  They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.  I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.  But Paul Kedrosky crystallized it for me when he posted this.  And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.  What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas — Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back “scaredy cat” regulators who don’t let banks deal in anything they don’t understand, which isn’t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing — that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and “scaredy cat” state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS — if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?  Probably, but consider this article here.  I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody’s Baa series — because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I’ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment — few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don’t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.  Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream — “Ratings are supposed to be good over a full market cycle!” When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can’t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)  Barry comments on how Goldman Sachs bags clients.  Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.  My comment:

I always advise retail investors not to buy structured notes — Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn’t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than “buyer beware,” and “Don’t buy what someone else wants to sell you. Buy what you want to buy.”

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.  It was featured by Barron’s and picked up in a piece by Barry.  Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.  My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.  My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.  They recently did a piece on whether it is better to buy a home now or wait a while.  My comment:

This is a book that gives a feeling for being in hedge fund management, rather than a dry description of what needs to be done if you are in the rare position of being asked to manage a hedge fund.

The author was an ambitious guy.  Growing up in Canada, he wanted to play professional hockey.  He played ably in youth leagues, the minors, and college.  Making the pros was not to be.

So, what does a competitive guy do when he can’t pursue his dream?  He pursues another dream, managing money. He works hard, and gets one break after another, and eventually manages his own firm, which he sells out to a larger one.  He gets a plum job at a firm that proves less than patient with his current performance, and he gets let go.  Even that is a triumph for the author.  He starts his own firm, which is what he is still doing today.

Think of an analogy to sports — every player makes mistakes, but the best players recover from mistakes well and learn from them.  The author definitely got his share of breaks, both good and bad, but he responded to the bad breaks well, and came out the better for it.

Though this book is about hedge funds and other areas of investing, really, this book is about the author.  It tells his story, and as the story gets told, you pick up incidental points along the way:

• What is it like to be an intern at a trading firm?
• How do you learn as you go?
• What was it like inside CSFB during the dot-com bubble?
• How to interview management teams to get an edge.
• How to sense if someone is lying.
• In general, the Fund of hedge funds operators are not desirable clients.
• Get a sense of the strength of consumers
• Get a sense of the three time horizons — days/weeks, months, and years.  (He uses other terms than this, but I appreciated his logic here, because it seemed a lot like what I did as a corporate bond manager.  Have a sense of short-term momentum, medium-term trend and long-term mean-reversion.)
• Very good to good means sell
• Very bad to bad means buy
• The value of keeping a trading journal, and reviewing performance.
• Be careful who you do business with, because eventually they may show you the door for less than good reasons.
• Surviving the credit bubble’s bust.  Buying back in when people are panicking.

The book runs 204 pages, but roughly 30 don’t have much on them.   The book is breezy, and though I mentioned a lot of things that I got out of the book, readers less familiar with the subject matter might miss some of the points.  He does not spend a lot of time on the details. On the other hand, a reader less familiar will get a feel for what it is like to be a part of a fast-paced area in investments.

Who would benefit from the book:  Those that would like to read the tale of an interesting guy who had a tiger-by-the-tail initial career in investments.

If you want to but the book, you can get it here: Diary of a Hedge Fund Manager: From the Top, to the Bottom, and Back Again.

Full disclosure: The publisher sent me this book. They send me a lot of books, and I review as many as I can. I don’t like every book that I receive, but typically I review the ones that seem the best, and let the rest pile up. Anyone entering Amazon through my site, and buying anything, I get a small commission, but your price does not go up. Such a deal.

PS — the blog for the author’s firm is here.

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 think earnings quality is one of the great neglected concepts of investing.  Why do many growth investors blow up on seemingly promising companies?  The answer is often that the investors did not review earnings quality.  Why do value investors fall into value traps?  The answer is often that the investors did not review earnings quality.

I have reviewed a number of books, and written many articles about earnings quality  Because so much of the investment world is blind here, the idea still has punch.

Thornton O’Glove hits at the subject in a traditional way — accrual accounting entries are always more suspect than cash entries.  He focuses on:

• Being skeptical — don’t trust management, analysts, auditors.
• Look for inconsistencies in disclosure.  Who tells a happy story broadly, bet is serious in regulatory filings?
• Who plays games with one-time events?  What companies push the limits in determining what is a one-time event?
• How do companies play with their accruals in order to report income?
• Is taxable income significantly out of whack with GAAP income?

The book was written in the Mid-1980s, before it was easy to review SEC filings.  That has changed, but few really review filings today, even though it is easy to do so.

This is a good book, and you can learn a lot from it, but many of the references are dated, as in the classic version of “The Intelligent Investor.”  I mean, I recognize most of the examples, but many readers will say, “Huh, I’ve never heard of that company!”

Do you want to improve your investing?  Look to earnings quality.

Who could benefit from the book?  Any investor could benefit from the book, particularly those that analyze fundamentals.

If you want to buy the book, you can buy it here: Quality of Earnings

Full disclosure:  I bought this book.  I review books old and new.  This old book still has value, and I recommend it.  It will require more effort than most investors are willing to put forth, but I believe it will yield value to those who work with it.  This is simple stuff, but it is work, and there is always a barrier to entry around work.

Also, anyone entering Amazon through my site and buying anything — I get a small commission, but you don’t pay anything more.  I love it when both my readers and I win.

I ordinarily like the writings of Jason Zweig, so this post is not meant as a criticism of him.  He wrote an interesting article suggesting that US investors may suffer reduced performance because they invest too much in US stocks.  Ideally, shouldn’t investors seek out the stocks that are likely to perform the best, regardless of where they are located in our world?

Ideally, yes.  Practically, there are difficulties.  I write this as one who has always allocated more than the average to international stocks.  Investing internationally assumes several significant things:

• There will be no war that changes the amount or terms of commerce.
• There will be no legal changes that affect property rights abroad.  This includes exchange controls.
• I will get the same flow of news that an investor in the target country will get.
• I understand the differences in the accounting rules, and will not get tripped up if they are more liberal than in the US.
• I understand that regulations are different in foreign countries as well.
• Transacting in non-ADR foreign stocks from the US can be expensive for retail accounts.  Buying mutual funds that invest in foreign stocks carries expensive management fees.
• Economic policy will remain rational in the target country, or at least, better than that of the US.
• I understand the trading nuances of the target country.

Home bias is normal, around the globe.  We understand the business dynamics of our own countries far better than foreign countries, together with our understandings of accounting, regulation, exchange controls, information disclosure, legal systems, economic policy, etc.

Even within the US, there is home bias among investors to the extent that we tend to invest more in companies that are near to us — perhaps it is a greater flow of informal information.

I would encourage all of my readers to invest abroad but to do it selectively.  Does the country allow for relatively free capital flows?  Do they honor the rule of law?  Is their accounting as good as that in the US?  Are there war risks?

There are risks in investing abroad that do not exist locally.  Make sure you minimize those risks if you invest abroad.

I once wrote a post on university endowment investing that I thought was one of my better ones, but drew little attention.  It helped to inform another piece I wrote that was better received, The Forever Fund.  Okay, two more if you are a glutton for this kind of stuff: Liquidity Management is the First Priority of Risk Management, and The First Priority of Risk Control. (Note: university endowments had a lousy year ending in June of 2009.  Things may be looking better now, but with interest rates so low, university endowments are even more reliant on outperformance of equities and other risky assets.)

The key idea is this: understand what you are trying to fund before you begin investing.  When will the money be needed?  How much?  How realistic is the implied rate of return?  What if everyone with needs like yours tried to do this?  Would it work then?  Is the demand for investments that are optimal for entities with your liability structure greater than the available investments to be had?  Do you have some sustainable competitive advantage that few others have?

When I look at ideas like pension plans employing leverage (also here), I think they don’t know what they are doing.  Anybody remember how New Jersey decided to sell pension bonds and lever up their pension investments in risky assets?

• How the Garden State Dug a Hole
• Strapped Governments Revive Pension Bonds
• Christie Crosses N.J. Party Line Amid $34 Billion Pension Gap

That last article is timely, published today.  What began as borrowing $2.7 billion to plug a gap became a $34 billion gap.  Risky assets, particularly equities, did not perform.  Not only did they not earn enough to earn the actuarial rate needed to fund the defined benefit plan, they also had to pay interest on the pension bonds.

Trying to fill a funding gap via a more aggressive strategy is usually foolish.  If that were the best strategy, you should have been employing it already.

But consider the leverage angle more closely.  A defined benefit plan is by its nature a plan to pay out a stream of benefits over time to beneficiaries.   Typically they invest some of their assets in bonds that are shorter than the length of the stream of benefits they will have to pay.  Those bonds typically don’t earn enough to cover the actuarial funding rate, so they invest the rest in risky assets that they think that blended with the return on the bonds, will earn the actuarial funding rate or better.

There are at least three problems here:

• It would be ideal to invest entirely in super-safe debt instruments that match the expected liability cash flows, but that would require too much in taxes from the citizenry.
• But the moment that you move to funding some of the assets into stocks you open up two risks: 1) funding risk — what if the risky assets don’t perform to the degree needed? and, 2) Interest rate risk — the moment you are not matched there are risks if interest rates move against you.  This is usually a risk if rates move down.  It is rare for a defined benefit plan to buy enough long debt such that the value of bonds rises as much or more than the present value of the liabilities rise when interest rates fall.
• Pension bonds, or any sort of investments with internal leverage have the potential to increase funding risk, and they increase interest rate risk as well.  Pension bonds add another fixed claim to the existing semi-fixed claim of the benefit stream.

Are we the double-down society as far as investing goes?  It sure seems like it, and if many entities do this as a group the failure of the idea will be spectacular.  Risk premiums are not high now; take a look at Jeremy Grantham’s forecasts on page 4 of this PDF (which has many other useful bits that you can learn from).  Borrowing money to invest when risk premiums are small is playing the exact same game as we were doing with CDOs from 2005 to 2007.  If the spreads are thin, pile on more leverage!  That will get us to our earnings target.

It’s sad to see this phenomenon reappearing.  Don’t we ever learn?