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.

Before I begin, I want to tell all of my friends in Japan that I have a great love for their country.  I have not traveled much, but if I were to travel abroad, Japan would be my first choice.  Plus, I have many friends in Kobe, Japan.

Japan is at the leading edge of the demographic wave where many developed countries have a shrinking population.  But beyond that, Japan has high government budget deficits and a very high government debt.  Consider this graph from Bill Gross’ latest missive:

Japan is in the awkward spot of having high government debt, though much is internally funded, and is still running high government budget deficits.

What a mess.  I happened across a blog I had never seen before today, and it gave a simple formula for when government debts would tend to become unsustainable.  It was analyzing Greece, but I looked at it and said to myself: “What about Japan?”

The main upshot of the equation in the article about Greece is that you don’t want the rate your government finances at to get above the rate of GDP growth.  If so, your debt will increase as a fraction of GDP, even if your deficits drop to zero.

So, what about Japan?  Can we say two lost decades?

Oooch! 0.2%/yr average growth of nominal GDP?!  That stinks.  But here is what is worse.  The Japanese government  finances itself at an average  rate of 0.6%.  The debt is walking backward on them unless GDP growth improves.  No wonder S&P has put Japan on negative outlook.

Japanese interest rates could rise.  Like the US. Japan has an average debt maturity around 5.5 years.  Unlike the US, 23% of its debt reprices every year, which makes them more vulnerable to a run on their creditworthiness.

Here are three more links on the Pimco piece, before I move on:

• An eye-catching quote…
• “UK gilts resting on a bed of nitroglycerine”
• Gross on Gilts: ‘On a Bed of Nitroglycerine’

We can think of central banks as equivalent to a margin desk inside an investment bank in the present situation.  Though I can’t find the data on the web, what I remember from the scandal at Salomon Brothers that led Buffett to take control, there was a brief loss of confidence that led the investment banks margin desk to raise the internal borrowing rate by 3-4% or so. Within a day or so, the trades expected to be less profitable of Salomon were liquidated, and Salomon had more than enough liquidity to meet demands.

But this is the opposite situation: what if the margin desk were to drop the internal lending rate to near zero?  Risk control would be hard to do.  Lines of business and people get used to used to cheap financing fast.  If it were just one firm that had the cheap finance, say, they sold a huge batch of structured notes to some unaware parties, it would be one thing, because after the easy money was used up, the margin rate would revert to normal, and so would business activities.

But let’s expand the paradigm, and think of the Central Bank as a margin desk for the nation as a whole.  Pre-2008, before the Fed moved to less orthodox money market policies, this would have been a more difficult claim to make, but the claim could still be made.

Pre-2008, the Fed controlled only the short end of the yield curve, which, with time, is a pretty powerful tool for making the economy rise and fall.  Short, high-quality interest rates move virtually in tandem with the Fed funds rate, but during good times, with the Fed funds rate falling, economic players seek to clip interest spreads off of longer and lower quality fixed claims, causing their interest rates to fall as well, with an uncertain timing, but it eventually happens.

And when Fed funds are rising, the opposite happens — funding rates for those clipping interest spreads rise, and the expectation of further rises gets built in, leading some to exit their trades into longer and riskier debts, which makes those yields rise as well, with uncertain timing, but eventually it happens.

I like to say that every tightening cycle ends with a crisis.  Let’s see it from an old RealMoney CC post:

		David Merkel
		Gradualism
		1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.  (Aaron Task has an interesting rejoinder to the latter of these.)

Things are a little different now, because the Fed is not limited to the Fed funds rate any more.  They have a wider array of tools, and the Treasury is in the act as well through the TLG program.  The Fed owns over $1.5 Trillion of longer dated debts, mostly residential MBS.  The Fed as the margin desk has itself become involved in clipping interest spreads, using its cheap short-term funding to buy longer dated paper, directly forcing long rates down.  The Fed may innovate in other ways as well, offering/receiving term financing as well as overnight financing via Fed funds.

But, here’s the rub.  If the Fed brings the margin rate down to near zero and leaves it there, while actively creating expectations that it will stay there “for a considerable period,” and does so in a lesser way for long-dated paper as well, it can manufacture lower interests rates seemingly everywhere for a time.  It’s amazing how fast bond managers can shift from fear to yield lust.  (I leave aside the effects of foreign players for now.)

But as I pointed out in my visit to the US Treasury, you can change the financing rate, but the underlying cash flows don’t change.  The margin desk drops the financing rate, and prior good trades look better, marginal trades look doable, but there are investments that are still losers at a discount rate of zero.  No way to help those.

So what happens when the next crisis arises?  It could be commercial real estate, inflation, a war, a sovereign default (e.g., Greece, Japan, UK, Italy), another wave of corporate defaults, or, a very weak economy, with banks that are willing to clip spreads, but not take any significant financing risks.

Back to Japan.  Two lost decades.  Debt walking backwards on them.  All of the Keynesian remedies they applied.  Government spending and deficits ultrahigh.  Interest rates ultralow.  Start with a government with little debt; end with a government that is the most indebted among developed nations.

This developed world in Bill Gross’s “ring of fire” is pursuing the same strategies that Japan did over the last two decades.  They should expect the same results, until sovereign defaults begin.  Then the game will change — mercantilists like China will see their strategies blow up, and the nations that default will see their living standards decline.

This has gotten too long, but one thing that I will try over the next few days is estimate Nominal GDP growth rates for nations in the “ring of fire,” and their Government’s financing rates.  If I find anything interesting, I will let you know.

Final note: Ben Franklin at the Constitutional convention in 1787 commented that the half-sun on Washington’s chair was a rising sun, not a setting sun.  Though my title plays on a name for Japan, all nations in this predicament may find that their sun is setting as well.  Unwillingness to take short run pain in trading leads to failure in trading — even so, it is the same for nations.

Insurance is probably the most complex industry as far as accounting goes.  Why?  When you sell the policy, you have a vague  idea of what the costs will be, and when those cash flows will occur.

That leaves room for a wide variety of games as far as the accounting goes.  Because hitting operating return on equity targets is often the “be all” and “end all” of management reporting, one of the holy grails was taking capital losses and turning them into operating income.  Net result on income is zero, but it looks like you are making a lot of returns off of operations.

At one company that I worked for, the new CEO want to great pains to declare how ethical the new CFO was.  I murmured to my boss, “Not ethical, but clever.”  He gave me a smile.  She had pulled that very trick, and if one reconciled the Statutory and GAAP accounting, the chicanery was obvious.

At AIG, my managers were quite concerned about what went above the line and below the line.  If an accounting item didn’t figure into net income my managers didn’t care about it, even if it diminished shareholders equity.

As an investor, this made me skeptical about income statements.  But if you don’t have an income statement, what do you do to estimate profitability?

Well, you could look at the change in tangible net worth due to common shareholders, and add back dividends, including the value of spinoffs, and net money spent on buybacks.  That is what a shareholder earns, in book value terms.  Back when I was an analyst of the insurance industry, there were companies run by value investors that would present their returns that way showing the the growth in fully converted book value over time.  In a sense , Berkshire Hathaway does that as well, but it doesn’t pay a dividend, so it is simply the increase in book value.

In the short run the market is influenced by net income due to common shareholders.  But there is a difference between the two measures of income, and I call the difference “cram.”  Cram is the amount of extra income reported through the income statements that does not makes its way through the balance sheet.

That said, I have another measure that I nickname “jam.”  Jam is the amount of money gained/lost from buying back stock.  In general, when companies buy back stock they dilute value for investors.  Better to retain and reinvest.

How do I know this?  I have been working on an accounting quality model, which is still a work in progress.  An aside, I have had my share of calls from consultants who tell me they have an earnings quality model that covers the whole market.  When they call me I ask them how they analyze financial companies.  I get the intelligent equivalent of a shrug.  The reason is that accruals on the financial statements of industrials and utilities are quite similar, but for financials, they are quite different.

Here are some of the results of my model on the S&P 100:

The data covers the last 4 3/4 fiscal years.  Why did I use fiscal years? Because data capture with companies is most complete at fiscal year ends, when they file their 10Ks.

What did I find?  In general, most companies lose money off of buybacks, whether it is 24% of cumulative net income, or 32% of final tangible net worth.  Individual company performance varies a great deal.  More surprising to me was that cram on average was only 1% of cumulative net income.  Maybe GAAP isn’t so bad on average after all.  But averages conceal a lot of variation — I would not want to own companies that lose a lot of money off of buybacks, or those that inflate net income versus growth in tangible book.

If buybacks ceased, companies might have a lot of slack assets on hand.  I know that companies keep themselves slim to avoid takeovers,  A large amount of slack assets invites others to come in and buy the assets to manage them.  Still, it seems that most buybacks waste the money of shareholders.  This seems to be another example of the agency problem, wheremanagers take an action that benefits them, but harms shareholders.

I would be negative on both cram and jam.  Good companies don’t report earnings in excess of what shareholders obtain, and they don’t buy back stock except when it is cheap.

Full disclosure: long ALL COP CVX ORCL PEP

I spent some time today updating my Treasury yield curve and inflation model.  Anytime a new Treasury note/bond is issued, or we get a new CPI figure, or a coupon payment date passes, the model must be updated.  Though I made some technical improvements to the program at the same time, what impressed me was the change in the forward inflation curve since I last wrote on the topic less than a month ago.

The big change is that inflation expectations rise  continually out to  2038.  Now the TIPS curve only goes out to 2032, so the extrapolation should be discounted.  But the last time I wrote, inflation expectations peaked in 2022.  That is a significant change.  Investors have bid up the prices of long duration TIPS, to the point where I would be skittish about buying the long end of the TIPS curve.

Okay, let me post the graphs:

Using closing prices, here is my estimate of the coupon-paying yield curve:

And here is the spot curve (estimating where zero coupon bonds would price):

And finally, the forward curve, which estimates the expectations of future short-term rates, inflation, and real rates:

My model uses the whole Treasury and TIPS markets to estimate yields and inflation expectations.  Here is what is notable:

• Inflation expectations on the long end have risen considerably over the last month.
• I suspect that the US Treasury will be able to issue 30-year TIPS at yields lower than 20-year TIPS.  The new 30-year TIPS issue in February will prove me right or wrong.
• Real forward yields are lower than zero 27 years out — that is unlikely.  I would expect nominal forward rates to rise on the long end.

There are at least two ways to view this situation:

1) Investor inflation expectations have overshot, and it is time to sell long TIPS and buy long nominal bonds, as long-term inflation expectations may fall in the future.

2) Time is running out — rapidly rising long-term inflation expectations indicate that the average investor does not trust monetary policy to succeed over the next 20+ years.

What would I do here?  I would hedge my bets, and buy some long Treasury zeroes (not a lot), mostly intermediate-to-long TIPS, and some short nominal Treasuries.  I would bias the portfolio in favor of bonds that are seemingly underpriced.

The hedged position is because I don’t know which direction the US Government and Fed intend to go with policy.  They likely have no idea as well; this is a tough situation.

On the deflationist side there is Hoisington, Gary Shilling, Carpe Diem.

More inflation-oriented are Greg Mankiw, Tim Duy, and Pimco.  But I don’t see anyone of significance screaming for high price inflation in the long-term future. Yes, that is the default view of much of the financial blogosphere, but the US Government had that option in the ’30s.  It would have made things a lot easier if they had done it, but they didn’t do it.  They acted in the interests of the wealthy, rather than the interests of the economy as a whole.

That’s what makes my model interesting.  It shows that there is a lot of demand for long TIPS.  If the US Treasury thinks it can get things under control, the rational thing to do is to stuff the long TIPS buyers with as much product as they can gulp before it becomes obvious that low inflation will continue because the government will soon balance the budget and pay down debt, as they did after WWII.

But if the US Treasury can’t get things under control, the long TIPS buyers will do well, as they have the most sensitivity to rising forward inflation expectations.

Where do we go from here?  My guess is slowly rising inflation with a weak economy.  But so much depends on the rest of the world, that I hold that opinion skeptically.

Full disclosure: I own some of the Vanguard TIPS fund [VIPSX].

Would that there were one time horizon — a goal to shoot for, similar to the dispensationalists that plague Christianity with an announced date for the return of Christ.  But a major reason that the Chicago School (as well as the Keynesians) is wrong in their view of economics is that there are multiple time horizons that people consider.

Why one time horizon?  It makes the math simple.  It is similar to the foolish Modern Portfolio Theory which has one version of risk which bears no resemblance to risk in the real world.  Modern Portfolio Theory exists so that bright people who can’t interpret the real world can receive salaries and look smart.  What’s that, you say, Modern Portfolio Theory has a fixed time horizon?  Another reason to cast it over the edge.  It is useless.

There have been a series of interviews at The New Yorker with Chicago School economists to try to test them in their allegiance to the free markets.  There is a problem here in that what makes sense in the short run does not always make sense in the long run.

Bubbles develop from short-run thinking.  What has worked in the immediate past  will work even better in the future.  In hindsight, it sounds dumb, but remember that most people are imitative; they imitate the seeming success of others.  People are rational, but not rational in the way that most economists posit.  Imitating your neighbor is a logical move for many actions.  If he is doing something that looks good, it can make a lot of sense to do the same thing — e.g., asking for the recipe for the delicious meal you had at their house, as well as asking where they got a certain obscure ingredient.

Imitation conserves on thinking.  People avoid thinking, because it hurts.  “If it works for my loser brother-in-law, than it certainly will work better for  me,” is the way some think.  There is the implicit appeal to taking an action out of greed or jealousy.  Smart people avoid those temptations, and think for themselves, looking to the long term consequences of any action.

Momentum investors live on the short-term horizon; value investors invest for the long term — if success comes quickly, very good, if slowly, good.  The ability to wait is a plus, because the ability to wait allows for optionality that may produce more value.

Back to bubbles.  They usually exist because financing is too cheap relative to what financing costs on average over a full market cycle.  Lending or equity investing at such times goes on with little thought for what can go wrong.

“This junk bond won’t default.”

“This equity will grow into its valuation, and then some.”

But near the peaks of bubbles, two things happen.  The prices of the assets being financed are so high, that one borrowing to own the asset faces a negative arb — he has to keep paying to keep the asset afloat — the net yield is negative.  The second thing is that chatter becomes uncertain, and the pace of closing deals slows.

These are signs that the cash flows that the assets throw off are less than the cash flows needed to hold the assets.  Such a condition can only exist for a short time during a mania.  When the pace of deals slackens, and the arb is negative it is time to run, not walk to the exits.

If enough economic actors did this, bubbles would self-deflate.  But it hurts to think.  Valuation questions are tough, and it is much easier to mimic the seemingly successful actions of others.

Better it would be if the Fed, which is the main blower of bubbles through easy monetary policy, would pull back on policy when aggregate levels of debt in the economy get above 200% of GDP, or, would allow us to go through recessions where there is significant pain, and liquidation of bad investments.  But no, during the bubble years, Greenspan was lionized for keeping the economy going smoothly — limiting the impact of recessions.  All that time, debts kept building up until the ratio far exceeded that achieved during the Great Depression.  Now Bernanke is lionized for increasing the Debt/GDP ratio while shifting debts from private to public hands.  He has saved us from the final reckoning of debt service.  Now what will the US Government do as its total obligations pass 4x GDP and head toward 5x GDP?  As I have said before, we are in uncharted waters here.

Debt is not neutral.  It creates inflexibility in the economy, because an economy built on fixed commitments has higher bankruptcy risks than one built on equity commitments.  Real reform would force banks to delever.  It would force the US Government to delever.  Real reform would get the government out of the prosperity business (it has never been good at that), and get it to focus on areas where it can make a difference — justice, defense, public health, and other public goods.

One simple solution: phase out the deduction for interest expenses, and phase in a deduction for dividends (preferred dividends would be at 50%).  Disallow trust preferred and hybrid debt structures.  Make finance more transparent by eliminating complex structures, and limiting all derivative transactions such that only hedgers may initiate transactions.  Transactions between two speculators should be regulated as gambling, because that is what it is.

If the government is not willing to take actions that hurt those being regulated, they are not worthy of being called a government.  The government should look out for the best interests of the nation as a whole, regardless of whom it might seem to favor.

Once again, back to bubbles.  Bubbles don’t get popped by the powers that be because the powers that be like bubbles as they are inflating.  Who would be a humbug and stop the sunbeam of prosperity when it is shining with full power?

But when the deflation of the bubble happens, everyone points the finger outward, few point at themselves.  Let Messrs. Greenspan, Paulson, Geithner, and Bernanke, among others, come before the cameras and apologize for their mismanagement of the US economy, and, let them suggest that the government get out of the economy business, because the government has consistently failed there.

To come back to the beginning of this article, the fetish of rationality exists in economics because the math doesn’t work without it.  Many tests of rationality have failed, yet the profession does not give up, because their skills are useless if man is not economically rational.

It is time to unemploy a lot of economists.  Unemploy them at the Fed; if we don’t eliminate the Fed, at least let’s slim it down.  Unemploy them at universities and colleges.  Let the business departments teach practical economics, and close the economics departments themselves.

The failure of Keynesian, Chicago School, and Neoclassical economics in this present crisis is severe.  We need a new economic paradigm to replace the failures that exist within our universities.

Neoclassical economics will fail; I may not live to see it fail, but it will fail.

I resisted getting this book when it first came out.  Much as I enjoy Ken Fisher as a writer, and appreciate the interaction that I have had with him over the years, the title turned me away.  “Three questions? Only three?  Investing is far more complex than that.”  I would say that to myself.

After reviewing his most recent book, I said to myself, “Well, you’ve reviewed all of his books but one; you may as well do it.”  So, I borrowed the book from a friend.

I wish I had read it sooner.  The three questions are simple ones, and they have been mentioned elsewhere on the internet, so here they are:

• What do you believe that is actually false?
• What can you fathom that others find unfathomable?
• What the heck is my brain doing to blindside me now?

The idea is to get us to think more deeply.  Test the received wisdom to see if it is really true.  Look for unusual areas of competitive advantage that you have that are possessed by few.  Your emotions will often lead you astray: look for opportunity amid fear; look for shelter amid wild abandon.

Competitive advantage in investing is an elusive thing.  The clever idea that you might discover is just one journal article away from an academic toiling in obscurity, but will go to a  hedge fund two years from now.

Patterns that work in one market should work in most markets.  If your discovery seems to work in most places, it might work well, until it is discovered and used heavily.

I found a number of insights useful.  Like me, he uses E/P relative to bond yields to try to estimate whether markets are rich or cheap.  I also found his insights about how the yield curve affects style investing to be useful.  I do something like that through my industry rotation.

Now, in the intermediate-run, most things that people are scared about don’t affect the market much.  Government deficits seem to be a positive for stocks in the short run.  Trade deficit?  Little effect on stocks.  Weak dollar?  Little effect.  This book debunks a number of common worries, though I would say that if the problem got significantly bigger, perhaps the result would be different.

Ken Fisher offers what I would deem to be good advice on Asset Allocation, and how to make sell decisions, amid many other issues.  I enjoyed the book a lot, and would recommend it to my readers.

Quibbles

Occasionally, the book seems disjointed.  Ken Fisher is covering a lot of ground, and he takes a decent number of “side trips” to explain concepts.  The flip side of that is that the book covers many areas of the equity markets, and helps to explain what drives them.

Now, sometimes I wonder if multivariate approaches might reveal different conclusions than what Ken Fisher comes to.

Who would benefit from the book: Investors with moderate experience in investing who are finding the going harder than they expected.  This book will help them take a step back, and think twice about investment decisions.

If you want to buy the book, you can buy it here: The Only Three Questions That Count: Investing by Knowing What Others Don’t (Fisher Investments Press)

Full Disclosure: Book reviews are my main profit center at my blog.  They allow me  to create a win-win situation for me and my readers.  I don’t want my readers to waste their money to reward me.  I would rather they buy things that they want to buy at competitive prices through Amazon.  If they enter Amazon through my site, I get a small commission, and their price does not change at all.  Such a deal.

1) Inflate the size of my balance sheet by 2.5x over last year, all through borrowing at really low rates.

2) Increase my interest spreads by ~50% over last year.

means:

3) I only increased my profits by ~50% over last year??!    I would have thought that profits would have more than tripled.

Such is life for the Fed.  The crisis was a time that led me to write pieces like The Liquidity Monopoly, where the Fed, FDIC, and Treasury played favorites in the economy, and starved the portions of the economy not dominated by large firms, particularly with banks and autos.

My main point is that the Fed should have earned a lot more.  Where did it all go?  It will be interesting to see a detailed rendering of the Fed’s finances when this is done.  Did they realize losses on some of the assets that they bought?

My friend Peter Eavis of the Wall Street Journal agrees.  Or, read Felix, and then read the exchange between my two friends Alea and Kid Dynamite.  Alea knows more, but I like KD’s spirit.

The Fed has become more like the banks that it regulates.  They are taking on credit risk, duration risk, convexity risk, etc.  And being a government institution, they don’t have good incentives for knowing how to price risk.

So, when I see the Fed’s seniorage profits up only 50%, I am not impressed.  The Fed doesn’t mark to market, so we really don’t know the true performance.  Also, remember that seniorage profits are a hidden tax on savers, would earn a higher yield if the government provided less financing.

Part of why we end up in an economic funk is that we finance dud assets at favorable rates, so capital does not get redeployed to better uses.  Aside from that, cheap leverage creates a yield frenzy over healthy assets, so that they can become over-levered as well.  Examples are numerous:

• The corporate bond market continues to be on fire.
• Investors  including PIMCO, are flocking to European corporates, though generally only the stronger countries, not Greece, Italy, Ireland, Portugal or Spain.  (Note: PIMCO will exit the trade at a better time than most imitators.)
• Average people are willing to fund all of this as well, accepting low rates of return for the duration and credit risks that they take on.  If the Fed wanted people to bid up bond prices to unsustainable levels, they have succeeded.
• Finally, I suppose if one pours enough jet fuel on a soggy, rotten log, I suppose one could get it to burn.  If the prices of non-GSE mortgage debt are rising rapidly, to me, that means speculation is getting out of hand.  Financial leverage is even coming back to these markets.  As with junk bonds, the markets are subject to two risks — that the cheap financing disappears, or that the likelihood of defaults becomes more obvious.

To me it is no great achievement that the financial markets are doing well while the real economy is in the tank (Unemployment, Production).  That is the nature of what happens when credit is force-fed into an economy, even leaving aside the problems of cronyism.  There should be no optimism over the large profits realized by the Fed; it may defray our taxes, but on net, the policies have not helped create a healthier real economy.

I was recently asked where to look for how to understand quantitative investing, fixed income, etc.  Let me try to explain.

I have reviewed in the past Investing by the Numbers (Frank J. Fabozzi Series).  This is a good book that covers a wide number of areas in quantitative investing without getting too technical.  I learned a lot from it, and I don’t think the lessons there are out of date.

As for Fixed Income, the main book is Handbook of Fixed Income Securities 7th Edition, edited by Frank Fabozzi.  Fabozzi gets practical experts to write for him and he edits the book so that it reads well.  The result is a readable book that gives all of the qualitative information about the market, but does not deliver the math.  That’s a good thing.  Most people don’t want the math.

But… what if you are a misfit like me who does want the math.  Where do you go? Buy the Theory of Interest.  And, don’t buy it new.  Buy it used, or get it through interlibrary loan.  Same for Fabozzi’s book.  Don’t overpay.  And, if you can understand it well, maybe you would like to become an actuary.  The actuarial profession has done many good things for me; maybe it will do so for you also.

I have learned a lot from all three of these books.  You can too.

With markets, it doesn’t matter what people say.  What matters is what they rely upon.

Face it, people have opinions, and when asked only the most cautious or prudent won’t give an answer.  Talk is cheap.

But money talks.  What will people or institutions risk some of their financial well-being in order to make money?

Turning points are exceptionally difficult to call with time precision.  Anyone can say that a trend is going to break for a long while before it breaks; the trick is to be able to make the change within a short distance of the inflection point.  I’ve done it a few times, but I have little confidence in whether I can do it regularly.

Examples:

• Five months before the crest of the housing bubble, I wrote a piece on why it would pop soon.
• A few months before the subprime mortgage crisis hit, I wrote a piece on why it would end badly.
• In March of 2000, I told the investment department that I worked in that financing for tech companies was unwinding, and that the tech bubble would deflate.
• In October 2002, I sensed that the bear market was over and began taking risk in my own portfolio, as well as my main client’s portfolio.
• In May 2003, I told my boss that we were in a liquidity rally and that shorting lower grade companies was suicidal, because financing was becoming available for marginal ideas.  In early 2004, I confirmed that by writing a piece showing that the bull market had a way to go.
• And recently, I made predictions on munis, mortgage bonds, agency bonds, and investment grade and junk corporates.

Now part of this is that if you predict enough things, you will have some right ones to point to.  I am obviously picking and choosing here, but when I made these predictions, there was a method to my madness.  I am not like Cramer, who makes predictions every day.  I wait for points where markets are out of kilter, and then I act, and sometimes predict.

Calling turning points is very difficult.  I want to offer two bits of advice to those to try to do so.

1) Look for situations where the yield is unsustainable on the high side or on the low side.

Examples:

• Earnings yield too low during the tech bubble.  Also workers were relying on stock to rise, because they were getting much of their pay through options.
• Net yield on much residential investment real estate negative in 2005-7, without even factoring in maintenance costs.  When someone is relying on price appreciation in order to break even something is wrong.
• Toward the end of the commercial real estate bubble, the same was true.  Equity investors began to rely on price appreciation in order to break even.
• When spreads on high yield blew out, at its worst the market was assuming that half of all high yield issues would die, with low recoveries.  Even the Great Depression wasn’t that bad.  The same was true in a faint echo for BBB Corporates.
• During the recent bottom in March 2009, high quality companies could be bought for less than their net worth and at earnings yields unseen since 1973-74.

2) Look for a qualitative change when you think we might be near a turning point.

• Chatter changes at/near turning points.  Certainty gives way to uncertainty.  Uncertainty gives way to worry.  Worry gives way to panic.  In October 2005, Googlebots that I created tipped me off to the change in the residential real estate markets way ahead of most parties.
• Inflection points tend to be times of stasis as far as economic variables go, but confusion in terms of chatter.  During the tech bubble in early 2000, the chatter became decidedly less certain.

Inflection points are times of change, and chatter should reflect that.

Coming back to contrarianism, ask yourself, “What are people relying on to be true, that may not be true?”  That is what it means to be a contrarian.  Mere disagreement means little.  Where have men placed their bets?  Betting against the consensus is what a contrarian does.

I finished the first phase of a project today.  But first let me tell you a story.  It was 1990, and the Society of Actuaries Investment Section was holding a conference.  It was a great conference; I still have the binder from it.  There are few meetings from twenty years ago that still have relevance for me.

One of the presentations was by Stanley Diller, a managing director of Bear Stearns, who insulted all of the actuaries at the conference by telling them the the insurance industry was dead wrong for talking about yields and spreads.  Everything was duration and convexity, and those that did not understand that would lose.

He ended his presentation suddenly, did not take questions, and stormed out of the room.  I’m not sure why, but I had a seat in the back, and intercepted him.  I said, “You can’t just say this and not give any justification for your views, how do you back it up?”  He thrust a business card into my hand and said, “Call my secretary, she will send you the info.”  He stormed away.

The next day I called the secretary, and she told me she would send the information.  Two days later, I had it, and a few days later, I had replicated it in my own model.

Since then, I have used the model profitably many times.  Today I use it to describe the yields in Treasury Notes and TIPS.  I have used it to produce an estimate of future inflation expectations.

Using closing prices, here is my estimate of the coupon-paying yield curve:

And here is the spot curve (estimating where zero coupon bonds would price):

And finally, the forward curve, which estimates the expectations of future short-term rates, inflation, and real rates:

Pretty neat, huh?  Let me tell you a little about the model:

• Values are as of the close 12/22/2009, but the model can be run in real time.
• It is estimated from the full coupon-paying Treasury Note and Bond markets — over 200 bonds in the model.
• The model estimates a nominal spot curve, fitting prices with 4 parameters, over 99% R-Squared.
• The model estimates a forward inflation curve, fitting TIPS prices with 4 parameters, over 99% R-Squared.
• The two models are estimated jointly, through nonlinear optimization.
• The model has one constraint — nominal spot yields must be positive after 4 months.
• Every other curve is derived from those two curves.

What are the useful things that we learn from the model?

• There are mispricings in the Treasury and TIPS curves, but they are typically small, and would be hard to make money off of.  That’s  demonstrated by the high R-Squareds.
• The Fed has achieved its goal of making real rates negative in the short term.
• And, has made made nominal rates negative for some very short instruments inside 6 months of maturity.
• Inflation expectations start low, and peak around 2022, then tail off.
• Long term inflation expectations are still under 3.5% — ignore the portion of the inflation and real curves after 23 years, they are extrapolations.
• Implied short-term real yields go positive in 2011, peak in 2024 and tail off thereafter.
• The nominal forward curve is steep as a mountain on both sides.  Though there is a lot of fear over what will happen over the next 12-14 years, those fears have not been built into the prices of longer-dated Treasury securities.
• The nominal spot curve peaks after 22 years — in my experience, that is normal, and is a reason why longer nominal note yields decline.  US Treasury — take note.
• Inspecting the differences between coupon-paying yields on Treasuries and TIPS makes inflation expectations look more tame than they really are.  Federal Reserve — take note.
• 30-year TIPS would likely fund cheaper than 20-year TIPS — US Treasury, take note.  The scarcity value would help as well.

This is just the beginning.  I’m not planning on writing about this every day, but I should be able give you some updates every now and then.  Hopefully the firm I work for should be able to benefit through research that this enables me to create for institutional clients.

Full disclosure: I own shares in Vanguard’s TIPS fund.  And truth, we all own Treasuries somewhere if we look deep enough.