When I buy a car, I analyze what car I would like to buy.  I look at reliability, repair costs, overall costs, and style.  I use Consumer Reports to help me analyze this.  Then I go to the website(s) of the manufacturer in question, and copy the data on all of the used models on offer at the dealerships within 30 miles of me.  With price as the dependent variable, I then run a regression with model year as dummy independent variables, and total miles as an independent variable.  After I run my regression, I look at the cars with the biggest price deviations, the predicted price is a lot higher than actual.  I then look at the features of the underpriced cars, and choose one where there are good features with a discounted price.

I go to that dealer, review the car, test drive it, and if it passes my tests, I haggle over the price, and buy it.   In my experience, this cuts thousands off the price of the car.  What a great reason to have studied econometrics.

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

1) The blog was out of commission most of Saturday and Sunday, for anyone who was wondering what happened. From my hosting provider:

We experienced a service interruption affecting the Netfirms corporate websites and some of our customer hosted websites and e-mail services.

During scheduled power maintenance at our Data Centre on Saturday Feb. 23 at approximately 10:30 AM ET, the building’s backup generator system unexpectedly failed, impacting network connectivity. This affected several Internet and Hosting Providers, including Netfirms.

Ouch. Reliability is down to two nines at best for 2008. What a freak mishap.

2) Thanks to Bill Rempel for his comments on my PEG ratio piece. I did not have access to backtesting software, but now I do. I didn’t realize how much was available for free out on the web. He comes up with an interesting result, worthy of further investigation. My main result was that PEG ratio hurdles are consistent with a DDM framework within certain moderate values of P/E and discount rates. Thanks also to Josh Stern for his comments.

3) I posted a set of questions on Technical Analysis over at RealMoney, and invited the technicians to comment.

		David Merkel
		Professionals are Overrated on Fundamental Analysis
		2/21/2008 5:19 PM EST

I’m not here to spit at technicians. I have used my own version of technical analysis in bond trading; it can work if done right. But the same thing is true of fundamental investors, including professionals. There are very few professional investors that are capable of delivering above average returns over a long period of time. Part of it is that there are a lot of clever people in the game, and that raises the bar.

But I have known many good amateur investors that do nothing but fundamental analysis, and beat the pros. Why? 1) They can take positions in companies that are too small for the big guys to consider. 2) They can buy and hold. There is no pressure to kick out a position that is temporarily underperforming. With so many quantitative investors managing money to short time horizons, it is a real advantage to be able to invest to longer horizons amid the short-term volatility. 3) They can buy shares in companies that have been trashed, without the “looks that colleagues give you” when you propose a name that is down over 50% in the past year, even though the fundamentals haven’t deteriorated that much. 4) Individual investors avoid the “groupthink” of many professionals. 5) Individual investors can incorporate momentum into their investing without “getting funny looks from colleagues.” (A bow in the direction of technical analysis.)

When I first came to RM 4.4 years ago, I asked a question of the technicians, and, I received no response. I do have two questions for the technicians on the site, not meant to provoke a fundy/technician argument, but just to get opinions on how they view technical analysis. If one of the technicians wants to take me up on this, I’ll post the questions — hey, maybe RM would want to do a 360 on them if we get enough participation. Let me know.

Position: none

		David Merkel
		The Two Questions on Technical Analysis
		2/22/2008 12:15 AM EST

I received some e-mails from readers asking me to post the questions that I mentioned in the CC after the close of business yesterday. Again, I’m not trying to start an argument between fundies and techies. I just want to hear the opinions of the technicians. Anyway, here goes: 1) Is there one overarching theory of technical analysis that all of the popular methods are applications of, or are there many differing forms of technical analysis that compete against each other for validity (and hopefully, profits)? If there is one overarching method, who has expressed it best? (What book do I buy to learn the theory?)

2) In quantitative investing circles, it is well known (and Eddy has written about it recently for us) that momentum works in the short run, and is often one of the most powerful return anomalies in the market. Is being a good technician just another way of trying to decide when to jump onto assets with positive price momentum for short periods of time? Can I equate technical analysis with buying momentum?

To any of you that answer, I thank you. If we get enough answers, maybe the editors will want to do a 360.

Position: none

I kinda thought this might happen, but I received zero public responses. I did receive one thoughtful private response, but I was asked to keep it private. Suffice it to say that some in TA think there is a difference between TA and chart-reading.

As for me, though I have sometimes been critical of TA, and sometimes less than cautious in my words, my guesses at the two questions are: 1) There is no common underlying theory to all TA, there are a variety of competing theories. 2) Most chart-readers are momentum players, as are most growth investors. Some TA practitioners do try to profit from turning points, but they seem to be a minority.

I’m not saying TA doesn’t work, because I have my own variations on it that I have applied mainly to bond investing. But I’m not sure how one would test if TA in general does or doesn’t work, because there may not be a commonly accepted definition of what TA would say on any specific situation.

4) One more note from RM today:

		David Merkel
		Just in Case
		2/25/2008 4:20 PM EST

Um, after reading this article at the Financial Times, I thought it would be a good idea for me to point readers to my article that explained the 2005 Correlation Crisis. Odds are getting higher that we get a repeat. What would trigger the crisis? A rapid decline in creditworthiness for a minority of companies whose debts are referenced in the relevant credit indexes, while the rest of the companies have little decline in creditworthiness. One or two surprise defaults would really be gruesome.

Just something to watch out for, as if we don’t have enough going wrong in our debt markets now. I bumped into some my old RM articles and CC comments from 2005, and the problems that I described then are happening now.

Position: none, and there are times when I would prefer not being right. This is one of them. Few win in a bust.

There are situations that are micro-stable and macro-unstable, and await some force to come along and give it a push, knocking it out of its zone of micro-stability, and into a new regime of instability. When you write about situations like that before the fact, it is quite possible that you can end up wrong for a long time. I wrote for several years as RM about overleveraging credit, mis-hedging, yield-seeking, over-investment in residential real estate (May 2005), subprime lending (November 2006), quantitative strategies gone awry, etc. The important thing is not to put a time on the prediction because it gives a false message to readers. One can see the bubble forming, but figuring out when cash flow will be insufficient to keep the bubble financed is desperately hard.

5) This brings up another point. It’s not enough to know that an investment will eventually yield a certain outcome, for example, that a distressed tranche of an ABS deal will eventually pay off at par. One also has to understand whether an investor can handle the financing risks before receiving the eventual payoff. Will your prime broker continue to finance you on favorable terms? Will your regulator force you to put up more capital against the position? Will your investors hang around for the eventual payoff, or will they desert you, and turn you into a forced seller? Can your performance survive an asset that might be a dud for some time?

This is why the price path to the eventual payoff matters. It shakes out the weak holders, and moves assets that should be financed by equity onto strong balance sheets. It’s also a reason to be careful with your own balance sheet during boom times, and in the beginning and middle of financial crises — don’t overextend your positions, because you can’t tell how long or deep the crisis might be.

6) I agree with Caroline Baum; I don’t think that the FOMC is pushing on a string. The monetary aggregates are moving up, and nominal GDP will as well… it just takes time. The yield curve has enough slope to benefit banks that don’t face a lot of credit problems… and the yield curve will steepen further from here, particularly if the expected nadir of Fed funds drops below 2%. Now, will real GDP begin to pick up steam? Not sure, the real question is how much inflation the Fed is willing to accept in the short run as they try to reflate.

7) Now, inflation seems to be rising globally. At this point in the cycle, the FOMC is ahead of almost all major central banks in loosening policy. I think that is baked into the US dollar at present, so unless the FOMC gets even more ahead, the US Dollar should tread water here. Eventually inflation elsewhere will get imported into the US. It’s just a matter of time. That’s why I like TIPS here; eventually the level of inflation passing through the CPI will be reflected in implied inflation rates.

8 ) Okay, MBIA will split in 5 years? That is probably enough time to strike deals with most everyone that they wrote coverage for structured products, assuming the losses are not so severe that the entire holding company is imperiled. If it’s five years away, splitting is a possibility, but then are the rating agencies willing to wait that long? S&P showed that they are willing to wait today. Moody’s will probably go along, but for how long?

9) I found it interesting that AQR Capital has not been doing well in 2008. When quant funds did badly in the latter half of 2007, I suffered along with them. At present, I am certainly not suffering, but it seems that the quants are. I wonder what is different now? I suspect that there is too much money chasing the anomalies that the quant funds target, and we reached the end of the positive self-reinforcing cycle around mid-year 2007; since then, we have been in a negative self-reinforcing cycle, with clients pulling money, and the ability to carry positions shrinking.

10) Now some graphs tell a story. Sometimes the story is distorted. This graph of the spread on Fannie Mae MBS is an example. Not all of the spread is due to the creditworthiness of Fannie Mae. Those spreads have widened 30 basis points or so over the past six months for Fannie’s on-the-run 5-year corporate bond, versus 50 basis points on the graph that I referenced. So what’s the difference? Increased market volatility makes residential MBS buyers more skittish, and they demand a higher yield for bearing the negative optionality inherent in RMBS. Fannie and Freddie are facing harder times from the guarantees that they have written, and the credit difficulties at the mortgage insurers, but it would be difficult to imagine the US Government allowing Fannie or Freddie to default on senior obligations.

That’s another reason why I like agency-backed RMBS here. You’re getting paid a decent spread to bear the risks involved.

11) I would be cautious about using prics from CMBX, ABX, etc., to make judgments about the cash bonds that they reference. It is relatively difficult to borrow and short small ABS and CMBS tranches. It is comparatively easy to buy protection on the indexes, the only question is what level does it take to induce another market participant to sell protection to you. When there is a lot of pressure to short, prices overshoot on the downside, and stay well below where the cash bonds would trade.

12) One last point, this one coming via one of our dedicated readers passing on this blurb from David Rosenberg at Merrill Lynch:

A client sent this to us last week

It was a New York Times article by Louis Uchitelle in December 1990 on the housing and credit crunch. In the article, there is a quote that goes like this – “This is different from the experience of the Great Depression, but something related to the 1930’s is beginning to happen”. Guess who it was that said that (answer is at the bottom of the Tidbits).

Answer to question above

“Ben Bernanke, a Princeton University Economist” (and future Fed chairman, but who knew that then?).

My take: it is a very unusual time to have a man as Fed Chairman who is a wonk about the Great Depression. That makes him far more likely to ease. The real question is what the FOMC will do if economic weakness persists, and inflation continues to creep up. I know that they want to save the day, and then remove all policy accomodation, but that’s a pretty difficult trick to achieve. In this scenario, I don’t think the gambit will work; we will likely end up with a higher rate of price inflation.

This piece is a work in progress, so I solicit your feedback on it. How could it be improved?

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

I enjoy it when my expectations are proven wrong, because it means that I learned something in the process. When I began preparation for this post (which will probably have two parts, because I am having difficulty posting files, tables and pictures at my blog), I expected to write a post that would conclude that the PEG ratio (P/E divided by the anticipated growth rate expressed as an integer) is a nifty market artifact, but had no sound theoretical grounding.

The answer to the question in my title is complex. The answers are No, Sometimes, and Yes.

• If you’re a deep value investor: No.
• If you’re a moderate value or core investor: Sometimes.
• If you’re a fundamentally-driven moderate growth investor: Yes.
• If you’re an aggressive growth investor: No.

When I did my earlier post on my version of the Fed Model, I began by showing that it was a simplification of the simple version of the dividend discount model [DDM], which states that the value of a stock is equal to the present value of its future dividends. I’m going to do the same thing here with a few changes:

· I can’t prove what I am stating analytically, that is, by manipulating equations. I’m going to do it through scenario analysis and regression.

· My piece on my Fed model used the simple DDM. This piece uses a three-stage DDM. The stages are growth, transition, and maturity. For those with access to a Bloomberg Terminal, my implementation is a more conservative version of what they did.

Three-Stage DDM Assumptions

• · Initial forecast earnings (E₁)
• · Initial dividend payout ratio as a portion of earnings (PR₁)
• · Growth rate of earnings in the first phase of the model (g)
• · Length of the first phase (5 years)
• · Length of the second transition phase (6 years)
• · Ultimate earnings growth rate in maturity (6%)
• · Ultimate payout ratio in maturity (50%)
• · Discount rate for the dividend stream (k_s), otherwise known as the required rate of return (i.e., what does an investor have to expect to earn in order to get him to part with his cash?)

In brief, in the first phase of the model, earnings grow at a rapid rate, and dividends are paid at a relatively low rate, in the second (transition) phase, the earnings growth and dividend payout rates grade linearly into the rates of the ultimate phase. The resulting dividend stream gets discounted at a discount rate reflecting the riskiness of the company.

Limitations of the Model

• · It is difficult to forecast earnings for next year, much less give a growth rate for the next 5 years. I use sell side estimates as an initial jumping off point.
• · Companies grow erratically.
• · The maturation of a company is rarely so linear.
• · The lengths of the first two phases are somewhat arbitrary, though the sell side typically does 5-year growth rates.
• · A 6% growth rate in maturity is consistent with long term nominal GDP growth, but it is still quite an assumption.
• · Payout rates and growth rates should be inversely correlated. To the extent that capital constrains business growth, a higher rate of dividend payout should result in a lower earnings growth rate.
• · The discount rate is difficult to calculate. Theoretically, it should be 2-3% percent higher than the highest yield on the longest, most subordinated debt or preferred of the company. If a company has no debt, compare it to the yields of bonds of other companies with similar put option implied volatility 20% or more out of the money. Then add 2-3% to those yields.
• · Payout rates and the discount rate should be negatively correlated. Companies with high payout rates will be judged to be less risky most of the time, and vice-versa.

All that said, the DDM is a model, and a richer model than the PEG ratio. My question became, “Are there conditions where the results of the DDM resemble a PEG ratio?” The answer to that is yes, when:

• The discount rate is 14% or lower
• At lower discount rates, only for higher P/Es. For example at a discount rate of 8%, the PEG ratio works for P/Es 16 and higher.

Now I oversimplified my conclusions here. Look at this graphic:

Or, based off of that, consider this graph, which shows the PEG hurdle rates as a function of initial P/Es. and cost of capital (discount) rates:

How did I come to this result? For differing levels of the discount rate, I varied P/E levels, calculating the initial phase growth rate that would make price equal to value in the DDM. Those P/E and growth levels gave me the PEG ratios. Those PEG ratios were often quite flat for higher P/Es at a given level of the discount rate of 14% or below. There is usually a bit of a smile or smirk, but you can see an average level.

At 16% or higher levels of the discount rate, the PEG ratio falls apart. At low levels of P/E the required PEG ratio should be low. At high levels of P/E, the required PEG ratio can be higher. The intuition here is that situations with high discount rates, and thus high risk, require high growth to fuel value in a DDM calculation.

At low discount rates, and low P/Es, the DDM says that value investors don’t need much growth at all in order to buy good values. If one considers the inverse of the P/E, the E/P, or earnings yield, when it is greater than the discount rate, it is hard to lose money, even when earnings don’t grow. Even more so when the dividend yield exceeds or is near the discount rate.

A Formula for the PEG Ratio Hurdle

Taking the average PEG hurdle rates for P/Es 16 and above, where price equaled DDM Value, for various discount and payout rates, I calculated a regression to give a more general PEG hurdle rate formula. The factors appeared multiplicative, so I used a formula that looked like this:

ln ( average PEG hurdle) = a + b * ln(discount rate) + c * ln(payout rate) + e (error term)

The regression had an adjusted R-squared of 98%, with all coefficients statistically significant at prob-values of 99% or better. a was 7.8646, b was -1.3169 and c was .0752. In summary form, the formula looks like this:

Average PEG hurdle = 26.03 * discount rate^-1.3169 * payout rate^0.0752

Pretty good, but after a little while, I asked if I could create a formula that better represented the curves in graph 2. So, I ran the following regression:

ln (PEG hurdle) = a + b * ln(discount rate) + c * ln(payout rate) + d * ln(P/E) + e (error term)

I had a debate as to how to censor the data. I threw out data points with negative PEG hurdles in the first analysis. In the second one, I threw out negative PEG hurdles, and PEG hurdles over 2.0x. On the second analysis, my reasoning was that if PEG hurdles over 2.0 are acceptable, we’re in weird times. Now perhaps that pre-judges the situation, but the right functional form for graph 2 eludes me here. Personally, I would use the second formula here:

Formula 1: Average PEG hurdle = 0.01823 * discount rate^-1.6279 * payout rate^0.1039 * PE Ratio^0.1893

Formula 2: Average PEG hurdle = 0.02035 * discount rate^-1.4215 * payout rate^0.0941 * PE Ratio^0.2704

Formula 1 has an R-squared of 76%, and with 2 it is 88%. The t-statistics are all significant at 99% levels.

Now, suppose I am a growth investor and I decide to apply formula 2. I look for stocks with PE ratios of around 20, my discount rate is 15%, and the dividend payout rate is around 10%. What annual earnings growth should I be looking for over the next 5 years? The formula says 36.6%. Pretty aggressive. At a discount rate of 12%, the growth rate drops to 26.6%.

What this points out in a way is the difficulty of making consistent money in growth stocks. The earnings growth rates needed to make money in excess of the discount rate on average over time is higher than most growth investors realize.

Growth investors overpay for growth. That is one of the reasons that I am a value investor.

One final note: Jim Cramer has a limit for what he is willing to pay for growth stocks – a PEG ratio of 2.0x. Now, he’s a bright guy, so there are two ways that I can interpret this. 1) Since momentum plays a large role in Cramer’s investing, the 2.0x ceiling limits his risk while he plays momentum. Or, 2) he has longer periods of competitive advantage and transition than I do. I favor the first interpretation, because it is rare in my opinion that growth investors should pay over 1.5 times the growth rate for any investment, unless the barriers to entry are significant.

Summary

PEG ratios work for core and growth investors, but the PEG ratio hurdles needed for investment are lower than most investors think, so long as the expected rate of return (discount rate) is high.  As for me, I will stick with value investing, where the need for earnings growth is negligible.

With apologies to Mr. Krugman, I must correct some of what I wrote in my piece, “Pushing on a String? Credit Marches to its Own Drummer.“  When one does statistical analyses, one needs to understand the limitations/features of the tools that one uses.  Bloomberg’s regression function had a funny default that led me to make an error.  Had I done it right, the R-squared over the full sample period would have been 64.8% (correlation 80.5%), with a beta of 0.614.  Lagging the Fed funds target by one year, roughly the time it takes Fed policy to work boosted the R-squared to 77.2% (correlation 87.9%), with a beta of 67.1%.

But, here ’s what is unusual.  If one is looking at the last five years, the relationship has broken down.  During that period, with no lag, the R-squared was 11.2% (correlation 33.5%), with a beta of negative 13.0%.  Even with the lag, the R-squared was 3.8% (correlation 19.4%), with a beta of negative 3.7%.

My conclusion: given the unusual credit conditions in the 2000s, where we have had extremes of default and monetary policy, I would not rush to say that the Fed is pushing on a string, yet.  That said, the debts of financial companies are a larger part of the index than they were five of ten years ago, and they are the ones in trouble at present, unlike the prior difficulties in industrials and utilities in 2001-2003.  Because of that, the Baa index of Moody’s may lag longer than ordinary versus Fed funds… but Fed policy has been called impotent before, and usually just before it shows its bite, as in the tech bubble of 2000, or the liquidity rally of spring 2003.

To my readers: if you see something that might be amiss in my writings, post a comment.  I owe it to all of you that I post corrections when I make mistakes.  Thanks for bearing with me on this one.  In the original piece, I sounded more certain than I should have, to my detriment…

Thanks to Naked Capitalism for pointing out this post by Paul Krugman. Here was my response:

Mr. Krugman, do your homework. Extend the graph out to five years, and you will see that yields on Baa bonds fluctuated between 7.1% and 5.7% over that time period. The correlation between Fed funds and Moody’s Baa series was pretty small during that time period, whether the fed funds rate was rising or falling. I just calculated the R-squared on the regression — 0.1%, for a 3.2% correlation.

Maybe it’s just a bad time period, so I ran it back to 1971, which was as far as my Bloomberg terminal would let me go. (Maybe I’ll go to FRED and download longer series, and use Excel, but I don’t think the result will be much different — the R-squared was 6.5%, for a correlation coefficient of 25.5%. Not a close relationship in my book for two time series relationships that are both interest rates.

Practical economists like me are aware that credit-sensitive investments often have little practical relationship to Fed funds. We work in the trenches of the bond market, not the isolation of academic economics, where you don’t contaminate your theories with data.

The Fed may or may not be pushing on a string, but you have certainly not proven your case.

-=-=-=-=-

Here’s the graph for the Fed funds rate and Moody’s Baa yield series since 1971. (When I ran my calculations, I used monthly, but could only get the graph back to 1971 if I went to quarterly.

(graph: Bloomberg)

As I said, not much of a correlation, but why so low?  This is related to a topic on which Bill Rempel has asked me for an article.  (To do that article, I have to drag a lot of yield data off of Bloomberg for analysis; I will be getting my full subscription soon, and once that happens, I can start.)

As an investment actuary, I’ve had to develop models of the full  maturity/credit yield curve — maturities from 3 months to 30 years (usually about 10 points) and credit from Treasuries, Agencies and Swaps to Corporates, AAA to Single-B.  A Treasury yield curve at any point in time can be fairly expressed by a four factor model, and the R-squared is usually around 99%.  (I learned this in 1991, and there is a funny story around how I learned this, involving a younger David and a Bear Stearns managing director.)

The short end of the Treasury yield curve is usually far more volatile than the long end in yield terms (but not in price terms!).  All short high-quality rates are tightly correlated, and that includes Fed funds, Agency discount notes, T-bills, LIBOR (well, usually), A-1/P-1 commercial paper, etc.  As one goes further down the yield curve in maturity, the correlations weaken, but still remain pretty tight among bonds rated single-A or better.  (As a further note, Fed funds and 30-year Treasury yields also don’t correlate well.)

Credit is its own factor, which varies with expectations of the economy’s future prospects.  A single-B, or CCC borrower can only repay with ease if the economy does well.  If prospects are looking worse, no matter what the Fed does to short high-quality rates, junk grade securities will tend to rise in yield.  Marginal investment grade securities (BBB/Baa) will tread water, and short high-quality bond yields will correlate well with Fed funds.

When I say “credit is its own factor,” what I am saying is that outside of Treasury securities, every credit instrument participates to varying degrees in exposure to the future prospects of the economy.  (Credit in its purest form behaves like equity returns.)  For conservatively capitalized enterprises with high quality balance sheets, their credit spreads don’t change much as prospects change for the economy.  For entities with low quality balance sheets, their spreads change a lot as prospects change for the economy.

So, for two reasons, Mr. Krugman should not have expected the Fed funds target rate and the Moody’s Baa yield to correlate well:

1. Fed funds is a short rate, and Moody’s Baa is relatively long (bonds go over the full maturity spectrum).
2. Fed funds correlates well with the highest quality yields, and Baa is only marginally investment grade.  Recessions should hurt Baa spreads, leaving yields relatively constant.

There are many things that are unusual about the current Treasury yield curve. I’ve built a moderately-sized model to analyze the shape of the curve, and what it might tell us about the state of the economy, and perhaps, future movements of the yield curve. My model uses the smoothed data from the Federal Reserve H15 series, which dates as far back as 1962, though some series, like the 30-year, date back to 1977, and have an interruption from 2002-2005, after the 30-year ceased to be issued for a time.

So, what’s unusual about the current yield curve?

1. The slope of six months to three months (19 bp) is very inverted — a first percentile phenomenon.
2. The slope of two years to three months (38 bp) is very inverted — a third percentile phenomenon.
3. The slope of seven years to ten years is steep (57 bp - 5 bp away from the record wide) — a 100th percentile phenomenon.
4. The slope of five years to thirty years is steep (186 bp - 30 bp away from the record wide) — a 100th percentile phenomenon.
5. The slope of two years to thirty years is steep (274 bp - 97 bp away from the record wide) — a 97th percentile phenomenon.
6. The slope of ten years to thirty years is steep (82 bp - 29 bp away from the record wide) — a 98th percentile phenomenon.
7. The butterfly of three months to two years to thirty years is at the record wide (312 bp). (Sum of #5 and #2. Buy 3 months and 30-years, and double sell 2-years? Lots of positive carry, but the 30-year yield could steepen further versus the rest of the curve, and its price volatility is much higher than the shorter bonds.)

What prior yield curves is the current yield curve shaped like?

• 9/7/1993 — after the end of the 1990-1992 easing cycle to rescue the banks from their commercial real estate loans.
• 2/15/1996 — after the end of a minor easing cycle, recovering from the 1994 “annus horribilis” for bonds.
• 9/14/2001 — 60% through the massive easing cycle where Greenspan overshot Fed policy in an effort to reliquefy the economy, particularly industrial companies that were in trouble. Also days after 9/11, when the Fed promised whatever liquidity the market might need to stave off the crisis.

Okay, I’ve set the stage. What conclusions might we draw from the current shape of the yield curve?

1. The curve is forecasting a 2% Fed funds rate in 2008.
2. Fed policy is adequate at present to reliquefy the economy; the Fed doesn’t need to ease more, but it will anyway. Political pressure will make that inevitable. (If we really want an independent central bank, let’s eliminate the pressure oversight that Congress has over the Fed. Better, let’s go back to a gold standard; a truly private monetary policy. Oh, wait. I’m behind the times. We don’t want an independent central bank. Dos that mean we can now blame Congress for monetary policy errors?)
3. We could see a record slope for the yield curve (in the post Bretton Woods era) if the Fed persists in its easing policies.
4. One can sell sevens and buy tens, dollar-duration-weighted and have positive carry. Assuming one can hold onto the position, it would be hard to lose at these levels, if the last thirty years of history is an adequate guide to the full range of possibilities.
5. The Fed is planting the seeds of its next tightening cycle now. Every cut from here will make the tightening cycle that much more intense.
6. The curve can get steeper from here, but it is getting close to the boundaries where strange things begin to happen. The Fed is not omnipotent, and the steepening curve is evidence of that.
7. As I have said before, recently, the US Dollar is no longer a “sell” for now. The anticipation of Fed funds cuts is already factored in, and even if we get down to 2%, I suspect that we can’t go much lower because of negative real interest rates and rising inflation.

That’s where I stand for now. The Fed is trying to rescue the economy from asset deflation, much like 1990-1992, but will run into the buzzsaw of price inflation, and tighten a la 1994. Conditions in the real economy are not as weak today as they were in 2001, but the banks are in worse shape. That will drive further loosening by the Fed, until inflation is intolerable. (more…)

I’m just trying to clean up old topics, so bear with me:

1) This blog is not ending because of my new job. Finacorp wants me to keep it going, and they may use the posts in PDF form for clients. Also, unlike my prior employer, Finacorp wants me to have a high degree of exposure, because it aids them. You may see me in more venues, which could include TV and radio.

2) In one sense, I had an unusually productive Saturday. I built two models — one for a critique of the PEG ratio, and one for a model of the Treasury yield curve. You will see articles on both of these, and I am really jazzed on both of them. It is not often that I get one impressive result in a day. Today I got two. I’ll give you one practical upshot for now, if you are an institutional bond investor: go long 10-year Treasuries and short 7-year. We are very near the historical wides. If you are like me, and can live with negative carry, dollar duration-weight the trade, so that you are immune to parallel yield curve shifts.

3) I didn’t read Barron’s, Forbes, or The Economist today, but I did read the Financial Analysts Journal. In it there were three articles that are worth a comment. There was an interesting article on fundamental indexation that comes close to my view on the topic. Fundamental indexation, when properly done, is nothing more than enhanced indexing with a value tilt. Will it make you more money than an ordinary index fund? Yes, it will, over a long enough period of time. Will it work every year? No. Is there one optimal way to fundamentally index? No. There is no one cofactor, or set of cofactors that optimally define value, if for no other reason than the accounting rules keep changing.

4) The second article went over the value of immediate annuities as risk reducers to retirees, something I commented on recently. The tweak here is buying annuities that start paying later in retirement, for example at 80 or 85, with the risk that if you die before then, you get nothing. Longevity insurance; a very good concept, but the execution is tough.

5) The third article was on Risk Management for Event-Driven Funds. Here’s my take: risk arb is like being a high yield bond manager. Anytime a deal is announced, you have to do a credit risk analysis:

• How likely is it that this deal will go through?
• How badly could I be hurt if it does not go through?
• Am I getting paid more than a junk bond with equivalent risk?

But the portfolio manager must ask some more questions:

• Are there any common factors in my risk arb book that could bite me? Sectors? Need for debt finance?
• What if deal financing terms go awry all at the same time? How will that affect the worst risks in my book?
• Am I getting paid more than a junk bond with equivalent risk? (Okay, it’s a repeat, but it deserves it.)

Risk arbs have been burned lately, with all of the deals that have been busted because financing is not available on easy terms. It’s tough but this happens. Most easy arbs tend to get overplayed before blowups happen. The lure of easy money brings out the worst in people, even institutional investors.

6) Naked Capitalism had an interesting post on GM. I made the following comment:

I took some criticism at RealMoney.com for writing things like this about GM, though the author here was a much better writer.

The thing is, there are enough levers here that GM can keep the debt ball in the air for some time, as can many of the financial guarantors, so long as they can make their interest payments.

The “Big 3″ lose vitality vs. Toyota and Honda each year — in the long run GM and Ford don’t make it. Perhaps after they go through bankruptcy, and shed liabilities to the PBGC, and issue new equity to the current unsecured bondholders, they can exist as smaller companies that have focus. Maybe Ford could be a division of Magna, and GM a division of Johnson Controls. At least then there would be competent management.

7) Barry Ritholtz had a good post called, 5 Historical Economic Crises and the U.S. The paper he cited went into five recent crises in the developed world, and how the current US situation stacks up against that.  Here was my comment on one of the areas where the US situation did not seem so dire, that of the run-up in government debt:

On the last point about the increase in the debt, what is missed is that a lot of the government debt increase is hidden by the non-marketable Treasury bonds held by the entitlement programs. Add that in, and consider the unfunded promises made at the Federal, State, and municipal levels, and the debt increase on an accrual basis is staggering.

We do face real risks here.  The rest of the world will not finance us in our own currency forever.  Oh, one critical difference between the US and the 5 crises — we are the worlds reserve currency, for now.

8 )  I like Egan-Jones on corporate debt.  They have quantitative models that follow contingent claims theory, and use market based factors to estimate likelihood and severity of default.  They are now trying to do models for asset backed securities.  Very different from what they are currently doing, and their corporate models will be no help.  They will also find difficulties in getting the data, and few market-based signals that inform their corporate models.  I wish them well, but they are entering a new line of business for which they have no existing tools to help them.

9) This article from Naked Capitalism pokes at the rating agencies, and the proposed reforms from the SEC.  My view is this: the financial regulators need a model on credit risk.  They need a common platform for all credit risks.  They need one set of ratings that allow them to set capital levels for the institutions that they regulate, or they need to bar investments that cannot be rated adequately.  The problem is not the rating agencies but the regulators.  How do they properly set capital levels.  They either have to use the rating agencies, or build internal ratings themselves.  Given my experiences with the NAIC SVO, it is much better to use the rating agencies.  They are more competent.

10)  Finally, on Friday, a UBS report stirred the pot regarding non-borrowed reserves.  You can see the H.3 report here. Both Caroline Baum of Bloomberg and Real Time Economics debunked the UBS piece.  But it was simpler than that.  The Fed published its own explanation at the time they put out the H.3 report.  UBS did not include the effect of the new TAF.  Whoops.  Oh well, I make mistakes also.  It’s just better to make mistakes when one doesn’t sound so certain.
Full disclosure: long MGA, HMC

The Financial Guarantors are receiving a lot of attention these days, and for good reason.  I want to offer a few observations to give my own take on the problem:

1) With structured finance, the initial choice is “Do we ask a financial guarantor to bring the credit up to AAA, or do we do it through a senior-subordinate structure?”  A senior-subordinate structure has classes of lenders with differing rights to payment.  The AAA, or, senior lenders only take losses after the subordinate lenders (who are receiving higher yields) have lost all of their money.  In the present environment, S&P and Moody’s have been downgrading subordinates, and even some senior bonds in senior-sub structures.

This should lead to downgrades of MBIA and Ambac, eventually.  The rating agencies can’t keep downgrading bonds that are similar to those guaranteed by MBIA and Ambac, without downgrading them as well.  Remember, MBIA and Ambac were late to the party; their bonds are disproportionately weak because later lending standards were weaker.

2) The main difficulty with a bailout of the guarantors is that most interested parties have different interests.  That said, the beauty of a bailout is that the guarantor can sit back and pay timely principal and interest, while waiting for better times to come.

3) Did the rating agencies force the guarantors into the CDO business?  I’ve heard rumors to this effect, but it would be pretty easy to prove or disprove.  Look at when MBIA and Ambac entered the business, and look at the commentary from the rating agencies around it; if they are trumpeting diversification, then it is likely that they pitched it to the guarantors.  If not, then the guarantors did it on their own.

4) Even in a bailout of financial guarantors, current shareholders may find themselves diluted beyond measure.  Given current political pressures, those risks are elevated; remember that management teams want to keep their jobs, and that regulators have some say in that.

5) As I noted today at RealMoney:

		David Merkel
		Considering the “Margin of Safety”
		2/5/2008 11:07 AM EST

Tim, I like your stuff, since I am a value investor. Be careful with XL Capital. The challenge is estimating what sort of guarantees they face from Security Capital Assurance. When I looked at them last, the potential payments could be huge — potentially larger than XL’s net worth, but hey, that’s the financial guarantee business. I looked at XL during my last portfolio reshaping — Finish Line also, and could not get past the potential risks. I had easier plays to go for, with less uncertainty, if also lower upside. I don’t try to hit home runs, so it makes it easier for me to not buy the stocks that are optically stupid cheap, but might have balance sheet issues. Cheap means that a company will have the capability to carry their positions through a downturn; it’s part of the “margin of safety” that we require.

Anyway, keep it up, and let’s see if we can’t make some money on our value investing.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance and Finish Line to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

 XL was downgraded recently as a result of those guarantees.  I would be cautious here.

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Summary: there is still downside risk here.  Avoid the financial guarantors, and economic areas affected by the overleveraging of our credit markets.   Stick with companies that have strong balance sheets.

I wrote at RealMoney.com today:

		David Merkel
		What Would Make More Sense to Me, Redux
		2/1/2008 10:14 AM EST

Nine months ago, I wrote this: Microsoft and Yahoo! are in several different businesses with modest synergies between them. Buried inside such a merger would be (at least):

Going back to our discussion of GE earlier this week, Microsoft does not need more businesses in its portfolio. It needs to focus its activities on what it does best. Same for Yahoo! but their problems are less severe unless they do this merger.

If I were Microsoft, I would accept defeat, and sell all web properties to Yahoo! If I were Yahoo!, I would spin off all content production in a new company to shareholders. You would end up with three focused companies that would be able to hit their markets with precision, in a business where scale matters inside your market, but not across markets. The ending configuration would be:

This to me would be rational, but corporate cash gets spent by self-aggrandizing folks with egos, so this is not likely to happen in the short run. But I think the eventual economic outcome will resemble something like this.

Microsoft has not shown a lot of competence in the areas that Yahoo! has focused on, and because of their long history of growth, I’m not sure they get how to run a company that is transisting into maturity. I would be bearish on the total concept.

The market has awarded an additional $3.7 billion to the combined valuations on Microsoft and Yahoo! off of this news. After some time, that premium should reverse, and it will come out of the valuation of Microsoft. But then, I only play in tech when it is trashed, so what do I know?

Position: none

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By the end of the day, that initial valuation premium of $3.7 billion turned into a deficit of $1.2 billion, and that was against a rising market. I’m not that kind of trader, but some deals make sense, and some don’t. When you find one that doesn’t make sense, and the market value of the package rises, one can short both the acquirer and the target, and wait for rationality to arrive.

That’s not to say that all deals are bad. Value can be added through synergies or improved management, or unlocked through expense savings and more leverage. Microsoft-Yahoo is unlikely to fit any of those descriptions in any major way.