Category: Quantitative Methods

On Benchmarking

On Benchmarking

Posted on by David Merkel

Sorry for not posting yesterday, there were a number of personal and business issues that I had to deal with.

Sometimes I write a post like my recent one on Warren Buffett, and when I click the “publish” button, I wonder whether it will come back to bite me. Other times, I click the publish button, and I think, “No one will think that much about that one.” That’s kind of what I felt about, “If This Is Failure, I Like It.” So it attracts a lot of comments, and what I thought was a more controversial post on Buffett attracts zero.

As a retailer might say, “The customer is always right.”? Ergo, the commenters are always right, at least in terms of what they want to read about.? So, tonight I write about benchmarking.? (Note this timely article on the topic from Abnormal Returns.)

I’m not a big fan of benchmarking.? The idea behind a benchmark is one of three things:

  1. A description of the non-controllable aspects of what a manager does.? It reflects the universe of securities that a manager might choose from, and the manager’s job is to choose the best securities in that universe.
  2. A description of the non-controllable aspects of what an investor wants for a single asset class or style.? It reflects the universe of securities that describe expected performance if bought as an index, and the manager’s job is to choose the best securities that can beat that index.
  3. A description of what an investor wants, in a total asset allocation framework.? It reflects the risk-return tradeoff of the investor.? The manager must find the best way to meet that need, using asset allocation and security selection.

When I was at Provident Mutual, we chose managers for our multiple manager products, and we would evaluate them against the benchmarks that we mutually felt comfortable with.? The trouble was when a manager would see a security that he found attractive that did not correlate well with the benchmark index.? Should he buy it?? Often they would not, for fear of “mistracking” versus the index.

Though many managers will say that the benchmark reflects their circle of competence, and they do well within those bounds, my view is that it is better to loosen the constraints on managers with good investment processes, and simply tell them that you are looking for good returns over a full cycle.? Good returns would be what the market as a whole delivers, plus a margin, over a longer period of time; that might be as much as 5-7 years.? (Pity Bill Miller, whose 5-year track record is now behind the S&P 500.? Watch the assets leave Legg Mason.)

My approach to choosing a manager relies more on analyzing qualitative processes, and then looking at returns to see that the reasons that they cited would lead to good performance actually did so in practice.

Benchmarking is kind of like Heisenberg’s Uncertainty Principle, in that the act of measurement changes the behavior of what is measured.? The greater the frequency of measurement, the more index-like performance becomes.? The less tolerance for underperformance, the more index-like performance becomes.

To the extent that a manager has genuine skill, you don’t want to constrain them.? Who would want to constrain Warren Buffett, Kenneth Heebner, Marty Whitman, Michael Price, John Templeton, John Neff, or Ron Muhlenkamp? I wouldn’t.? Give them the money, and check back in five years.? (The list is illustrative, I can think of more…)

What does that mean for me, though?? The first thing is that I am not for everybody.? I will underperform the broad market, whether measured by the S&P 500 or the Wilshire 5000, in many periods.? Over a long period of time, I believe that I will beat those benchmarks.? Since they are common benchmarks, and a lot of money is run against them, that is a good place to be if one is a manager.? I think I will beat those broad benchmarks for several reasons:

  • Value tends to win in the long haul.
  • By not limiting picks to a given size range, there is a better likelihood of finding cheap stocks.
  • By not limiting picks to the US, I can find chedaper stocks that might outperform.
  • By rebalancing, I pick up incremental returns.
  • Industry analysis aids in finding companies that can outperform.
  • Avoiding companies with accounting issues allows for fewer big losses.
  • Disciplined buying and selling enhances the economic value of the portfolio, which will be realized over time.
  • I think I can pick good companies as well.

I view the structural parts of my deviation versus the broad market as being factors that will help me over the long haul.? In the short-term, I live with underperformance.? Tactically, stock picking should help me do better in all environments.

That’s why I measure myself versus broad market benchmarks, even though I invest more like a midcap value manager.? Midcap value should beat the market over time, and clients that use me should be prepared for periods of adverse deviation, en route to better returns over the long haul.

Tickers mentioned: LM

Options as an Asset Class

Options as an Asset Class

Posted on by David Merkel

Well, my CDO model is complete for a first pass. There is still more work to do. Imagine buying a security that you thought would mature in ten years, but two years into the deal, you find that the security will mature in twenty years from then, though paying off principal in full, most likely. Worse, the market has panicked, and the security you bought with a 6.5% yield is now getting discounted at a mid-teens interest rate. Cut to the chase: that is priced at 40 cents per dollar of par. Such is the mess in some CDOs today.

Onto the topic of the night. There have been a number of articles on volatility as an asset class, but I am going to take a different approach to the topic. Bond managers experience volatility up close and personal. Why?

  • Corporate bonds are short an option to default, where the equity owners give the company to the bondholders.
  • Mortgage bonds are short a refinancing option. Volatile mortgage rates generally harm the value of mortgage bonds.
  • Even nominal government bonds are short an inflation option, should the government devalue the currency. (Or, for inflation-adjusted notes, fuddle with the inflation calculation.)

Why would a bond investor accept being short options? Because he is a glutton for punishment? Rather, because he gets more yield in the short run, at the cost of potential capital losses in the longer-term.

Most of the “volatility as an asset class” discussion avoids bonds. Instead, it focuses on variance swaps and equity options. Well, at least there you might get paid for writing the options. Bond investors might do better to invest in government securities, and make the spread by writing out-of-the-money options on a stock, rather than buying the corporate debt.

I’m not sure how well futures trading on the VIX works. If I were structuring volatility futures contracts, I would create a genuine deliverable, where one could take delivery of a three month at-the-money straddle. Delta-neutral — all that gets priced is volatility.

Here’s my main point. Volatility is not an asset class. Options are an asset class. Or, options expand other asset classes, whether bonds, equities, or commodities. Whether through options or variance swaps, if volatility is sold, the reward is more income in the short run, at the cost of possible capital losses in asset classes one is forced to buy or sell at disadvantageous prices later.

Over the long term, in equities, unlike bonds, being short options has been a winning strategy, if consistently applied. (And one might need an iron gut to do it.) But when many apply this strategy, the excess returns will dry up, at least until discouragement sets in, and the trade is abandoned. For an example, this has happened in risk arbitrage, where investors are short an option for the acquirer to walk away. For a long time, it was a winning strategy, until too much money pursued it. At the peak you could make more money investing in Single-A bonds. Eventually, breakups occurred, and arbs lost money. Money left risk arbitrage, and now returns are more reasonable for the arbs that remain.

Most simple arbitrages are short an option somewhere. That’s the risk of the arbitrage. With equities, being perpetually short options is a difficult emotional place to be. You can comfort yourself with the statistics of how well it has worked in the past, but there will always be the nagging doubt that this time it will be different. And, if enough players take that side of the trade, it will be different.

Like any other strategy, options as an asset class has merit, but there is a limit to the size of the trade that can be done in aggregate. Once enough players pursue the idea, the excess returns will vanish, leaving behind a market with more actual volatility for the rest of us to navigate.

Book Review: What Works on Wall Street

Book Review: What Works on Wall Street

Posted on by David Merkel

This book was really popular in 1996, when it was published. James O’Shaughnessy gained access to the S&P Compustat database, and tested a wide variety of investment strategies to see which ones worked the best over a 43-year period. Unlike most books I will review at my site, this one does not get wholehearted approval from me. My background in econometrics makes me skeptical of some of the conclusions drawn by the book. There are several valuable things to learn from the book, which I will mention later; whether they justify purchase of the book is up to the reader.

My first problem is the title of the book. It should have been titled “What Has Worked on Wall Street.” Many analyses of history suffer from the time period analyzed. The author only had access to data from a fairly bullish period. Had he been able to analyze a full cycle that included the Great Depression, he might have come to different conclusions.

My second problem is that he tests a number of strategies that should yield similar results. One of them will end up the best — the one that happened to fit the curiosities of history that are unlikely to repeat. (That’s one reason why I use a blend of value metrics when I do stock selection. I can’t tell which one will work the best.) The one that works the best just happens to be the victor of a large data-mining exercise. Also, when you test so many strategies, and possibly some that did not make it into the book, the odds that the best strategy was best due to a fluke of history rises.
Now, what I liked about the book:

  1. Combining growth and value strategies produced the best risk-adjusted returns. The growth and value strategies that did the best embedded a little value inside growth, and a little growth inside value.
  2. Avoiding risk pays off in the long run, for the most part. If nothing else, one can maintain the strategy after bad years.
  3. Value and Momentum both work as strategies. They work best together.
  4. He did try to be statistically fair, avoiding look-ahead bias, diversifiying into 50 stocks, avoiding small stocks, and rebalancing annually.

Now, two mutual funds based on his “cornerstone growth” and “cornerstone value” strategies have run since the publication of the book. The value strategy has not worked, while the growth strategy has worked. Go figure, and it may reverse over the next ten years.

Now for those that like data-mining, and don’t want to pay anything, review Tweedy, Browne’s What Has Worked in Investing. This goes through the main factors that have worked also. Theirs are:

  1. Low P/B
  2. Low P/E
  3. Net Insider Buying
  4. Significant Declines in the Stock Price (anti-momentum)
  5. Small Market Capitalization

Either way, pay attention to value factors, and if you trade often, use momentum. If you don’t trade often, avoid momentum.

Getting Closer to a Bounce

Getting Closer to a Bounce

Posted on by David Merkel

Over at RealMoney.com, Jim Cramer occasionally talks about the “oscillator” during times of market stress.? Well, I will offer you my guess at what the oscillator is: a 10-day moving average of NYSE & Nasdaq up volume, less NYSE & Nasdaq down volume.? When that figure gets too high, the market is short term overbought, and when that figure gets too low, the market is short term oversold.? We are close to that oversold level now.

That doesn’t mean that the market is a long-term buy, but that sellers are getting short-term tired.? As the market has fallen, my own cash position has shrunk from 17% of assets to 11% of assets.? I have added gradually to out-of-favor positions, and will add more if the market declines further.

Miscellaneous note: some readers asked what relative strength figure I use.? Typically, I use 14-day RSI.? Why?? It’s the default on Bloomberg.

Industry Ranks October 2007

Industry Ranks October 2007

Posted on by David Merkel

Here are my Industry Ranks October 2007 for the current portfolio reshaping.? Remember that my ranks can be used two ways.? If you are a value guy like me, you pick from the bottom quartile, the green zone, for out-of-favor industries.? I further filter that by striking out industries that in my subjective opinion, still have more pain to take.? That’s why housing, housing finance, and housing related names are absent.

If you are a growth or momentum player, pick from the top of the list, because in the short run, momentum tends to persist.? In the intermediate term momentum tends to mean revert.? I play for the latter of those two momentum effects, because I am not much of a trader, and I think the effect is more reliable, and tax-effective.

Later today, I’ll post my final list of additions to the candidates list for the portfolio reshaping, after running an industry screen.? Then over the next three days, I’ll get to work on the reshaping.

Ten Years From Now

Ten Years From Now

Posted on by David Merkel

Recently Bill Rempel posed the following question to me:

Could you compare the total return of a 10-yr Treasury bought fresh and new anywhere from 1976-1980, and held to maturity (sending the coupons to cash) — to the total return from an equal-sized basket of stocks or residential real estate over the same time period? Please use “risk-adjusted returns” in the previous comment, re: returns on bonds. As a non-institutional investor who doesn’t care as much about the “mark to model” on any bonds I would hold, I would view double-digit Treasuries as free money, especially in light of long-term returns on stocks barely cracking the DD with divvies included …

He also made this recent post to further elucidate his views. So, let’s do a thought experiment. Suppose you knew where real interest rates and inflation would be ten years from now. How would that affect your investment policy?

The easy answer would be that you would know what to do with bonds. After all if rates are higher in the future, you would shorten your bond holdings to preserve your capital, and vice-versa if rates were lower.

But what do you do with your stocks? How is their performance impacted by future real interest rates and inflation rates? Before I answer that, let’s consider the difference between the yield of a bond, and its realized return from reinvesting the coupons. The following graph shows the coupon rate on a ten year Treasury note, and the realized return from investing the coupons at money market rates until the bond matured. The realized return is higher than the coupon when the average money market rate was higher than the coupon, and vice versa. But the difference is rarely very large. Most bond income comes from coupons.
Slide 1

Now, let’s consider how the ten year Treasury yield, inflation and real rates have varied over my study period, 1954-1997.

Slide 2

And look at how the ten year Treasury yield, the real rate of interest, and the inflation rate would change over the next ten years.
slide 3

Looking at these graphs, you can guess that future equity returns are affected by changes in inflation and real interest rates, but here’s proof:

Slide 4

Or, another way of looking at it, future equity returns depend on future real interest rates and inflation rates. Note that bonds only beat stocks for ten-year investments beginning during the period 1964-1973, and not all of the time even then.
Slide 5

I ran a regression on the difference between ten-year stock returns and ten-year realized Treasury note returns, with the regressors being the current inflation and real interest rate, and the inflation and real interest rates 10 years from then. The R-squared was 57% (good in my opinion), and the coefficients were:

  • Current inflation: +22%
  • Current real interest rate: -12%
  • Inflation 10 years from then: -121%
  • Real interest rates 10 years from then: -46%

There was some autocorrelation of the residuals, indicating that periods of under- and out-performance of equities over bonds tends to persist:

Slide 6

All were statistically significant at a 95% two-sided level. What the regression tells us is that of the four variables considered, the most important one is future inflation rates. If future inflation rises, the value of future cash flow declines. It gets even worse if the Federal Reserve tries to squeeze out inflation by raising real interest rates high enough to overcome the inflation. Oddly, higher current inflation is a modest plus — maybe that indicates pricing power? Perhaps it is useful to think of equities as ultra-long bonds, with rising coupons. Rising rates would hurt those considerably.

 

Upshots

  1. Note that it was a bullish period, and that stocks did not lose nominal money over a ten-year period to any appreciable extent.
  2. Stocks almost always beat bonds over a ten-year period, except when inflation and real interest rates 10 years from now are high.
  3. Investing in stocks during low interest rate environments can be hazardous to your wealth.
  4. Watch for inflation pressures to protect your portfolio. Stocks get hurt worse than bonds from rising inflation.
  5. Inflation and real rate cycles tend to persist, so when you see a change, be willing to act. Buy stocks when inflation is cresting, and buy short-term bonds when inflation is rising.
The Longer View, Part 5

The Longer View, Part 5

Posted on by David Merkel

There’s no order to this post, so enjoy my reflections on broader trends that are affecting the markets.

  1. Corn-based ethanol is costly, and a mistake for our government to subsidize it, when we could buy sugar-based ethanol from Brazil. I’m no environmentalist, but even I can see the advantages of eliminating sugar subsidies and quotas here in the US. The only people hurt are some rich farmers that bribe Washington to keep the subsidies. With a little encouragement from the US, Brazil could adopt more environmentally friendly harvesting techniques, while not kicking up costs that much. Such a deal, better economics, and better for the environment.
  2. Stories like this always make me skeptical. Remember cold fusion? Maye there is a real innovation here that produces more energy than it consumes on net. I wouldn’t bet on it, though.
  3. Since the creation of the Earth, farming has been the dominant occupation of man, until now. More people are employed outside of farming, than inside it. This is not big news, except to confirm that what happened to the developed world 80 years ago is happening to the world as a whole now.
  4. ETFs are not open end mutual funds, where there is one price struck per day for liquidity. For small ETFs, the bid-ask spread can be quite wide on small funds. This shouldn’t be too surprising; the same is true of any small stock. If there is demand for an ETF concept, more units will get created as people bid for them, and the bid-ask spread will narrow.
  5. Rationality in markets is misunderstood. You can bring bright people to manage money, and they will still in aggregate become prey to the speculative aspects of the markets. Some will resist it, but most won’t. It is not a question of intelligence, but of discipline.
  6. Give Hersh Shefrin some credit. I think that behavioral finance is a much richer explanation of the markets than modern portfolio theory. MPT exists because it is easily mathematically tractable, which allow professors to publish, and not because it is a correct description of reality.
  7. It’s tough to be an orphan company. Much as I like investing in companies that have no analyst coverage, if they are cheap enough, when a company loses analyst coverage, the stock price typically declines, and often, the company disappears within a few years. Perhaps the lack of analyst coverage is a proxy for the demand for a company to be public, rather than private.
  8. Here’s a good article on why the market crashed in October of 1987. My quick summary for why it happened was that bonds were more attractive relative to stocks, and dynamic hedging left the market unstable, as many player were willing to sell on big down days.
  9. Will junk defaults triple from 2007 to 2008? Seems reasonable to me; given all of the CCC and single-B issuance over the last few years, the companies that have recently issued bonds seem weak to me.
  10. Can Thompson-Reuters give Bloomberg a run for its money? My guess would be no. Bloomberg is a much richer system, and for those that need that level of complexity, that is where you can get it with great ease.

Enough for the evening. More to come tomorrow.

The Longer View, Part 4

The Longer View, Part 4

Posted on by David Merkel

In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

 

1) Asset Allocation

 

  • Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.? An article on the web reminded me of this debate.? The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.? Security selection matters.
  • Two interesting papers on asset class correlation.? Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.? Value tends to march to its own drummer more than other equity styles in a crisis.? The effects on correlation in crises vary by crisis; no two are alike.? Natural resources and globa bonds tend to be good diversifiers.
  • In bull markets, risky asset classes all tend to do well.? Vice-versa in the bear markets.? My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
  • There are a few good states, but by and large, public pensions are a morass.? Most are underfunded, and rely on future taxation increases to support them.? When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.? This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

 

2) Insurance

 

 

3) Investment Abuse of the Elderly

 

It’s all too common, I’m afraid.? Senior citizens get convinced to buy inappropriate investments.? Even the SEC is looking into it.? This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.? The comment that a CEO doesn’t fully understand his own annuity products is telling.

 

Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

 

The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

 

4) Accounting

 

  • I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.? What is FASB’s main goal in life — to destroy comparability of financial statements?? We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
  • Congress moves from one ditch to the other.? This time it’s sale of subprime loans.? Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.? Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
  • As I’ve said before, I don’t like SFAS 159.? It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

 

5) Volatility

 

  • Earn 40%/year from naked put selling?? Possible, but with a lot of tail risk.? I remember how a lot of naked put sellers got smashed back in October 1987.? That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
  • Here’s an interesting graph of the various VIX phases over the past 20 years.? Interesting how the phases are multiyear in nature.? Makes me think higher implied volatility is coming.
  • I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.? If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

 

That’s all for now.? More coming in the next part of this series.

The Longer View, Part 3

The Longer View, Part 3

Posted on by David Merkel
  1. August wasn’t all that bad of a month… so why were investors squealing? The volatility, I guess… since people hurt three times as much from losses as they feel good from gains, I suppose market-neutral high volatility will always leave people with perceived pain.
  2. Need a reason for optimism? Look at the insiders. They see more value at current levels.
  3. Need another good investor to follow? Consider Jean-Marie Eveillard. I’ve only met him once, and I can tell you that if you get the chance to hear him speak, jump at it. He is practically wise at a high level. It is a pity that Bill Miller wasn’t there that day; he could have learned a few things. Value investing involves a margin of safety; ignoring that is a recipe for underperformance.
  4. Call me a skeptic on 10-year P/E ratios. I think it’s more effective to look at a weighted average of past earnings, giving more weight to current earnings, and declining weights as one goes further into the past. It only makes sense; older data deserves lower weights, because business is constantly changing, and older data is less informative about future profitability, usually.
  5. I found these two posts on the VIX uncompelling. Simple comparisons of the VIX versus the market often lead to cloudy conclusions. I prefer what I wrote on the topic last month. When the S&P 500 is below the trendline, and the VIX is relatively high, it is usually a good time to buy stocks.
  6. What does a pension manager want? He wwants returns that allow him to beat the actuarial funding target over the lifetime of the pension liabilities. If long-term high quality bonds allowed him to do that, then he would buy them. Unfortunately, the yield is too low, so the concept of absolute return strategies becomes attractive. Well, after the upset of the past six weeks, that ardor is diminished. As I have said before, to the extent that hedge funds seek stable, above average returns, they engage in yield-seeking behavior which prospers as credit spreads and implied volatilities fall, and fail when they rise. Eventually pension managers will realize that hedge fund returns cannot provide returns over the full length of the pension liability, in the same way that you can’t invest more than a certain amount of the pension assets in junk bonds.
  7. Is productivity growth slowing? Probably. What may deserve more notice, is that we have larger cohorts entering the workforce for maybe the next ten years, and larger cohorts exiting as well, which will decrease overall productivity. Younger workers are less productive, middle-aged most productive, and older-aged in-between. With the Baby Boomers graying, productivity should fall in aggregate.
  8. This is just a good post on sector data from VIX and More. It’s worth looking at the websites listed.
  9. Economic weakness in the US doesn’t make oil prices fall? Perhaps it is because the US is important to the global economy, but not as important as it used to be. It’s not hard to see why: China and India are growing. Trade is growing outside of the US at a rapid pace. The US consumer is no longer the global consumer of last resort. Now we get to find out where the real resource shortages are, if the whole world is capitalist in one form or another.
  10. Calendar anomalies might be due to greater macroeconomic news flow? Neat idea, and it seems to fit with when we get the most negative data.
  11. Is investing a form of gambling? I get asked that question a lot, and my answer is in aggregate no, because the economy is a positive-sum game, but some investors do gamble as they invest, while others treat it like a business. Much depends on the attitude of the investor in question, including the time horizon and return goals that they have.
  12. Massachusetts vs. the laws of economics. Beyond the difficulty of what to do with expensive cohorts in a public insurance system, I’ve heard that they are having difficulties that will make the system untenable in the long run… most of which boil down to antiselection, and inability to fight the force of aging Baby Boomers.
  13. Rationality is one of those shibboleths that economists can’t abandon, or their mathematical models can’t be calculated. Bubbles are irrational, therefore they can’t happen. Welcome to the real world, gentlemen. People are limitedly rational, and often base their view of what is a good idea, off of what their neighbor thinks is a good idea, because it is a lot of work to think independently. Because it is a lot of work, people conserve on hard thinking, since it is a negative good. They maximize utility where utility includes not thinking too hard. Any surprise why we end up with bubbles? Groupthink is a lot easier than thinking for yourself, particularly when the crowd seems to be right.
  14. Is China like the US with 120 years of delay? No, China has access to better technology. No, China does not have the same sense of liberty and degree of tolerance of difference. Its culture is far more uniform from an ethnic point of view. It also does not have the same degree of unused resources as the US did in the 1880s. Their government is in principle totalitarian, and allows little true freedom of religious expression, which is critical to a healthy economy, because people work for more than money/goods, but to express themselves and their ideals.
  15. As I have stated before, prices are rising in China, and that is a big threat to global stability. China can’t continue to keep selling goods without receive goods back that their workers can buy.
  16. The US needs more skilled immigrants. Firms will keep looking for clever ways to get them into the US, if the functions can’t be outsourced abroad.
  17. It’s my view that dictators like Chavez possess less power than commonly imagined. They spend excess resources on their pet projects, while denying aid to the people whom they claim to rule for their benefit. With inflation running hard, hard currencies like the dollar in high demand, and the corruption of his cronies, I can’t imagine that Chavez will be around ten years from now.
  18. Makes me want to buy Plum Creek, Potlach, or Rayonier. The pine beetle is eating its fill of Canadian pines, and then some, with difficult intermediate-term implications. More wood will come onto the market in the short run, depressing prices, but in the intermediate term, less wood will come to market. Watch the prices, and buy when the price of lumber is cheap, and prices of timber REITs depressed.
  19. Pax Romana. Pax Americana. One went decadent and broke, the other is well on its way. I love my country, but our policies are not good for us, or the world as a whole. We intrude in areas of the world that are not our own, and neglect the proper fiscal and moral management of our own country.
  20. Finally, it makes sense for economic commentators to make bold predictions, because there’s no such thing as bad publicity. Sad, but true, particularly when the audience has a short attention span. So where does that leave me? Puzzled, because I enjoy writing, but hate leading people the wrong way. I want to stay “low hype” even if it means fewer people read me. At least those who read me will be better informed, even if it means that the correct view of the world is ambiguous.

Tickers mentioned: PCH PCL RYN

The Longer View, Part 2

The Longer View, Part 2

Posted on by David Merkel

When the market gets wonky, I write more about current events.? I prefer to write about longer-dated topics, because the posts will have validity for a longer time, and I think there is more money to be made off of the longer trends.? Before I go there tonight, I would like to say that at present the Fed says that it is ready to act, but it hasn’t done much yet.? As for the Bush Administration, and Congress, they have done nothing so far, and the few credible promises are small in nature.? My counsel: don’t be surprised if the markets stay rough for a while.

Onto longer-dated topics:

  1. Perhaps this should go into my “too many vultures” file, but conservative players like Annaly can take advantage of bargains produced by the crisis.? My suspicion is that they will succeed in their usual modest conservative way.
  2. Falling rates?? Falling equity prices?? Pension funding declines.? This issue has not gone away in the UK, and here in the US, the PBGC is still struggling.? As it is, FASB is facing the issue head on (finally), and the result will likely be a diminution of shareholders’ equity for most companies with defined benefit plans.
  3. China is a capitalist country?? Eminent domain can be quite aggressive there.? At least now they are promising compensation, but who knows whether the government really follows through.
  4. Any strategy, like quant funds, can become overcrowded.? As a strategy goes from little known to crowded, total returns rise and then flatten.? Prospective returns only fall as more and more compete for scarce excess returns.? As the blowout occurs, total returns go negative, and more so for the most leveraged.? Prospective returns rise as capital exits the trade.? Smart quants measure prospective return, and begin liquidating as prospective returns get too low.? Not many do that for institutional imperative reasons (investor: what do you mean cash is building up?? What am I paying you for?), but it is the right strategy regardless.
  5. This is a useful graph of sector weights in the S&P 500.? If nothing else, it is worth knowing what one is underweighting and overweighting.? I am overweight Energy, Basic Materials, Staples, Utilities, and (urk) Financials, and underweight the rest.? My portfolio, right or wrong, never looks like the market.
  6. I’ve written about SFAS 159 before.? Well, we may have a new poster child for why I don’t like it, Wells Fargo.? Mark-to-model is impossible to escape in fixed income, but I would treat gains resulting from changes in model assumptions as very low quality.? Watch SFAS 159 disclosures closely with complex financial companies.? If we wanted to repeat the late 90s headache from gain on sale accounting, we may have created the conditions to repeat the experience in a related way.
  7. How dishonest is the P&C insurance industry?? It varies, as in most industries.? Insurance is a bag of complex promises, which leaves it more open to abuse.? This article goes into some of that abuse, and teaches us to evaluate a company’s claims paying record.? You may have to pay more to get Chubb or Stancorp, but they almost always pay.
  8. China’s financial system is maturing slowly; one example of that is reduced reliance on bank finance, and issuing bonds directly.
  9. I don’t care what regulations get put into place, capitalist economies are unstable, and that’s a good thing.? There are always information asymmetries, and always crowd behavior, such that risk preferences change precipitously.? That’s the nature of the system.? The only true protection is to be aware of this reality, and adjust your behavior before things get crazy.
  10. A firm I was with had an early opportunity to invest in LSV and we didn’t do it.? The two members of our committee that read academic research thought we ought to (I was one), but the practical men of the committee objected to investing with unproven academics.? Oh, well, win some, lose some.
  11. Speaking of academic research, here’s a non-mathematical piece on cognitive biases.? Economists believe that man is economically rational not because of evidence, but because it simplifies the models enough to allow calculations to be made.? They would rather be precisely wrong than approximately right.
  12. Bit by bit, the efficient markets hypothesis get chipped away.? Here we have a piece indicating persistence of excess returns of the best individual investors.? For those of us that have done well, and continue to plug away in the markets, this is an encouragement.? It’s not luck.

I have enough for two more pieces on longer dated data.? It will have to come later.

Tickers Mentioned: NLY WFC CB SFG

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