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The Shadows of the Bond Market’s Past, Part II

Wednesday, August 13th, 2014

This is the continuation of The Shadows of the Bond Market’s Past, Part I.  If you haven’t read part I, you will need to read it.  Before I start, there is one more thing I want to add regarding 1994-5: the FOMC used signals from the bond markets to give themselves estimates of expected inflation.  Because of that, the FOMC overdid policy, because the dominant seller of Treasuries was not focusing on the economy, but on hedging mortgage bonds.  Had the FOMC paid more attention to what the real economy was doing, they would not have tightened so much or so fast.  Financial markets are only weakly representative of what the real economy is doing; there’s too much noise.

All that said, in 1991 the Fed also overshot policy on the other side in order to let bank balance sheets heal, so let it not be said that the Fed only responds to signals in the real economy.  (No one should wonder who went through the financial crisis that the Fed has an expansive view of its mandate in practice.)

October 2001

2001 changed America.  September 11th led to a greater loosening of credit by the FOMC in order to counteract spreading unease in the credit markets.  Credit spreads were widening quickly as many lenders were unwilling to take risk at a time where times were so unsettled.  The group that I led took more risk, and the story is told here.  The stock market had been falling most of 2001 when 9/11 came.  When the markets reopened, it fell hard, and rallied into early 2002, before falling harder amid all of the scandals and weak economy, finally bottoming in October 2002.

The rapid move down in the Fed funds rate was not accompanied by a move down in long bond yields, creating a very steep curve.  There were conversations among analysts that the banks were healthy, though many industrial firms, like automobiles were not.  Perhaps the Fed was trying to use housing to pull the economy out of the ditch.  Industries that were already over-levered could not absorb more credit from the Fed.  Unemployment was rising, and inflation was falling.

There was no bad result to this time of loosening — another surprise would lurk until mid-2004, when finally the loosening would go away.  By that time, the stock market would be much higher, about as high as it was in October 2001, and credit spreads tighter.

July 2004

At the end of June 2004, the FOMC did its first hike of what would be 17 1/4% rises in the Fed funds rate which would be monotony interspersed with hyper-interpretation of FOMC statement language adjustments, mixed with the wonder of a little kid in the back seat, saying, “Daddy, when will we get there?”  The FOMC had good reason to act.  Inflation was rising, unemployment was falling, and they had just left the policy rate down at 1% for 12 straight months.  In the midst of that in June-August 2003, there was a another small panic in the mortgage bond market, but this time, the FOMC stuck to its guns and did not raise rates, as they did for something larger in 1994.

With the rise in the Fed funds rate to 1 1/4%, the rate was as high as it was when the recession bottomed in November 2002.  That’s quite a long period of low rates.  During that period, the stock market rallied vigorously, credit spreads tightened, and housing prices rallied.  Long bonds stayed largely flat across the whole period, but still volatile.

There were several surprises in store for the FOMC and investors as  the tightening cycle went on:

  1. The stock market continued to rally.
  2. So did housing.
  3. So did long bonds, at least for a time.
  4. Every now and then there were little panics, like the credit convexity panic in May 2005, from a funky long-short CDO bet.
  5. Credit complexity multiplied.  All manner of arbitrage schemes flourished.  Novel structures for making money off of credit, like CPDOs emerge.  (The wisdom of finance bloggers as skeptics grows.)
  6. By the end, the yield curve invests the hard way, with long bonds falling a touch through the cycle.
  7. Private leverage continued to build, and aggressively, particularly in financials.
  8. Lending standards deteriorated.

We know how this one ended, but at the end of the tightening cycle, it seemed like another success.  Only a few nut jobs were dissatisfied, thinking that the banks and homeowners were over-levered.  In hindsight, FOMC policy should have moved faster and stopped at a lower level, maybe then we would have had less leverage to work through.

June 2010

15 months after the bottom of the crisis, the stock market has rallied dramatically, with a recent small fall, but housing continues to fall in value.  There’s more leverage behind houses, so when the prices do finally fall, it gains momentum as people throw in the towel, knowing they have lost it all, and in some cases, more.  For the past year, long bond yields have gone up and down, making a round-trip, but a lot higher than during late 2008.  Credit spreads are still high, but not as high as during late 2008.

Inflation is low and volatile, unemployment is off the peak of a few months earlier, but is still high.  Real GDP is growing at a decent clip, but fitfully, and it is still not up to pre-crisis levels.  Aside from the PPACA [Obamacare], congress hasn’t done much of anything, and the Fed tries to fill the void by expanding its balance sheet through QE1, which ended in June 2010. Things feel pretty punk altogether.

The FOMC can’t cut the Fed funds rate anymore, so it relies on language in its FOMC Statement to tell economic actors that Fed funds will be “exceptionally low” for an “extended period.”  Four months from then, the QE2 would sail, making the balance sheet of the Fed bigger, but probably doing little good for the economy.

The results of this period aren’t fully known yet because we still living in the same essential macro environment, with a few exceptions, which I will take up in the final section.

August 2014

Inflation remains low, but may finally be rising.  Unemployment has fallen, much of it due to discouraged workers, but there is much underemployment.  Housing has finally gotten traction in the last two years, but there are many cross-currents.  The financial crisis eliminated move-up buyers by destroying their equity.  Stocks have continued on a tear, and corporate credit spreads are very tight, tighter than any of the other periods where the yield curve was shaped as it is now.  The long bond has had a few scares, but has confounded market participants by hanging around in a range of 2.5%- 4.0% over the last two years.

There are rumblings from the FOMC that the Fed funds rate may rise sometime in 2015, after 72+ months hanging out at 0%.  QE may end in a few more months, leaving the balance sheet of the Fed at 5 times its pre-crisis size.  Change may be upon us.

This yield curve shape tends to happen over my survey period at a time when change is about to happen (4 of 7 times — 1971, 1977, 1993 and 2004), and one where the FOMC will raise rates aggressively (3 of 7 times — 1977, 1993 and 2004) after fed funds have been left too low for too long.  2 out of 7 times, this yield curve shape appears near the end of a loosening cycle (1991 and 2001).  1 out of 7 times it appears before a deep recession, as in 1971. 1 out of 7 times it appears in the midst of an uncertain recovery — 2010. 3 out 7 times, inflation will rise significantly, such as in 1971, 1977 and 2004.

My tentative conclusion is this… the fed funds rate has been too low for too long, and we will see a rapid rise in rates, unless the weak economy chokes it off because it can’t tolerate any significant rate increases.  One final note before I close: when the tightening starts, watch the long end of the yield curve.  I did this 2004-7, and it helped me understand what would happen better than most observers.  If the yield of the long bond moves down, or even stays even, the FOMC probably won’t persist in raising rates much, as the economy is too weak.  If the long bond runs higher, it might be a doozy of a tightening cycle.

And , for those that speculate, look for places that can’t tolerate or would  love higher short rates.  Same for moves in the long bond either way, or wider credit spreads — they can’t get that much tighter.

This is an unusual environment, and as I like to say, “Unusual typically begets unusual, it does not beget normal.”  What I don’t know is how unusual and where.  Those getting those answers right will do better than most.  But if you can’t figure it out, don’t take much risk.

The Shadows of the Bond Market’s Past, Part I

Tuesday, August 12th, 2014

Simulated Constant Maturity Treasury Yields 8-1-14_24541_image001

 

Source: FRED

Above is the chart, and here is the data for tonight’s piece:

DateT1T3T5T7T10T20T30AAABAASpdNote
3/1/713.694.505.005.425.705.946.01*7.218.461.25High
4/1/775.446.316.797.117.377.677.738.049.071.03Med
12/1/914.385.396.196.697.097.667.708.319.260.95Med
8/1/933.444.365.035.355.686.276.326.857.600.75Med
10/1/012.333.143.914.314.575.345.327.037.910.88Med
7/1/042.103.053.694.114.505.245.235.826.620.80Med
6/1/100.321.172.002.663.203.954.134.886.231.35High
8/1/140.130.941.672.162.523.033.294.184.750.57Low

Source: FRED   |||     * = Simulated data value  |||  Note: T1 means the yield on a one-year Treasury Note, T30, 30-year Treasury Bond, etc.

Above you see the seven yield curves most like the current yield curve, since 1953.  The table also shows yields for Aaa and Baa bonds (25-30 years in length), and the spread between them.

Tonight’s exercise is to describe the historical environments for these time periods, throw in some color from other markets, describe what happened afterward, and see if there might be any lessons for us today.  Let’s go!

March 1971

Fed funds hits a local low point as the FOMC loosens policy under Burns to boost the economy, to fight rising unemployment, so that Richard Nixon could be reassured re-election.  The S&P 500 was near an all-time high.  Corporate yield spreads  were high; maybe the corporate bond market was skeptical.

1971 was a tough year, with the Vietnam War being unpopular. Inflation was rising, Nixon severed the final link that the US Dollar had to Gold, an Imposed wage and price controls.  There were two moon landings in 1971 — the US Government was in some ways trying to do too much with too little.

Monetary policy remained loose for most of 1972, tightening late in the years, with the result coming in 1973-4: a severe recession accompanied by high inflation, and a severe bear market.  I remember the economic news of that era, even though I was a teenager watching Louis Rukeyser on Friday nights with my Mom.

April 1977

Once again, Fed funds is very near its local low point for that cycle, and inflation is rising.  After the 1975-6 recovery, the stock market is muddling along.  The post-election period is the only period of time in the Carter presidency where the economy feels decent.  The corporate bond market is getting close to finishing its spread narrowing after the 1973-4 recession.

The “energy crisis” and the Cold War were in full swing in April 1977.  Economically, there was no malaise at the time, but in 3 short years, the Fed funds rate would rise from 4.73% to 17.61% in April 1980, as Paul Volcker slammed on the brakes in an effort to contain rising inflation.  A lotta things weren’t secured and flew through the metaphorical windshield, including the bond market, real GDP, unemployment, and Carter’s re-election chances.  Oddly, the stock market did not fall but muddled, with a lot of short-term volatility.

December 1991

This yield curve is the second most like today’s yield curve.  It comes very near the end of the loosening that the FOMC was doing in order to rescue the banks from all of the bad commercial real estate lending they had done in the late 1980s.  A wide yield curve would give surviving banks the ability to make profits and heal themselves (sound familiar?).  Supposedly at the beginning of that process in late 1990, Alan Greenspan said something to the effect of “We’re going to give the banks a lay-up!”  Thus Fed funds went from 7.3% to 4.4% in the 12 months prior to December 1991, before settling out at 3% 12 months later.  Inflation and unemployment were relatively flat.

1991 was a triumphant year in the US, with the Soviet Union falling, Gulf War I ending in a victory (though with an uncertain future), 30-year bond yields hitting new lows, and the stock market hitting new all time highs.  Corporate bonds were doing well also, with tightening spreads.

What would the future bring?  The next section will tell you.

August 1993

This yield curve is the most like today’s yield curve.  Fed funds are in the 13th month out of 19 where they have been held there amid a strengthening economy.  The housing market is doing well, and mortgage refinancing has been high for the last three years, creating a situation where those investing in mortgages securities have a limited set of coupon rates that they can buy if they want to put money to work in size.

An aside before I go on — 1989 through 1993 was the era of clever mortgage bond managers, as CMOs sliced and diced bundles of mortgage payments so that managers could make exotic bets on moves in interest and prepayment rates.  Prior to 1994, it seemed the more risk you took, the better returns were.  The models that most used were crude, but they thought they had sophisticated models.  The 1990s were an era where prepayment occurred at lower and lower thresholds of interest rate savings.

As short rates stayed low, long bonds rallied for two reasons: mortgage bond managers would hedge their portfolios by buying Treasuries as prepayments occurred.  They did that to try to maintain a constant degree of interest rate sensitivity to overall moves in interest rates.  Second, when you hold down short rates long enough, and you give the impression that they will stay there (extended period language was used — though no FOMC Statements were made prior to 1994), bond managers start to speculate by buying longer securities in an effort to clip extra income.  (This is the era that this story (number 2 in this article) took place in, which is part of how the era affected me.)

At the time, nothing felt too unusual.  The economy was growing, inflation was tame, unemployment was flat.  But six months later came the comeuppance in the bond market, which had some knock-on effects to the economy, but primarily was just a bond market issue.   The FOMC hiked the Fed funds rate in February 1994 by one quarter percent, together with a novel statement issued by Chairman Greenspan.  The bond market was caught by surprise, and as rates rose, prepayments fell.  To maintain a neutral market posture, mortgage bond managers sold long Treasury and mortgage bonds, forcing long rates still higher.  In the midst of this the FOMC began raising the fed funds rate higher and higher as they feared economic growth would lead to inflation, with rising long rates a possible sign of higher expected inflation.  The FOMC raises Fed fund by 1/2%.

In April, thinking they see continued rises in inflation expectation, they do an inter-meeting surprise 1/4% raise of Fed funds, followed by another 1/2% in May.  It is at this pint that Vice Chairman McDonough tentatively realizes [page 27] that the mortgage market has now tightly coupled the response of the long end of the bond market to the short end the bond market, and thus, Fed policy.  This was never mentioned again in the FOMC Transcripts, though it was the dominant factor moving the bond markets.  The Fed was so focused on the real economy, that they did not realize their actions were mostly affecting the financial economy.

FOMC policy continued: Nothing in July, 1/2% rise in August, nothing in September, 3/4% rise in November, nothing in December, and 1/2% rise in February 1995, ending the tightening. In late December 1994 and January of 1995, the US Treasury and the Fed participated in a rescue of the Mexican peso, which was mostly caused by bad Mexican economic policy, but higher rates in the US diminished demand for the cetes, short-term US Dollar-denominated Mexican government notes.

The stock market muddled during this period, and the real economy kept growing, inflation in check, and unemployment unaffected.  Corporate spreads tightened; I remember that it was difficult to get good yields for my Guaranteed Investment Contract [GIC] business back then.

But the bond markets left their own impacts: many seemingly clever mortgage bond managers blew up, as did the finances of Orange County, whose Treasurer was a mortgage bond speculator.  Certain interest rate derivatives blew up, such as the ones at Procter & Gamble.  Several life insurers lost a bundle in the floating rate GIC market; the company I served was not one of them.  We even made extra money that year.

The main point of August 1993 is this: holding short rates low for an extended period builds up imbalances in some part of the financial sector — in this case, it was residential mortgages.  There are costs to providing too much liquidity, but the FOMC is not an institution with foresight, and I don’t think they learn, either.

This has already gotten too long, so I will close up here, and do part II tomorrow.  Thanks for reading.

Redacted Version of the July 2014 FOMC Statement

Wednesday, July 30th, 2014
June 2014July 2014Comments
Information received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months.Information received since the Federal Open Market Committee met in June indicates that growth in economic activity rebounded in the second quarter.This is another overestimate by the FOMC.
Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated.Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources. More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow.Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.No real change

 

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.No change.  Funny that they don’t call their tapering a “restraint.”
Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.Inflation has moved somewhat closer to the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.Finally notes that inflation has risen.  TIPS are showing slightly higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.60%, up 0.14% from June.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.Adds in inflation, also changes measure of the labor market to broaden it from “conditions” to “indicators,” not that that will help much.

They can’t truly affect the labor markets in any effective way.

The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.CPI is at 2.1% now, yoy.  They shade up their view on inflation’s amount and persistence.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month.In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in August, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $10 billion per month rather than $15 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than $20 billion per month.Reduces the purchase rate by $5 billion each on Treasuries and MBS.  No big deal.

 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.No change.  But it has almost no impact on interest rates on the long end, which are rallying into a weakening global economy.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change. Useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetingsNo change.  Says that purchases will likely continue to decline if the economy continues to improve.
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.No change.
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.No change.  Monetary policy is like jazz; we make it up as we go.  Also note that progress can be expected progress – presumably that means looking at the change in forward expectations for inflation, etc.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No change.  Its standards for raising Fed funds are arbitrary.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.Plosser dissents.  Finally someone with a little courage.
 Voting against was Charles I. Plosser who objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.Thank you, Mr. Plosser.  The end to easing is coming, but what will happen when it starts to bite?

 

Comments

  • The two main points of this FOMC statement are: 1)  The Fed recognizes that inflation has risen, and is likely to persist. 2)   Despite lower unemployment levels, labor market conditions are still pretty punk.  Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Markets don’t move much on the news.  Really, not a lot here.
  • Small $10 B/month taper.  Equities and long bonds both rise.  Commodity prices rise.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC needs to chop the “dead wood” out of its statement.  Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do?  I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

The Tails of the Distribution do not Validate the Mean

Friday, June 20th, 2014

17 months ago I wrote a post How to Become Super-Rich?  Now, many of my articles are timeless — they will still have value 10 years from now.   I like to write for the long-run.  Teaching basic principles is what this blog is about.

The surprise for me is that article is the most popular one at my blog.  That says something about the desires of mankind.  Now, if you do want a chance to become super-rich, you create your own company, and focus your efforts on it exclusively.  Diversification is not  a goal here.  We are swinging for the fences here.

But just as in baseball the guys who swing for the fences to hit home runs, they also tend to strike out the most.  The same is true of businessmen.  Many start companies, put their all into it, and end up broke.  Many end up with marginal businesses that give them a living, but not much more.  A few prosper and become moderately wealthy.   A tiny amount of them create a hugely profitable company that makes them super-rich.

Anyway, after I was cold-called by Militello Capital, I reviewed articles on the blog, including one called CRACK THE WEALTH CODE.  I’ll quote the most relevant portion of the post:

According to Get Rich, Stay Rich, Pass It On: The Wealth-Accumulation Secrets of America’s Richest Families by Catherine McBreen and George Walper Jr, “Building up a nest egg with the equity in your home is a fine thing. But what distinguishes the model for getting rich, staying rich and passing it on is its emphasis on investing in current and future income-producing real estate”. Andrew Carnegie, the wealthiest man in America during the early 20th century, said that “90 percent of all millionaires become so through owning real estate.” If that’s not enough to peak your interest, consider this: “The major fortunes in America have been made in land”, coined by John D. Rockefeller. What does he know…..his net worth in today’s dollars is onlyaround $300 billion. Invest in areas you know. Real estate gives you the opportunity to visit and connect with your investment. When’s the last time you connected with your mutual fund?

Don’t forget about the second part of the winning combo: private companies. Open your eyes to entrepreneurial opportunities. McBreen and Walper advise that at least one-quarter of your investment dollars should be in enterprises that develop products and services or invent breakthrough technologies. In 10 things billionaires won’t tell you, number seven’s title, “We didn’t get rich investing in stocks”, hits the nail on the head. Billionaires like Steve Jobs, Bill Gates, and Mark Zuckerberg made their fortunes in start-ups, says Robert Klein, founder and president of Retirement Income Center, a retirement and income planning firm in Newport Beach, California. The article confirms that “you’re far more likely to become a billionaire in Silicon Valley than on Wall Street.”

In one sense, I agree with what they say.  If you want to become super-rich, pursue one goal with your one company.  Less than 1% will succeed.  Maybe 5-10% will attain to being multi-millionaires.  Most will muddle or fail.

Running your own business, including real estate investing, is not a magic ticket to riches.  A lot depends on:

  • Solving problems people didn’t know they had.
  • The time period that you invest during — were financial conditions favorable for speculation?
  • The ability to manage a large enterprise is an uncommon skill.
  • The ability to be an entrepreneur is also not common.  Most people don’t want to take that much risk.
  • Discipline, hard effort, taking time away from family and friends.

There is a cost to trying to be super-rich, and most people die at that altar of greed.  I suspect that most that succeed, did not aim to be super-rich, but pursued that task because they found it interesting.  They were idealists who happened to be in business, and their ideals matched up with what would enable society to pursue its goals more effectively.

So does it make sense for average people to invest in private equity funds or private real estate funds because the wealthy ran their own companies and invested in commercial real estate?

No.  First, remember that the super-wealthy were swinging for the fences.  They were the rare success stories.

Second, note that those who invest in private equity funds or private real estate funds are diversifying.  As such, they are seeking more certainty, and will not gain an abnormally large return.

Third, recognize the data bias.  Those who succeed with private equity funds or private real estate funds, their data exists, while those who fail disappear.

There is no advantage to being public or private as a business.  Private businesses can keep things secret, but public businesses have a lower cost of capital.

Conclusion

Just because the wealthy got that way by making big bets that most people lose, does not mean that average people should do that.  Alternative investments like private equity funds or private real estate funds are not an automatic road to wealth, and are less transparent than their liquid alternatives on the stock exchanges.

Average people should avoid low probability bets — they tend to impoverish, with high probability.

PS — that said, I like commercial real estate as a diversifier, but it won’t make you rich.

Redacted Version of the June 2014 FOMC Statement

Wednesday, June 18th, 2014
April 2014June 2014Comments
Information received since the Federal Open Market Committee met in March indicates that growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions.Information received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months.The FOMC has constantly overestimated GDP growth, They forecast badly because they serve their political masters, who demand optimism to delude the public.
Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated.Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated.No significant change.  What improvement?
Household spending appears to be rising more quickly. Business fixed investment edged down, while the recovery in the housing sector remained slow.Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow.Shades household spending down, raises their view on business fixed investment.

The FOMC needs to stop interpreting every short-term wiggle in the data.  They whipsawed on business fixed investment over the last three periods.

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.No change.  Funny that they don’t call their tapering a “restraint.”
Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.No change.  TIPS are showing slightly higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.46%, up 0.05% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.No change.
The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced.The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced.No change.
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.No change.  CPI is at 2.1% now, yoy.  Hey, above the threshold, and no comment from the FOMC?
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in May, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $20 billion per month rather than $25 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $25 billion per month rather than $30 billion per month.In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month.Reduces the purchase rate by $5 billion each on Treasuries and MBS.  No big deal.

 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.No change.  But it has almost no impact on interest rates on the long end, which are rallying into a weakening global economy.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change. Useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.No change.  Says that purchases will likely continue to decline if the economy continues to improve.
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.No change.
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.No change.  Monetary policy is like jazz; we make it up as we go.  Also note that progress can be expected progress – presumably that means looking at the change in forward expectations for inflation, etc.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No change.  Its standards for raising Fed funds are arbitrary.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Richard W. Fisher; Narayana Kocherlakota; Sandra Pianalto; Charles I. Plosser; Jerome H. Powell; Jeremy C. Stein; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.Stanley Fischer is an interesting addition to the FOMC, because he would be capable of an independent opinion, not that he will ever do that.  Brainard and Mester are sock puppets.  If we see a dissent out of them, I will be shocked, and revise my opinion.

 

Comments

  • Small $10 B/month taper.  Equities and long bonds both rise.  Commodity prices rise.  The FOMC says that any future change to policy is contingent on almost everything.
  • They shaded household spending down, and raised their view on business fixed investment.  Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC is ignoring rising inflation data.
  • The FOMC needs to chop the “dead wood” out of its statement.  Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do?  I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
  • GDP growth is not improving much if at all, and much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.

Avoid Illiquidity

Wednesday, June 18th, 2014

There are several reasons to avoid illiquidity in investing, and some reasons to embrace it.   Let me go through both:

Embrace Illiquidity

  • You are offered a lot of extra yield for taking on a bond that you can’t easily sell, and where you are convinced that the creditor is impeccable, and there are no sneaky options that you have implicitly sold embedded in the bond to take value away from you.
  • An unusual opportunity arises to invest in a private company that looks a lot better than equivalent public companies and is trading at a bargain valuation with a sound management team.
  • You want income that will last for your lifetime, and so you take some of the money you would otherwise allocate to bonds, and buy a life annuity, giving you some protection against longevity.  (Warning: inflation and credit risks.)
  • In the past, you bought a Variable Annuity with some good-looking guarantees.  The company approaches you to buy out your annuity at a 10-20% premium, or a 20-30% premium if you roll the money into a new variable annuity with guarantees that don’t seem to offer much.  Either way, turn the insurance company down, and hold onto the existing variable annuity.
  • In all of these situations, you have to treat the money as money lost to present uses.  If there is any significant probability that you might need the money over the term of the asset, don’t buy the illiquid asset.

Avoid Illiquidity

  • Often the premium yield on an illiquid bond is too low, or the provisions take value away with some level of probability that is easy to underestimate.  Wall Street does this with structured notes.
  • Why am I the lucky one?  If you are invited to invest in a private company, be skeptical.  Do extra due diligence, because unless you bring something more than money to the table (skills, contacts), the odds increase that they are after you for your money.
  • Often the illiquid asset is more risky than one would suppose.   I am reminded of the times I was approached to buy illiquid assets as the lead researcher for a broker-dealer that I served.
  • Then again, those that owned that broker-dealer put all their assets on the line, and ended up losing it all.  They weren’t young guys with a lot of time to bounce back from the loss.  They saw the opportunity of a lifetime, and rolled the bones.  They lost.
  • We tend to underestimate how much we might need liquidity in the future.  In the mid-2000s people encumbered their future liquidity by buying houses at inflated prices, and using a lot of debt.  When everything has to go right, the odds rise that everything will not go right.
  • And yet, there are two more more reason to avoid illiquidity — commissions, and inability to know what is going on.

Commissions

Illiquid assets offer the purveyor of the assets the ability to pay a significant commission to their salesmen in order to move the product.   And by “illiquid” here, I include all financial instruments that carry a surrender charge.  Do you want to know how much the agent made selling you an insurance product?  On single-premium products, it is usually very close to the difference between the premium you paid, and the cash surrender value the next day.

Financial companies build their margins into their products, and shave off a portion of them to pay salesmen.  This not only applies to insurance products, but also mutual funds with loads, private REITs, etc.  There are many brokers masquerading as financial advisers, who do not have to act strictly in the best interests of the client.  The ability to receive a commission makes them less than neutral in advising, because they can make a lot of money selling commissioned products.  In general, it is good to avoid buying from commissioned salesmen.  Rather, do the research, and if you need such a product, try to buy it directly.

Not Knowing What Is Going On

There are some that try to turn a bug into a feature — in this case, some argue that the illiquid asset has no volatility, while its liquid equivalents are more volatile.  Private REITs are an example here: the asset gets reported at the same price period after period, giving an illusion of stability.  Public REITs bounce around, but they can be tapped for liquidity easily… brokerage commissions are low.  Some private REITs take losses and they come as a negative surprise as you find  large part of your capital missing, and your income reduced.

What I Prefer

In general, I favor liquid investments unless there is a compelling reason to go illiquid.  I have two private equity investments, both of which are doing very well, but most of my net worth is tied up in my equity investing, which has done well.  I like the ability to make changes as time goes along; there is value to being able to look forward, and adjust.

No one knows the future, but having some slack capital available to invest, like Buffett with his “elephant gun,” allows for intelligent investing when liquidity is scarce, and yet you have some.  Many wealthy people run a liquidity “barbell.”  They have a concentrated interest in one company, and balance that out by holding very safe cash equivalents.

So, in closing, avoid illiquidity, unless you don’t need the money, and the reward is very, very high for making that fixed commitment.

Sorted Weekly Tweets

Saturday, May 31st, 2014

Debt Markets

  • Leverage Addicts Get Junk-Loan Fix With Derivatives ETF http://t.co/CWMxLXlz3v Not much different than a HY closed-end fund or a CLO $$ Jun 01, 2014
  • Bond Market Flips the Script on Risk and Reward http://t.co/3geslTXRMo Difficult for rates 2 rise when monetary velocity keeps falling. $$ Jun 01, 2014
  • Shakeout Threatens Shale Patch as Frackers Go for Broke http://t.co/pGj2CUiTxG Not healthy 4 so many 2b financing w/high amount of debt $$ Jun 01, 2014
  • Bond Market to Fed: Your 4% Rate Forecast Is Way Too High http://t.co/Ji55pmAlYZ Forward rates r much lower than wrong Fed forecasts $$ Jun 01,
  • New Fund Stars Ride Junk Bonds to the Top http://t.co/1WtqogYOZX Junk credit & HQ long duration risks have paid off, what an odd couple $$ Jun 01, 2014
  • The Hidden Risks in Your Local Housing Market http://t.co/7OcDXnTvGC As the amount of debt behind housing rises, systemic risks rise also $$ Jun 01, 2014
  • Pimco Rehires Former Senior Executive Paul McCulley http://t.co/7U71N8jO12 Wish he had stayed retired; I enjoyed him not publishing $$ Jun 01, 2014
  • And so it begins: Square is to start lending to customers http://t.co/F7xDzGTxAQ Harder than it looks 2b a lender; 2 much optimism $$ May 31, 2014
  • S&P, Moody’s Lose Bid to Block Calpers $800M Suit http://t.co/crQdAbw2v2 Ratings r advice not guarantees, sophisticated investors know it $$ May 31, 2014
  • How to Manage Bankers Voracious Risk Appetites http://t.co/yrwkZkQaHW Criminal liability, clawback of pay, & boards holding mgmt acctable $$ May 31, 2014
  • Goldman Shuns Bonds Pimco’s Gross Favors in ‘New Neutral’ http://t.co/bTPbJpi6Me Go with Goldman over Pimco; buy tails, short belly $$ $GS May 31, 2014
  • You’re All Whales in Bond Market Now With Trading Volume Slump http://t.co/ewXmldKzC5 It means that more Tsy notes r held 2maturity $$ $IEF May 30, 2014
  • Pimco Rehires Former Senior Executive Paul McCulley http://t.co/7U71N8jO12 Wish he had stayed retired; I enjoyed him not publishing $$ Jun 01, 2014
  • How to Manage Bankers Voracious Risk Appetites http://t.co/yrwkZkQaHW Criminal liability, clawback of pay, & boards holding mgmt acctable $$ May 31, 2014
  • Goldman Shuns Bonds Pimco’s Gross Favors in ‘New Neutral’ http://t.co/bTPbJpi6Me Go with Goldman over Pimco; buy tails, short belly $$ $GS May 31, 2014
  • You’re All Whales in Bond Market Now With Trading Volume Slump http://t.co/ewXmldKzC5 It means that more Tsy notes r held 2maturity $$ $IEF May 30, 2014

 

US Politics & Policy

  • Geithner’s Dubious Accounting http://t.co/8uwwJyeKHo “justifying the bailouts b/c a simplistic measure shows the govt made $$ is a stretch.” Jun 01, 2014
  • Seven States Running Out of Water http://t.co/pXpEU9Hu7K All in southern west & midwest — CA, NV, NM, KS, AZ, OK, & TX $$ Jun 01, 2014
  • State Pension Transparency Is Right Message At Right Time http://t.co/vwGqJn7ZDq Read about troubles of North Carolina Public Pensions $$ Jun 01, 2014
  • ‘Pink Slime’ Makes Comeback as Beef Prices Spike http://t.co/XmDfVz5zAB “Finely textured beef” returns to cheap hamburger; ask yr butcher $$ May 31, 2014
  • Economy Shrank, U.S. Now Says http://t.co/qm9rarCX9P They’re blaming the weather which is always a weak reason 4 the structural slowdown $$ May 30, 2014

 

Rest of the World

  • Japan Begins Purposely Dumping 100s Of Tons Of Radioactive Water From Fukushima In2 The Pacific http://t.co/TklIa4ECs2 Source fish w/care $$ Jun 01, 2014
  • Spain Sees Embers Glow in Wreckage of Property Crash http://t.co/J1KWh56u0l Prices finally gaining real money buyers $$ Jun 01, 2014
  • Escape From Tiananmen: How Secret Plan Freed Protesters http://t.co/yAmoc6MfKT Unlikely group of people risked their lives 2 aid escapees $$ Jun 01, 2014
  • Iran, Stable but Miserable http://t.co/1HNuO03Ncv @Steve_Hanke Once Govts start giving subsidies, is very difficult 2 end them $$ #bigbang May 31, 2014
  • Aging Swiss Face Pension Funding Dilemma on Immigration http://t.co/9k2X7Oeszf Demographic eclipse faces Switzerland, needs immigrants $$ May 30, 2014
  • No, China Isn’t Really Rebalancing http://t.co/HbR7rVIiOZ @WilliamPesek notes quick return of stimulus measures in China as growth flags $$ May 30, 2014

 

Market Impact

  • Bad Credit No Problem as Balance-Sheet Bombs Rally 94% http://t.co/6xLjaGnBCp A backward-looking insight, one common 2 late bull markets $$ Jun 01, 2014
  • Reynolds Aims to Oust Fidelity in Push to Gain 401(k)s http://t.co/CO9RF3YZsk 401k financial servicing is a scale game 4 Great-West Fin’l $$ Jun 01, 2014
  • Bets on Higher Food Costs Reach 11-Week Low: Commodities http://t.co/Bqi5PPkTsS Time for food costs to move up $$ Jun 01, 2014
  • Neff’s do’s and dont’s http://t.co/Sx2oExlAHb The thinking of John Neff is underrated in my opinion; this article summarizes some of it $$ Jun 01, 2014
  • Top 10 Valuation Ratios and How to Use Them http://t.co/bbdT2lMHeI Worth a read $$ Jun 01, 2014
  • Dragon King beats Black Swan: Ted Talk with Didier Sornette http://t.co/QMJNGE3N8w Listen to Sornette; black swans can be predicted $$ Jun 01, 2014
  • New Rules 2 Alter How Companies Book Revenue http://t.co/3siTlXkluz Mostly liberalizes revenues, lowers earnings conservatism, watch $$ flow Jun 01, 2014
  • Nasdaq Nears 13-Year High as Technology Becomes Loved http://t.co/0Q7VrPsnUy Note unprofitable IPOs coming 2 market eating sideline cash $$ Jun 01, 2014
  • Dennis Gartman: We Were Wrong Calling for a Correction http://t.co/IhmICbVO2M Few more capitulations & then the topping process will end $$ Jun 01, 2014
  • Managing a Portfolio I – Stop Wasting Time, Start Adding Value, Part V http://t.co/2z2bLQV7zK A very good series, very worthy of a read $$ May 31, 2014

 

Other

  • Little Children and Already Acting Mean http://t.co/4RRva4OVu1 Should only surprise if u think ppl r natually good; good must b trained $$ Jun 01, 2014
  • The Myth of the Climate Change ’97%’ http://t.co/BCsHXfzudX I know science Ph.D.s who don’t agree, but how 2do a fair count? $$ Jun 01, 2014
  • How Many Kidneys Is an NFL Career Worth? http://t.co/EdaeHVt8zW Gives reasons to eliminate team doctors; players, get yr own doc 4 safety $$ May 31, 2014
  • Mementos of triumphs make a return to bankers’ desks http://t.co/1fetPsXSrc Deal toys made of Lucite return to Wall Street $$ $GS $MS $XLF May 30, 2014
  • My Resume http://t.co/lkMocQczJB James Altucher spills all of the beans on his business career & life. A train wreck in slow motion $$ $SPY May 30, 2014
  • Railcar Shortage in US Pushes Up Lease Rates http://t.co/bcaqp0DvwV If pipelines aren’t built, more crude will flow by rail $$ $GATX $TRN May 30, 2014

 

Wrong

  • Wrong: SEC Set to Spur Exchange Trading http://t.co/jU2JJvc3vi This may help mutual fund managers, but it won’t help small investors $$ Jun 01, 2014
  • Wishful thinking: Is Hillary Clinton Too Old for the White House? http://t.co/Fy0qYw11a6 People, particularly women live longer than b4 $$ Jun 01, 2014
  • Wrong:Annotated History Of The World’s Next Reserve Currency http://t.co/XtCSg2WQPt Only free countries w/open markets r reserve curncies $$ Jun 01, 2014
  • Fink Says Leveraged ETFs May ‘Blow Up’ Industry http://t.co/cVTubsqeiY More likely they blow themselves up, & not the all mutual funds $$ Jun 01, 2014
  • Wrong: Paper money is unfit for a world of high crime and low inflation http://t.co/XC4pAWjHf2 We need 2get currency out of govt hands $$ May 31, 2014
  • Wrong: Borrowers Show in Rush to Grab US Rate Break http://t.co/H8yJX9TCQQ Funny how everyone keeps saying rates will rise $$ FD: + $TLT May 30, 2014
  • Wrong: Make more money by dumping your investment adviser http://t.co/8hSPQqgDlr Investment advisers can prevent panic & greed $$ $TROW

 

Retweets, Replies & Comments

  • RT @ReformedBroker: Nice that we printed a new record S&P 500 high today. Too bad so few stocks are involved. Via @allstarcharts http://t.c… May 26, 2014

Yet Another Letter from a Reader

Tuesday, May 6th, 2014

I get a lot of interesting letters — here is another one:

First, let me say how much I appreciate your blog. I started my career in sellside research covering life insurers (after interning in insurance M&A). Your posts on insurance investing were invaluable in developing my understanding of the industry. My superiors did not have time to teach me the basics – I would have had a hard time getting started without your blog. 

 I’m now in equity research at a large mutual fund company, also covering insurers (and asset managers). However, I do not have an actuarial background. So I am very interested in why you think financial & mortgage insurers don’t have an actuarially sound business models. 

 And as a former life insurance analyst, I am curious what aspect of life insurance reserving you view as liberal – I’m guessing secondary guarantees on VAs? 

 Finally, to digress, do you have any views on medical malpractice insurance? I’ve been looking at PRA, and find it pretty compelling at first glance: massive excess capital, consistently conservative and profitable underwriting, and a relatively reasonable valuation. 90% of policies are claims made. There are headwinds: Obamacare, the reserve releases from mid-2000s accident years rolling off, and a diversifying business model (although PRA has historically proven competent at M&A). My only concerns are management continuing to underwrite at too low a level (currently writing at 0.32x NPW / Equity; regulators would be fine with up to 1.0x), and potentially squandering that capital. 

In the interest of full disclosure, I own no insurance stocks personally for compliance reasons.

Thanks for writing.  Let’s start with mortgage and financial insurance.  It’s not that there isn’t a good way to calculate the risk (in most cases), it is that they do not choose to use those models.  The regulators do not subscribe to contingent claims theory.  They do not look at default as an option, even if it is not efficiently exercised.  They should use those models, and assume efficient execution of default risk.

Even if they use approximations, the recent crisis should have forced reserves higher for mortgage credit, and other credit exposures.

Credit and mortgage insurers are bull market stocks.  When I was a bond manager, I sold away my few financial insurer bonds from MBIA and Ambac, and avoided the mortgage insurers.  The possibility of default was far higher than he market believed.

With respect to Life Insurers, it is secondary guarantees of all sorts, especially with variable products.  Options that have a long duration are hard to price.  Options that have a long duration, and involve significant contingencies where insureds may make choice hurting the insurer are impossible to price.

On Medmal, I have always liked PRA, but it has never been cheap enough for me to buy it.  Always thought they were the best of the pure plays.  They have survived many other companies by their clever management.  I would not begrudge them their conservatism, Medmal is volatile, and it pays to be conservative in volatile businesses.

Redacted version of the April 2014 FOMC Statement

Wednesday, April 30th, 2014
March 2014April 2014Comments
Information received since the Federal Open Market Committee met in January indicates that growth in economic activity slowed during the winter months, in part reflecting adverse weather conditions.Information received since the Federal Open Market Committee met in March indicates that growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions.Weather is always a weak reason for a bad result.  You almost never see anyone claim good weather boosted results.

Didn’t they see today’s weak GDP report?

Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated.Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated.No significant change.  What improvement?  Note: this is the one remaining place where they mention the “unemployment rate.” Shh.
Household spending and business fixed investment continued to advance, while the recovery in the housing sector remained slow.Household spending appears to be rising more quickly. Business fixed investment edged down, while the recovery in the housing sector remained slow.Shades household spending down, lowers their view on business fixed investment.
Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.No change.  Funny that they don’t call their tapering a “restraint.”
Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.No change.  TIPS are showing slightly lower inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.41%, up 0.15% from March.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.No change.
The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced.The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced.No change.
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.No change.  CPI is at 1.5% now, yoy.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in April, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month rather than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $30 billion per month rather than $35 billion per month.In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in May, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $20 billion per month rather than $25 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $25 billion per month rather than $30 billion per month.Reduces the purchase rate by $5 billion each on Treasuries and MBS.  No big deal.

 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.No change.  But it has almost no impact on interest rates on the long end, which are rallying into a weakening global economy.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change. Useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.No change.  Says that purchases will likely continue to decline if the economy continues to improve.
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.No change.
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.Monetary policy is like jazz; we make it up as we go.  Also note that progress can be expected progress – presumably that means looking at the change in forward expectations for inflation, etc.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No change.  Its standards for raising Fed funds are arbitrary.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
With the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward guidance. The change in the Committee’s guidance does not indicate any change in the Committee’s policy intentions as set forth in its recent statements. That sentence lasted only one month.  Note that the phrase “unemployment rate” is close to being banned by the FOMC.  The dual mandate is not so dual, at least in the old sense.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Richard W. Fisher; Sandra Pianalto; Charles I. Plosser; Jerome H. Powell; Jeremy C. Stein; and Daniel K. Tarullo.

 

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Richard W. Fisher; Narayana Kocherlakota; Sandra Pianalto; Charles I. Plosser; Jerome H. Powell; Jeremy C. Stein; and Daniel K. Tarullo.Kocherlakota rejoins the majority, even with no change to the “fifth paragraph” of the March statement.
Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the Committee’s commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity. Thus ends the lamest vote against an FOMC decision that I have ever seen.  The differences between the last statement’s fifth and sixth paragraphs were minuscule.

Comments

  • Small $10 B/month taper.  Equities and long bonds both rise.  Commodity prices fall.  The FOMC says that any future change to policy is contingent on almost everything.
  • They shaded household spending down, and lowered their view on business fixed investment.  Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • At least they are abandoning the unemployment rate as their measure of labor conditions.
  • They missed a real opportunity to simplify the statement.  More words obfuscate, they do not clarify.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do?  I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
  • GDP growth is not improving much if at all, and much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.

Why it is Hard to Win in Investing

Saturday, April 26th, 2014

Before I start this evening, I want to say something about many investment books that I have been reading of late.  In terms of information toward the stated goal of the book, there is often a lot of build up, some of it necessary, some not, some of it interesting, some not, occasionally some unique insights, but most of the time not.  Much of it is filler that could be eliminated.  And, if you eliminated the filler, and boiled down the part of the book that attempts to prove the stated goal, you would have something the size of a long-form blog post.  That’s why there is the filler — you would have a hard time selling a single chapter book, even though that contains the real value of the book, and would save your reader the time of wading through filler material.

Also, when I review books, I read them in entire.  If I don’t read them in entire, I state that plainly at the beginning of the review, along with why I thought I could review the book without reading it.  But after some of the books I have read lately, editing to condense the volume and stick to the topic at hand would be a help.

Finally, if the author doesn’t prove his case in an ironclad way, maybe the book shouldn’t be written.  I often get to the end of a book disappointed, because the author promised a significant result, and did not deliver.

Onto tonight’s topic:

When is the best time to invest?  When everyone else is scared to death of investing.  It’s when friends come up to you and say, “I’m never investing in stocks ever again.”  When the magazine covers proclaim “The Death of Equities,” it is time to invest.

Guess what?  Very few people do invest then.  It’s too painful to contemplate throwing away your money when nothing is going right, and losses are cascading.  Remember, we are not rational, we are mimics.

When do people like to invest?  When it’s popular to do so. When prices have been rising for a while, and the lure of “free money” is in the air.  Books on easy money flipping homes proliferate, and there is a brisk business in seminars teaching an easy road to riches.  It’s that time when people say, “Let the market pay your employees.”

I’ve talked about the fear/greed cycle many times before.  I’ve also talked about time-weighted vs dollar-weighted returns before. I’ve talked about vintage years in lending before, and about absolute return investors before.  I’ve talked about industry rotation before, as well as long-term mean reversion.  These are all manifestations of the same phenomenon in investing — it is best to invest in any given area when few are doing so, and worst to invest when almost all are doing so.

Let me give a bunch of parallel examples to make this clear.

Why do great mutual fund managers cease to be great?  When they are great, they have less money to manage than their ideas could bear managing.  But money follows performance because we are not rational, we mimic.  Eventually enough money comes in  such that the talented investor no longer has good places to put incremental money, and can’t just leave some of the money in cash, or an index fund… from a business angle, it would not fly.

Lest you think that this does not happen to passive investing, money follows performance there also.  It also happens in open-ended index funds, ETPs, and closed-end funds of any sort (expressed through the premium or discount).

This also applies to quantitative investment strategies — even those with broad themes like momentum and valuation.  Let me illustrate this with a slide from a presentation I have done before a large CFA Society:

Efficient Markets versus Adptive Markets

 

And this applies to lending whether securitized or direct.  When money is being thrown at a sub-asset class, like subprime RMBS in 2006-7, or manufactured housing ABS in 2000-1, the results are bad.  The best results occur when few are lending, and only the best deals are getting done.  But that means that few get those high returns.  That is the nature of the markets.

The same applies to corporate bonds.  It is wise to avoid the area of the market where issuance is well above average.  When I was a corporate bond manager, I sold out my auto bonds, and my questionable telecom bonds, amidst much issuance.  I had many brokers puzzle over why I would not buy their deals, even though they were cheap relative to their ratings.

The same applies to private equity.  When a lot of money is being applied there, it is a time to avoid it.  As it is now, private equity is throwing money at promising companies, many of which hold onto the money for safety purposes, because they don’t have place to invest it.  That doesn’t sound promising for future returns.

Finally, we have a few absolute return investors like Klarman, Grantham, and Buffett.  They are reducing allocations to risk assets, at least in relative terms.  Opportunities are not as great, and so they wait.

Summary

The intelligent investor estimates likely returns, and invests if the returns are worth the risk.  I am reducing my risk positions, slowly, as I see best for my clients and me.

Most profitable investing takes an uncomfortable view versus the consensus, and buys when the market offers good deals.  If there are no good deals, profitable investing sits on cash, and waits for a better day.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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