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On Current Credit Conditions

Friday, July 18th, 2014

This should be short.  Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there.  I realize that I am usually early on credit issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield.  Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low.  They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made.  They are facing another significant default, and the Chinese Government looks like it will let the default happen.  That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets.  It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control.  Ah, remember that?  Maybe it is time to buy volatility when it is cheap.  Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives?  Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising.  Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model.  Dominant risk control models may not truly control risk, because who will they sell to?  Just another imbalance of which to be wary.

Book Review: The Secret Club that Runs the World

Tuesday, July 15th, 2014

la_ca_0506_the_secret_club_that_runs This is a very good book; I learned a lot as I read it, and you will too.

In this book, Kate Kelly takes on the economic sector of commodities.  This involves production, distribution, trading, hedging, and ultimate use.

There are many players trying to profit in many different ways.  There are hedge funds, commodity trading advisers, investment banks, producers, refiners.  Some do just one facet of the commodities sector; some do everything.

This book is replete with stories from the run-up in commodity prices, and all of the games that went on.   It tells of those who made a lot of money, and those that want  broke working in a very volatile part of the economy.

It is a book that gives a testimony that information is king, and those that understand future supply, demand, and transportation costs can make a great deal of money by buying cheap, transporting, and selling high.

That said, the math can get overly precise versus the real world… the book gives examples of hedging programs that were too clever by half, ending in disaster when prices moved too aggressively.

With hedging, simplicity is beauty.  But after some success in trading well, companies think that instead of hedging, let trading become a profit center of its own .  Far from reducing risk, risks rise beyond measure, until the scheme blows up.

The book also considers non-market players like politicians and regulators, and how they are almost always a few steps behind those they regulate.  A key theme of the book is whether market participants can manipulate prices or not.  I would invite all market participants to consider my writings on penny stocks.  Can the price be manipulated?  Yes.  For how long?  Maybe a month or two at best.  In bigger markets like commodities, I suspect the ability to manipulate prices is less, because there are more players trading, and the power is equal between buyers and sellers.  There are powerful parties on both sides seeking their advantage.

The Glencore/Xtsrata merger and Delta Airlines hedging program/buying a refinery occupy a decent amount of the book.  Glencore/Xstrata illustrates the desire for scale and control in owning production in trading assets in commodities.  Delta Airlines illustrates the difficulties involve in being a heavy energy user in a cyclical, capital-intensive business that carries a lot of debt.  It’s too early to tell whether owning their own oil refining operation was the right decision or not, though typically companies do better to specialize, rather than vertically integrate.

One you have read this book, you will have a good top-level view of how the commodities sector operates, and thus I recommend the book.

Quibbles

The book title is vastly overstated.  There is no secret.  Just becuse many people don’t know about them doesn’t mean they are secret.  There is adequate data about them if you look.

There is no club.  Yes, some move from one position in one firm to a position in another.  Some even become regulators.  That is common to most industries.

They don’t run the world.  At most, they have a weak hold over commodities markets, because the traders have better data on global supply and demand than most large producers and consumers do.  That information allows them to profit on spreads, but it doesn’t let them move markets.

Summary

Given my quibbles, I thought it was a great book.  A marketing guy probably wrote the title, so I give the author a pass on that.  If you want a readable high-level view of the commodities markets, you can get it in this book.  If you want to, you can buy it here: The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

A Stream of Hot Air

Saturday, June 28th, 2014

Let’s roll the promoted stocks scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 6/27/14DeclineAnnualizedSplits
GTXO5/27/20082.450.022-99.1%-53.9% 
BONZ10/22/20090.350.001-99.8%-72.7% 
BONU10/22/20090.890.000-100.0%-83.4% 
UTOG3/30/20111.550.001-100.0%-90.7% 
OBJE4/29/2011116.000.083-99.9%-89.9%1:40
LSTG10/5/20111.120.011-99.0%-81.6% 
AERN10/5/20110.07700.0001-99.9%-91.3% 
IRYS3/15/20120.2610.000-100.0%-100.0%Dead
RCGP3/22/20121.470.080-94.6%-72.4% 
STVF3/28/20123.240.430-86.7%-59.3% 
CRCL5/1/20122.220.013-99.4%-90.7% 
ORYN5/30/20120.930.026-97.2%-82.2% 
BRFH5/30/20121.160.620-46.6%-26.1% 
LUXR6/12/20121.590.007-99.6%-93.3% 
IMSC7/9/20121.51.000-33.3%-18.6% 
DIDG7/18/20120.650.047-92.8%-74.2% 
GRPH11/30/20120.87150.077-91.2%-78.6% 
IMNG12/4/20120.760.025-96.7%-88.8% 
ECAU1/24/20131.420.047-96.7%-90.9% 
DPHS6/3/20130.590.008-98.7%-98.3% 
POLR6/10/20135.750.051-99.1%-98.9% 
NORX6/11/20130.910.110-87.9%-86.8% 
ARTH7/11/20131.240.213-82.8%-84.0% 
NAMG7/25/20130.850.087-89.8%-91.5% 
MDDD12/9/20130.790.097-87.7%-97.8% 
TGRO12/30/20131.20.181-84.9%-97.9% 
VEND2/4/20144.342.090-51.8%-84.5% 
HTPG3/18/20140.720.090-87.5%-99.9% 
6/27/2014Median-96.7%-87.8%

 

My, but aren’t they predictable.  Onto tonight’s loser-in-waiting Windstream Technologies [WSTI].  This is another company with negative earnings and net worth, though it has a modest amount of revenue.

Think of it for a moment: this company has a “breakthrough technology,” and yet they were a hotel company within the last year or two.  That’s not how real businesses work.  I you have an incredible technology, but little capital, private equity investors will happily fund you.  You won’t try to do it in some underfunded corporate shell which tempts crooked financial writers to write fantasy.

Now, you might look at the disclaimer in the glossy brochure which came to my house, which in 5-point type takes back all of things that they about in bold headlines and readable text.  For example:

  • It begins with: DO NOT BASE ANY INVESTMENT DECISION UPON ANY MATERIALS FOUND IN THIS REPORT.
  • The Wall St. Revelator is neither licensed nor qualified to provide financial advice. As such, it relies upon the “publisher’s exclusion” as provided under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws.
  • The Wall Street Revelator and/or its publisher, Andrew & Lynn Carpenter, dba The Wall Street Revelator has received a total amount of twenty five thousand dollars [DM: $25,000] in cash compensation to assist in the writing of this Advertisement, as well as potential future subscription and advertising revenues, the amount of which is not known at this time with respect to the publication of this Advertisement and future publications.
  • Mandarin Media Limited paid nine hundred thousand dollars [DM: $900,000] to marketing vendors to pay for all the costs of creating and distributing this Advertisement, including printing and postage, in an effort to build investor and market awareness.
  • Mandarin Media Limited was paid by non-affiliate shareholders who fully intend to sell their shares without notice into this Advertisement/market awareness campaign, including selling into increased volume and share price that may result from this Advertisement/market awareness campaign.
  • The non-affiliate shareholders may also purchase shares without notice at any time before, during or after this Advertisement/market awareness campaign.
  • Non-affiliate shareholders acted as advisors to Mandarin Media Limited in this Advertisement and market awareness campaign, including providing outside research, materials, and information to outside writers to compile written materials as part of this market awareness campaign.

The disclaimer exists to cover the writers from legal risk, and what it tells us is that there are largish shareholders looking to profit by running up the stock price as a result  of the advertisement, enough to cover the $925,000 cost.

Such it is with a pump and dump.  One thing is virtually certain, though.  This is not a stock to hold onto.  Look at the stocks in the table above.  No winners, and most are almost total losses in the long run.  Manipulators love working with stocks that have no earnings and no net worth, because they are impossible to value for the grand majority of people.  New buyers, if they come in a group, can create a frenzy that raises prices.

That’s the goal of the advertising campaign: a short term “pop” that the sponsoring shareholders can sell into, letting a bunch of muppets take losses.

Again, never buy promoted stocks.  If they have to buy the services of others to promote the stock, it is a fraud.  Good stocks do not need promotion.  It’s that simple.

PS — the pretentiousness of the word “revelator” should be replaced by the simpler “revealer.”

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.

On Bond Risks in the Short-Run

Saturday, June 7th, 2014

From a letter from a reader:

Hi David,

I’ve been following your blog for the last few months and the articles are extremely insightful.

I’ve been working with fixed income credit trading the last few years but I feel that I have not been measuring risk well. I only look at cash bonds

Right now I’m only looking at DV01 and CR01, but my gut tells me that there’s a lot more to risk monitoring that can be done on a basic cash bond portfolio.

From your experience as a bond portfolio manager, what other risk metrics have you found useful?

I’d really appreciate if there were a few pointers you could give or just a trail that you could show me and I’ll follow it.

First, some definitions:

Basis Point [bp]: 0.01% — one one-hundredth of a percent.  If you have $10,000 in a money-market fund, and they pay one basis point of interest per year, at the end of the year you will have $10,001.  In this environment, that’s not uncommon.

DV01: bond valuation calculation showing the dollar value of a one basis point increase or decrease in interest rates. It shows the change in a bond’s price compared to a decrease in the bond’s yield.

CR01: Credit Sensitivity – Credit Default Swap [CDS] price change for 1bp shift in Credit par spread — same as DV01, but applied to CDS instead of a bond.

Now, onto the advice: when you manage bonds, the first thing you have to do is understand your time horizon.  Is it days, weeks, months, or years?  When I managed bonds for a life insurer 1998-2003, the answer was years.  Many years, because the liabilities were long.  That gave me a lot of room to maneuver.  You sound like you are on a short leash.  Maybe you have a month as your time horizon.

When the time horizon is short, the possibilities for easy profits are few, and here are a few ideas:

1) Momentum: yes, it works in the bond market also.  Own bonds that are rising, and sell those that are falling.  Be sensitive to turning points, and review the relative strength index.

2) Stick with sectors that are outperforming.  Neglect those that underperform.

3) If you have significant research that has a differential insight on a bond, pursue it with a small amount of money if it may take a while.  If the change might happen soon, increase the position.

4) Try to understand when CDS is rich or cheap vs cash bonds by issuer.  Look at the price history, and commit capital when pricing is significantly in your favor.

5) Set spread targets for your investing.  Decide on levels where you would commit minimum, normal, and maximum funds.  Be generous with the maximum level, because markets are more volatile than most imagine.

6) Look at the criteria for my one-minute drill: http://alephblog.com/2010/07/17/the-education-of-a-corporate-bond-manager-part-ii/

(and look at the end of the piece, but the whole piece/series has value.)

7) Analyze common factors in your portfolio, and ask whether those are risks you want to take:

  • Industry risks
  • Duration risks
  • Counterparty risks

8 ) Look at the stock.  If it is behaving well, the bonds will follow.

Maybe your best bet is to trade CDS versus cash bonds, if the spread is thick enough to do so.  If not, I would encourage you to talk with more senior  traders to ask them how they survive.  Trading is a tough game, and I do not envy being a trader.

The Good ETF, Part 2 (sort of)

Friday, April 18th, 2014

About 4.5 years ago, I wrote a short piece called The Good ETF.  I’ll quote the summary:

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a “roll” or some replication strategy.
  • Not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.  There are many ETFs that are Closed-end funds in disguise.  An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Though I said ETFs, I really meant ETPs, which included Exchange Traded Notes, and other structures.  I remain concerned that people get deluded by the idea that if it trades as a stock, it will behave like a stock, or a spot commodity, or an index.

What triggered this article was reading the following article: How a 56-Year-Old Engineer’s $45,000 Loss Spurred SEC Probe.  Quoting from the beginning of the article:

Jeff Steckbeck didn’t read the prospectus. He didn’t realize the price was inflated. He didn’t even know the security he read about online was something other than an exchange-traded fund.

The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a volatility bet, or about 80 percent of his investment, after a Credit Suisse Group AG (CSGN) note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he’d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.

“In theory, everybody’s supposed to read everything right to the bottom line and you take all the risks associated with it if you don’t,” he said this month by phone from Lebanon, Pennsylvania. “But in reality, you gotta trust that these people are operating within what they generally say, you know?”

No, you don’t have to trust people blindly.  Reagan said, “Trust, but verify.”  Anytime you enter into a contract, you need to know the major features of the contract, or have trusted expert advisers who do know, and assure you that things are fine.

After all, these are financial markets.  In any business deal, you may run into someone who offers you something that sounds attractive until you read the fine print.  You need to read the fine print.  Now, fraud can be alleged to those who actively dissuade people from reading the fine print, but not to those who offer the prospectus where all of the risks are disclosed.  Again, quoting from the article:

Some fail to adequately explain that banks can bet against the very notes they’re selling or suspend new offerings or take other actions that can affect their value, according to the letter.

[snip]

“My experience with ETN prospectuses is that they’re very clear about the fees and the risks and the transparency,” Styrcula said. “Any investor who invests without reading the prospectus does so at his or her own peril, and that’s the way it should be.”

[snip]

The offering documents for the VelocityShares Daily 2x VIX (VIX) Short Term ETN, the TVIX, says on the first page that the security is intended for “sophisticated investors.” The note “is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,” according to the prospectus.

While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name, didn’t say that the price had become unmoored from the index it was supposed to track.

David Campbell, president of Clermont Wealth Strategies, declined to comment.

Steckbeck, who found the TVIX on the Yahoo Finance website, doesn’t have time to comb through dozens of pages every time he makes an investment, he said.

“Engineers — we’re not dumb,” said Steckbeck, who founded his own consulting company in 1990. “We’re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can’t sit there and read prospectuses all day.”

If you are investing, you need to read prospectuses.  No ifs, ands, or buts.  I’m sorry, Mr. Steckbeck, you’re not dumb, but you are foolish.  Being bright with math and science is not enough for investing if you can’t be bothered to read the legal documents for the complex contract/security that you bought.  I read every prospectus for every security that I buy if it is unusual.  I read prospectuses and 10-Ks for many simple securities like stocks — the managements must “spill the beans” in the “risk factors” because if they don’t, and something bad happens that they didn’t talk about, they will be sued.

In general I am not a fan of a “liberal arts” education.  I am a fan of math and science.  But truly, I want both.  We homeschool, and our eight kids are “all arounds.”  They aren’t all smart, but they tend to be equal with verbal and quantitative reasoning.  Truly bright people are good with both math and language.  Final quotation from the article:

“The whole point of making these things exchange-traded was to make them accessible to retail investors,” said Colbrin Wright, assistant professor at Brigham Young University in Provo, Utah, who has written academic articles on the indicative values of ETNs. “The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.”

So, I contacted Colby Wright, and we had a short e-mail exchange, where he pointed me to the paper that he co-wrote.  Interesting paper, and it makes me want to do more research to see how great ETN prices can be versus their net asset values [NAVs].  That said, end of the paper errs when it concludes:

We assert that the frequent and persistent negative WDFDs [DM: NAV premiums] that appear to be driven by uninformed return chasing investors would not exist to the conspicuous degree that we observe if ETNs offered a more investor-driven and fluid system for share creation. We believe the system for share creation is ineffective in mitigating the asymmetric mispricing investigated in our study. Hence, we recommend that ETN issuers reformulate the share creation system related to their securities. Specifically, we recommend the ETN share creation process be structured to mirror that of ETFs. At a minimum, the share creation process should be initiated by investors, rather than by the ETN issuers themselves, as we believe profit-motivated investors will be more diligent and responsive in creating ETN shares when severe mispricing arises.

Here’s the problem: ETNs are debt, not equity.  To have the same share creation system means that the debtor must be willing to take on what could be an unlimited amount of debt.  In most cases, that doesn’t work.

So I come back to where I started.  Be skeptical of complexity in exchange traded products.  Avoid complexity.  Complexity works in favor of the one offering the deal, not the one accepting the deal.  I have only bought one structured note in my life, and that was one that I was allowed to structure.  As Buffett once said (something like this), “My terms, your price.”

To close, here are four valuable articles on this topic:

So avoid complexity in investing.  Do due diligence in all investing, and more when the investments are complex.  I am astounded at how much money has been lost in exchange traded investments that are designed to lose money over the long term.  You might be able to avoid it, but someone has to hold every “asset,” so losses will come to those who hold investments long term that were designed to last for a day.

To Live off of, and Die from, the Equity Premium and Alpha

Thursday, April 10th, 2014

I’m working on my taxes.  I’m not in a good mood.  Okay, writing that made me chuckle, because I am usually in a good mood.

Let me divide my working life into four segments:

  • 1986-1998: Actuary — reasonably well paid, and significantly underpaid compared to the value I delivered.
  • 1998-2007 — Investment risk manager, Mortgage bond manager, Corporate bond manager, and Senior Analyst at a long/short hedge fund.  Paid well for my efforts, and the  rewards to clients were far more than what I was paid.
  • 2007-2010 — Almost no pay, as I deal with home issues, provide research to a small minority broker-dealer, and try to gain institutional asset management clients.  Living off of assets from earlier days.
  • 2010-2014 — Living off of asset income as I slowly build a retail and small institutional client base for my value investing.

The last two periods are the most interesting in a way, because I was drawing more income from investments than I was from any other source.  Even during my time at the hedge fund, I made more money from my own investing every year than I was paid, and I was paid well.  That said the mid-2000s were a hot time, particularly if you made the right calls on a growing global economy.

My net worth today is roughly where it was at the peak of the markets in 2007, despite my low wage income.  I have been bailed out by the returns of the equity market and my alpha.

This is not a comfortable place to be, because general equity returns are not predictable, and alpha, though I have had it for years, is not predictable either.  That said, my client base has been growing, and in another year or so, my practice should support my family even if the markets don’t do well.

=-=-=-=-=-=–==-=-=–=-==-=–=-==–=-=-=-=-==-=–=-==-=-=-=-=-=-=-=-=-=-=-

Though I just told a story about me, the real story isn’t about me.  Think of all of the people who are trying to manage their lump sum in retirement.  They are relying on strong equity markets; they are hoping for alpha.  They are not ready for setbacks.

Unless you are seriously wealthy, when you are not receiving reliable income from a wage-like source, you can feel like you are in a weak position. I have felt that on occasion, but in general  I have not worried.

I write this because equity outperformance over bonds will likely be limited over the next ten years.  I peg equities at about a 5%/year average nominal return, with a diversified portfolio of bonds at around 2-3%/year.  Also the ability to add alpha is limited, because alpha is zero in total, and are you smart enough to find the managers that can do it?

In desperate times desperate men do desperate things.  Low interest rates are leading many to speculate more than they ordinarily would.  Equity allocations go higher.  Allocations to “alternatives” go higher.  People start using nonguaranteed income vehicles as if they had the structural protections of bonds.

As I always say, be careful.  Those trying to manage a lump sum for income in retirement are playing a dangerous game where if you try to draw more than 3.5%/year with regularity will prove challenging, because that is playing at the boundary of what the assets can deliver, and leaves little room for an adverse scenario.  Be careful.

Reaching For Yield

Sunday, April 6th, 2014

15 months ago I wrote a piece called Expensive High Yield – II.  High yield is still expensive.  I won’t post all of the regressions, but I have re-run them.  The results are largely the same as before.  Yields are low, and spreads are overly tight for everything except CCC bonds.

Much of this is the result of the Fed’s low fed funds rate and quantitative easing, which forces investors to take more risk.  Another aspect is the strong equity market.

Also, CCC bonds offering opportunity may not adjust for the loosening of covenant protections.  There is a tendency for investors to try to maintain yield levels while letting quality & covenants sag.  In a low interest environment, with more and more people retiring, there is a growing desire for the simplicity of yield.

My conclusion last time was this:

All of the corporate bond market is expensive relative to history, perhaps excluding CCC bonds.  That doesn’t mean it can’t get more expensive, particularly if stocks continue to move upward.   But this won’t last for more than two years; the signs of speculation are here, and that should make us cautious.

As a result, I am investing my bond strategy cautiously now.  What little yield I get comes from emerging market sovereigns.  Credit risk from corporates is small.

Well, I blew it with emerging markets; what a kick in the teeth.  I would have been better off in high yield.  As it is, for me and my bond clients, the strategy is Fire and Ice.  20% long Treasuries for deflation, 80% short credit instruments for inflation.  So far, so good.

Be wary in this environment.  So many are reaching for yield amid a weak economy with yields that are low relative to past trends.  But also be aware that a rising stock market can support the corporate bond market.  That has worked for the last two years, but it can’t work forever.

Classic: Know Your Debt Crises: This Too Shall Pass

Thursday, March 27th, 2014

The following was published at RealMoney on August 6th, 2007:

Editor’s Summary

The illiquid debt instruments at the heart of the current crisis are subject to regime shifts.

  •  We’re in a periodic repricing of illiquid debt instruments.
  • Look for the time when the bulk of the losses will be reconciled.
  • Stick with the companies that have strong balance sheets.

I appreciated Cramer’s piece Friday morning, which picks up on many themes that I have articulated for the last four years here on RealMoney.  Here are a few:

  • Hedge fund-of-funds demand smooth returns that are higher than that which a moderate quality short-term fixed-income fund can deliver.
  • This leads to the creation of hedge funds that seek yield through arbitrage strategies.
  • And the creation of hedge funds that seek yield through buying risky debts, unlevered.
  • And the creation of hedge funds that seek yield through buying less risky debts, levered.
  • And the creation of hedge funds that seek yield through buying risky debts, levered.

In the short run, yield-seeking strategies work.  If a lot of players pursue them, they work extra-well for a time, as late entrants to the trade push up the returns for early entrants, with greater demand for scarce, illiquid securities with extra yield.  Pricing grids are a necessity for such securities, because the individual securities don’t have liquid secondary markets.  The pressure of demand raises the value not only of the securities being bought, but also of those securities that are like them.  (Smart managers begin to exit then.)

I’ve been through regime shifts in the markets for collateralized debt obligations (CDOs), asset-backed securities (ABS), residential-backed securities (RMBS) and commercial mortgage-backed securities (CMBS).  Something shifts at the back of the chain that forces everything to reprice.  For example:

1989-1994: After the real estate boom of the mid-1980s, many banks, savings & loans and insurance companies get loose in their lending standards and real estate investment, leading to a crisis when rent growth can’t keep up with financing terms; defaults ensue, killing off a great number of S&Ls, some major insurance companies and a passel of medium and small banks.

Late 1991-early 1993: The adjustable-rate mortgage market, fueled by demand from ARM funds, overbids for ARMs in an effort to provide a high floating rate yield.  As the FOMC loosens monetary policy, higher than expected prepayments force losses onto the ARM funds

Late 1993-late 1994: The FOMC threatens to, and does, start raising interest rates, which throws the residential mortgage-backed market into crisis.

Mid-1998-mid-1999: Long Term Capital Management blows up, forcing all manner of exotic ABS, CMBS and RMBS into the market for bids.  The bids back up, until the entire market reprices and then tightens in the space of one year.

1998-1999: Home equity ABS blow up, as defaults threaten to, and then do, emerge at levels far higher than anticipated.  Almost no originators survive.

1999-2001: Cruddy high-yield bonds reveal their true value as defaults threaten to, and then do, emerge.

2002-2003: The manufactured-housing ABS market blows up, as originators don’t take initial losses but roll borrowers over into new loans that reduce payments and extend payment terms, technically keeping the loans current.  The system collapses when the buildup of bad debts and repossessed homes becomes too great to roll over.

(Of the existing large securitization markets, only the CMBS market so far has not faced a real crisis, partly due to the influence of the B-piece buyers cartel: six or so firms that buy the junk-rated debt of deals and enforce credit quality standards on the individual loans by kicking out poorly underwritten loans.  But who knows?  Even that could be overwhelmed under the right circumstances.)

In each of these situations, there was a boom-bust cycle.  The markets did not adjust slowly and evenly to changing conditions; the transitions between “boom” pricing, and “bust” pricing were swift.  This is the nature of markets, particularly when enough debt is employed to amplify the process.

There is no conspiracy necessary to make the shift happen (though often the media will make it seem like there was one); the bubble pops when the financing proves insufficient to carry the assets.  After the bubble pops, it becomes a question of what the underlying assets can be liquidated for, allocating losses mercilessly according to the loan documents and bankruptcy priority.

Today the crises are nonprime lending, leveraged buyouts and other high-yield debt and over-leverage in the CDO market.  These will get worked out, as all other crises do, handing losses to those who speculated unwisely and allowing those who financed properly to prosper on the other side of the crisis.

As you invest, look for the time when more than half of the losses will be reconciled.  That will be near the bottom for homebuilders and housing finance.

That time may not come for another two years or so, but there will be money to be made once the crisis is mostly reconciled.  Just stick with the companies that have strong balance sheets.

Limit Repo Financing

Friday, March 21st, 2014

If you have a moment, read this Bloomberg article.  The brokers are utterly dishonest when they say:

Brokers contend that their borrowing is generally less risky than bank lending. Repo borrowing, for instance, is backed by collateral that can be readily sold to raise cash in case the other party defaults, said Steven Lofchie, co-chairman of the financial services group at Cadwalader, Wickersham & Taft LLP.

“If you think about a bank that is lending 90 percent against a house, versus a broker-dealer taking in 102 percent against a loan of a security, the broker-dealer’s credit risk is exponentially less,” Lofchie said.

This is true under ordinary circumstances, but not in a crisis, as we saw in 2008.  Seemingly safe securities were no longer safe, because too many overleveraged parties could not hold their positions when the prices of their seemingly safe securities started to fall.  This led to a panic, because of the structural error of financing long-dated securities with short-dated funding.  In a crisis, that is the fatal flaw of repo financing.

I think the proposals of the SEC are decent, and those that the broker-dealers propose are not.  I would go further and abolish repo markets.  They are crisis-bait.  The asset-liability mismatch invites trouble.

The proposal of the broker-dealers is flawed, because they don’t adopt a model where they match assets and liabilities.  Stable systems match assets and liabilities.  Until they do so, they should not be taken seriously.  The math of risk control wars against them.

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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