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Book Review: Investor Behavior

Thursday, August 21st, 2014

Investor-BehaviorOrdinarily, I read all of the books that I review, but when I don’t, I tell my readers. This book I started to read, but I found it so dry that I started skimming it. It’s not that I don’t know the material; it is that I do know it.

The book covers most areas of behavioral finance, however, it does it in an academic way.  The book would be ideal for academics and those that appreciate an academic approach to finance, that want to have a taste of many different areas of behavioral finance.

There are more engaging books for practitioners and average investors to read — you would even do better reading articles like this from a leading blogger.  (Those at Amazon, please come to Aleph Blog if you want the links.)

Summary

 When I review books, I try to say who it would be good for — in this case, it is academics.  Let average market participants seek elsewhere for more engaging content.  If you still want to buy it, you can buy it here: Investor Behavior: The Psychology of Financial Planning and Investing.

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.

The Victors Write the History Books, Even in Finance

Thursday, August 21st, 2014

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“It ain’t what you don’t know that hurts you, it’s what you know that ain’t so.”

(Attributed to Mark Twain, Will Rogers, Satchel Paige, Charles Farrar Browne, Josh Billings, and a number of others)

A lot of what passes for investment knowledge is history-dependent, and may not serve us well in the future.  Further, a certain amount of it is misinterpreted, or, those writing about it, even really bright people, don’t understand the hidden assumptions that they are making.  I’m going to clarify this by commenting on three graphs that I have seen recently — two that I think deceive, and one that I think is accurate.  Let’s start with one of the two, which come from this article at AAII, interviewing Jeremy Siegel:

9298-figure-1

 

Leaving aside the difficulties with the data from 1802-1871, there is an implicit assumption of buying and holding that undergirds these statistics.  Though the lines look really smooth now in hindsight, for those investing at the time they were often scared to death in bear markets, selling out at the worst possible time, and in bull markets, getting greedy at the worst possible time.

Now one might say to me, “But David, forget what happened to individuals.  As a group, people must made returns like this, because every buyer has a seller — even if some panicked or got greedy, someone had to take the other side of the trade and benefit.”  True enough, though I am suggesting that average people can’t live with that much volatility.  Even if you cut 1929-32 in half by being 50/50 Stocks/Treasury Notes, how many people could live with a 40% downdraft without selling out?

But there is another problem: when does cash enter and exit the stock market?  Hint: it doesn’t happen via secondary trading.

Cash Enters the Stock Market

  • An Initial Public Offering [IPO], secondary IPO, or rights offering leads people to give money to a corporation in exchange for new shares.
  • Employees forgo pay to receive company stock.
  • Shares get issued to suppliers in lieu of cash (common with scammy promoted stocks)
  • Warrants get exercised, and new shares are issued for the price of cash plus warrants.

Cash Exits the Stock Market

  • Cash dividends get paid, and not reinvested in new shares
  • Stock gets bought back for cash
  • Companies get bought out either entirely or partially for cash.

I’m sure there are other ways that cash enters and exits the stock market, but you get the idea.  It means that cash is exchanged with the company for shares, and vice versa, not the trading that goes on every day.  Now, here’s the critical question: when do these things happen?  Is it random?

Well, no.  Like any other thing in investing, n one is out to do you a favor.  New stock tends to be offered at a time when valuations are high, and companies tend to be taken private when valuations are low.  Thus back in the tech bubble, 1998-2000, a lot of cash got soaked up into companies with dubious valuations and business models.  With a few exceptions, most lost over 90%+.  Now consider October 2002.  How many companies IPO’ed then?  Very few, but I remember one, Safety Insurance, that came public at the worst possible moment because it had no other choice.  Why else would the IPO price be below liquidation value?  Great opportunity for those who had liquidity at a bad time.

The upshot is that because stock is issued at times that do not favor new investors, and stock is retired at times that do not favor existing investors, the dollar-weighted returns for stocks in the above graph are overestimated by 1-2%/year.  Stocks still beat bonds, but not by as much as one would think.

But here’s a counterexample, taken from Alhambra Investment Partners’ blog:

LR-140815-Fig-1

Note that buybacks don’t follow that pattern.  Corporate managements often exist to justify themselves, and so a great number of them do not behave like value investors when they buy back stock.  Part of this is that capital seems cheap during the boom phase of the market, and so they lever the company up, issuing debt to buy back stock at high prices.  It increases earnings in the short-run, but when the bear market comes, the debt hangs  around, and intensifies the fall in the stock price.

This is why I favor companies that shut off their buybacks at a certain valuation level.  If they have to dispose of excess cash to avoid takeovers, pay out special dividends… leave the reinvestment issues to shareholders.  If they buy back stock at levels that are too high, it does not increase the intrinsic value of the firm, though it might keep the price higher for a little while.

Here’s the other graph  from this article at AAII, interviewing Jeremy Siegel:

9298-figure-2

 

What this graph is trying to say is that if you just buy and hold on long enough, results get really, really certain, and investing a lot in stocks reduces your risks, it does not raise your risks.

I’m here to tell you that is an amplification of the past, and maybe not even the best amplification of the past.  This is where the victors write the history books.  Your nation is blessed if:

  • You haven’t had war on your home soil.
  • There are no plagues or famines
  • Socialism is kept in check; expropriation is not a risk (note the many countries grabbing pension assets today)
  • Hyperinflation is avoided (we can handle the ordinary inflation)

Any of those, if bad enough, can really dent a portfolio.  We can have fancy statistics, and draw smooth curves, but that only says that the future will be like the past, only more so. ;)  I try to avoid the idea that mankind will avoid the worst outcomes out of self-interest.  There have been enough cases in history where that has not proven true, and envy and revenge dominate over shared prosperity.

I’ve already made the comment on how many can’t bear with short-run volatility.  There is another factor: when you look at the above graph, it represents the average valuation level, yield curve shape, etc.  If you are applying this model to today, where credit spreads are low, cash earns nothing, the yield curve is wide, equity valuations are medium-high, you would have to adjust the expected returns to reflect what the likely outcomes are, and the graph would not look as favorable.  Volatility looks low today, but realized volatility is likely to be higher, and will not likely follow a normal distribution.

Closing

My main point here is to beware of history sneaking in and telling you that stocks are magic.  Don’t get me wrong, they are very good, but:

  • they rely on a healthy nation standing behind them
  • their past results are overstated on a dollar-weighted basis, and
  • their past results come from a prosperous time which may not repeat to the same degree in the future
  • you may not have the internal fortitude to buy and hold during hard times.

 

Ranking P&C Reserving Conservatism

Wednesday, August 20th, 2014

6791185245_9cb9b5ccc1_zAbout 1 1/2 years ago, I wrote a seven-part series on investing in insurance stocks.  It is still a good series, and worthy of your time, because there aren’t *that* many writers freely available on the topic.

This particular article deals expands on part 4 of that series, which deals with insurance reserving.  I wanted to do this at the time, but I was short on time, and wrote out the general theory there, while not actually doing the time-consuming job of ranking the conservativeness of P&C insurers reserving practices.

Let me quote the two most important sections from part 4:

 

When an insurance policy is written, the insurer does not know the true cost of the liability that it has incurred; that will only be known over time.

Now the actuaries inside the firm most of the time have a better idea than outsiders as to where reserve should be set to pay future claims from existing business, but even they don’t know for sure.  Some lines of insurance do not have a strong method of calculating reserves.  This was/is true of most financial insurance, title insurance, etc., and as such, many such insurers got wiped out in the collapse of the housing bubble, because they did not realize that they were taking one big nondiversifiable risk.  The law of large numbers did not apply, because the results were highly correlated with housing prices, financial asset prices, etc.

Even with a long-tailed P&C insurance coverage, setting the reserves can be more of an art than science.  That is why I try to underwrite insurance management teams to understand whether they are conservative or not.  I would rather get a string of positive surprises than negative surprises, and you tend to one or the other.

and

What is the company’s attitude on reserving?  How often do they report significant additional claims incurred from business written more than a year ago?  Good companies establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.

So get out the 10K, and look for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years.”  That value should be consistently negative.  That is a sign that he management team does not care about maximizing current period profits but is conservative in its reserving practices.

One final note: point 2 does not work with life insurers.  They don’t have to give that disclosure.  My concern with life insurers is different at present because I don’t trust the reserving of secondary guarantees, which are promises made where the liability cannot easily be calculated, and where the regulators are behind the curve.

As such, I am leery of life insurers that write a lot of variable business, among other hard-to-value practices.  Simplicity of product design is a plus to investors.

P&C reserving_14389_image002Today’s post analyzes Property & Casualty Insurers, and looks at their history of whether they consistently reserve conservatively each year.   Repeating from above, management teams that reserve conservatively establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.  This should give greater confidence that the accounting is fair, if not conservative.

So, I went and got the figures for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years,” for 67 companies over the past 12 years from the EDGAR database.  Today I share that with you.

When you look at the column “Reserving by Year,” that tells you how the reserving for business in prior years went over time.  A company that was consistently conservative of the past twelve years would have “12N’ written there for twelve negative adjustments to reserves.  Using Allstate as an example, the text is “5N, 1P. 3N, 3P” which means for the last 5 years [2013-2009], Allstate had negative adjustments to prior year reserves.  In 2008, it had to strengthen prior year reserves.  2007-2005, negative adjustments.  2004-3, it had to strengthen prior year reserves.

Now, in reserving, current results are more important than results in the past.  Thus, in order to come up with a score, I discounted each successive year by 25%.  That is, 2013 was worth 100 points, 2012 was worth 75, 2011 was worth 56, 2010 was worth 42 points, etc.  Since not all of the companies were around for the full 12 years, I normalized their scores by dividing by the score of a hypothetical company that was around as long as they were that had a perfect score.

Now, is this the only measure for evaluating an insurance company?  Of course not.  All this measures in a rough way is the willingness of a management team to reduce income in the short-run in order to be more certain about the accounting.  Consult my 7-part series for more ways to analyze insurance companies.

As an example, imagine an insurance company that consistently writes insurance business at an 80% combined ratio.  [I.e. 20% of the premium emerges as profit.]  I wouldn’t care much about minor reserve understatement.  Trouble is, few companies are regularly that profitable, and companies that understate reserves tend to get into trouble more frequently.

Comments and Surprises

1) Now, it is possible for a company to game this measure in the short run, where the management aims to always release some reserves from prior year business whether it is warranted or not.  That may have happened with Tower Group.  Very aggressive in growth, after their initial periods, they consistently released reserves for eight years, before delivering huge reserve increases for two years.

Now, someone watching carefully might have noticed a reserve strengthening for their non-reciprocal business in 2011, and then strengthenings in mid-2012, before the whole world realized the trouble they were in.

2) Notice in the red zone (scores of 40% and lower) the number of companies that did subprime auto insurance — Infinity, Kingsway, and Affirmative.  That business is very hard to underwrite.  In the short run, it is hard to not want to be aggressive with reserves.

3) Also notice the red zone is loaded with companies with much recent strengthening of reserves.  Many of these companies are smaller, with a few exceptions — the law of large numbers doesn’t apply so well with smaller companies, so they mis-estimate more frequently.  I won’t put companies with less than $1 billion of market cap into the Hall of Shame.  It’s hard to get reserving right as a smaller company.

4) As for larger companies, they can be admitted to the Hall of Shame, and here they are:

Hall of Shame

  • AIG
  • The Hartford
  • AmTrust Financial Services
  • Mercury General, and 
  • National General Holdings

AIG is no surprise.  I am a little surprised at the Hartford and Mercury General.  National General Holdings and Amtrust are controlled by the Karfunkels, who are aggressive in managing their companies.  Maiden Holdings, another of their companies is in the yellow zone.

Final Notes

I would encourage insurance investors to stick to the green zone for their investing, and maybe the yellow zone if the company has compensating strengths.  Stay out of the red zone.

This analysis could be improved by using prior year reserve releases as a fraction of beginning of year reserves, and then discounting by 25% each year.  Next time I run the analysis, that is how I will update it.  Until then!

Full disclosure: long TRV, ENH, BRK/B, ALL

The Tip Culture in Amateur Investing

Saturday, August 16th, 2014

2132090594_78f91a417c_o A reader wrote to me and said:

I’m sure a lot of people have already told you but I want to tell you anyway: Your blog is awesome! I came across The Aleph Blog a couple of months ago and I’m very impressed with your content. I particularly like that 4-part article on Using Investment Advice. I am in the financial industry myself and it makes me wish I came up with the kind of ideas that you have on your blog. Awesome stuff!

Keep up the good work,

Many thanks to the reader, and if you want to read that series, it is located here.  But when I considered what he wrote to me, it made me think, “Why do we have to tell people how to think about investment advice?”

Then it hit me: because people are looking for easy tips to execute.  After all, when I wrote the 4-piece series, I had listening to Jim Cramer in mind.  The “tip culture” of inexperienced investors don’t want to learn the ideas behind investing, but just want someone to say, “Buy this.”  There is little if any guarantee that the same pundit will ever update his opinion.

We see this on the web, in magazines, newsletters, newspapers, etc.  On rare occasion, I will print one out, and add it to my “delayed research stack” which means I will look at it in 1-3 months.  I just did my quarterly clean-out a few days ago — anything I add to the stack now will wait until November.INTC

But why read articles like, “Ten Undervalued Large Cap Stocks with Growth Potential,” “Nine Stocks to Buy and Hold Forever,” “Eight Stocks that are Taking Off, Don’t Miss Out,” “Seven Hidden Gens Among Small Caps,” “Six Stocks for Income and Growth,” “Five Energy Stocks that are Poised to Surge,” Four Titanic Stocks that Every Investor Should Own,” “Three Turnaround Stocks with Potential for Large Capital Gains,” “Two Stocks with Breakthrough Technologies,” and “The One Stock that You Should Own for the Next Decade.”

Now, I made those titles up, though the last one was based off a Smart Money article on Intel in late 1999 which came very close to top-ticking  the market.  As you can see, Intel still hasn’t made it back to the tech bubble peak.

As I Googled phrases like, “Ten Best Stocks,” it was fascinating to see the range of pitches employed:

  • Appeals to Buffett (that never gets old)
  • Best stocks for this year
  • Favorite stocks of an author, manager or publication
  • With high dividends
  • With a low price
  • In emerging markets
  • That won’t lose money
  • That our patented investment screener spat out
  • For the rest of your life
  • Etc.

I know that I could get a lot more readers with list articles that tout stocks.  I don’t do it because most of the articles that you read like that are bogus.  [I also don’t want the inevitable scad of complaints that come with the territory.)  So why do such articles draw readers?

People would rather have false certainty than live in the reality that choosing good investments is difficult.  Even very good investors hit rough patches where they do not outperform.  Also, people aren’t comfortable with uncertain horizons for realizing value in investments — article tout holding forever, ten years, one year, but rarely 3-5 years or a market cycle.

The truth is, you can’t tell when a stock will perform, but when it does perform, the results will be lumpy.  The performance of a stock is rarely smooth.  During times when the success or failure of a stock idea is realized, the moves are often violent.

Now remember, those who write such articles are looking for media revenue — such articles are sensational, and pander to the desire for easy money.  But where are the articles telling you to sell ten stocks now?  (Yes, I know there are some, but they are not so common.)  Or, where are follow up pieces indicating how well prior picks have done, and whether one should sell, hold, or buy more now?

My main point is this: good amateur investing is like having a part-time job.  A part-time job, well, takes time.  Weigh that against other priorities in your life — family, friends, church, public service, fun, etc.  You may not want a part-time job, and so you can index your investments, or outsource them to a trusted advisor, who hopefully digs up his own ideas, and does not have a consensus, index-like portfolio (If he does, why not index?)

So, avoid tips if you can.  If you can’t, develop a research discipline, or set them aside like I do, and revisit them when the original reason for buying it is forgotten, and you must evaluate for yourself now.  The investment that you do not understand why you bought it, you will never know when it is the right time to sell it.

Either learn to evaluate investments on your own, or index your investments, or find a good investment advisor.  But don’t think that you will do well off of tips.

On Research Sources and Trading Rules

Friday, August 15th, 2014

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On a letter from a reader:

In your Industry Ranks August 2014 post you mentioned that you use Value Line analytic tools.

If it is not a secret, what other third-party research and analysis do you use, especially for company analysis (MorningStar, Zacks…)?

Do you rely/subscribed on Interactive Brokers “IBIS Research Essentials?” If yes, do you find it valuable?

In addition, if you do not mind, you said that you make adjustments to your portfolio once in a quarter. Does it mean that you do not look at market quotes during the day at all and, hence, you are not subscribed to IB real-time data (NYSE, Nasdaq, US Bond quotes?)

I would greatly appreciate your answers.

Thank you very much!

I don’t like to spend money on aids for research.  I can only think of two things that I pay for and actively use:

I do pay for quotes at Interactive Brokers, but because I don’t trade much, I don’t pay for the expensive packages.  I have not subscribed to Interactive Brokers “IBIS Research Essentials.”

But many of the best things in life are free.  My local library offers free Morningstar and Value Line online… I don’t have to leave my home to use it, an it is open all the time.  If I go two blocks to my library, there is a wealth of business data and books that I can draw upon.

That said, the Web offers a lot of free resources, and I make use of:

  • Yahoo Finance, which I think I have been using since 1996 — pretty close to its inception.  There is no better place on the web to get business news tagged for each corporation.  It has gotten better since removing some feeds that have questionable value.  There’s a great range of information to be had in a wide number of areas.
  • FRED, which just keeps getting better… more data series, more ways to use them… and I have been using them since it was a “bulletin board” (remember those?) back in 1991 or so.
  • Bloomberg.com is excellent in the general and business news areas.
  • Beyond that, Reuters, Marketwatch, the New York Times, and the Financial Times (especially FT Alphaville) have excellent business news coverage.  With the last two, NYT & FT, you have to decide if you want to pay for it, and I don’t pay for them.
  • When I do my stock research, I generally go to the SEC website and read the documents.  Then I go to Yahoo Finance and the company’s own website for color.
  • For bonds, bond funds and ETFs, I go to the provider websites, Morningstar, and the Wall Street Journal’s Market Data section.  I can visit FINRA Trace if I need to see how individual bonds have been trading.
  • Finally there is a lot of wisdom in many bloggers out there, and I strongly recommend you get to know them.  Some of the best are expertly curated each day at Abnormal Returns by Tadas Viskanta.

Now as to your question as to whether I look at prices of assets in my portfolio: in general, I check them 3-5 times a day, usually at a point where I will be switching tasks.  I sort my stocks two ways at that time:

  1. By absolute percentage change descending — all of the largest movers are at the top of the screen, and I can look for patterns and trends, which may make me check Yahoo Finance for news.  But that doesn’t make me trade, unless it ends up revealing something that I think will get a lot better or worse, and the market hasn’t figured that out yet.  (That doesn’t happen often.)
  2. By size of positions — if a position has gotten too large, I trim some back.  If it has gotten too small, I stop and research why the price has fallen.  If I am convinced that the stock offers significant returns, and low downside risk, I add a little to the position.  (See Portfolio Rule Seven for more details.)  In a rare number of cases, about once every two years, I will “double weight” the position that has fallen.  So far, all of those have worked over the last 14 years.  But if I realize that the company is unlikely to return anything comparable to the other stocks in my portfolio, I sell it.

Portfolio Rule Seven trades maybe amount to 3-12 small trades per quarter.  More trades come when the market is trending, fewer when it is choppy.  Portfolio Rule Eight is where I do the big trades once per quarter, comparing each stock in my portfolio against a group of potential replacements.  I usually sell 2-4 companies, and then buy a similar number of replacements.  That has my portfolio turn over at a 30%/year rate.  More details available in the article Portfolio Rule Eight.

In general, it is wise for both amateur and pro investors to trade by rule.  Take as much emotion out of the process as possible, and avoid greed and panic.  It is genuinely rare that decisions have to be made quickly, so take your time, do your analysis, and try to find assets with good long-term prospects.

Avoid Buying Individual Stocks in Distress

Thursday, August 14th, 2014

There is a temptation, particularly among novice value investors, to throw money at a stock that has fallen hard.  Bargains are hard to pass up.

It can be worse if you owned the stock prior to the fall, and kept investing as it went down.  There is the temptation to follow blindly the axiom, “Well, if you liked it before, you must love it now!  Load the boat!”  Far better to sit down and talk with a friend who has more skill than you, who does not own the stock, and if he/she has time, ask for his opinion.  While you are waiting, go out to the web, and listen to the opinions (perhaps triumphal opinions) of those that did not like the stock.  Particularly take note of:

  • Allegations that the accounting is aggressive, or worse, crooked
  • Claims that the management team has goals different than that of shareholders.
  • Check to see that the balance sheet isn’t weak.  Compare it to the balance sheets of competitors.
  • Is there too much debt?  Is there too much debt potentially coming due soon, and too little resources to pay the debt?
  • Is revenue falling dramatically?  What competitor is benefiting from the firm’s troubles?

But even if you didn’t own the stock, you might be wary of a stock that has fallen hard for a number of reasons, if the fall indicates the company may be in danger of default.

  • It’s likely that the management team that is responsible for the problem is still in charge.
  • Most ordinary management teams are not used to managing a company that is in distress.
  • Suppliers become less likely to extend favorable credit terms to the firm.
  • Rival companies spread rumors that you are going under and try to attract your best customers away.
  • Talented employees look for greener pastures as opportunities dry up.  It’s no fun to turn from growing a profitable business, to putting out fires.
  • Management will be distracted with staying alive, maybe vulture investors, analysts seeking more data, regulatory requests, lenders seeking assurances, etc.
  • Credit will be harder to get from bonds, loans, etc., and if the firm gets it, it will be expensive. (Especially if the firm uses the Financing Methods of Last Resort.)
  • And, management may make things even tougher by having a round of layoffs.  Less people to do the same work.
  • Not only that, but even if you are right about the stock, there will be a lot of sellers selling as the stock price rises, because they got back to even.

When a company is in distress, everything fights against it.  All of the normal courtesies are gone, replaced by a haze of suspicion.  At the time it most needs friends, they vanish.  Tempting as it may be to buy the stock quickly, it might be worth it to wait and see whether things get worse, and analyze who would like to buy the company to use some subset of the assets for their own company.

Now recently I read a classic Journal of Finance article called, “In Search of Distress Risk, by Campbell, Hilscher, and Szilagyi.” [Download is for wonks only, I will summarize.]  Distress tends to happen to firms that have negative price momentum, are small, and are classified as value stocks because of the high ratio of net worth to market capitalization.  As a result, some suggested that the risk premiums that exist for owning small and value stocks must be related to distress.  But firms under distress tend to do badly, while small and value stocks tend to do well.  Negative momentum fits, but distress is a small part of that anomaly.

So maybe if you are a value investor or a small cap investor, you might be able to improve your performance by screening out distress situations.  The simplified variables used in the paper are (and their effect on the probability of distress [page 2910]):

  • Net Income / Total Assets (lower means higher probability of distress)
  • Total Liabilities / Total Assets (higher means higher probability of distress)
  • Three month total returns (lower means higher probability of distress)
  • Realized stock price volatility over the last three months (higher means higher probability of distress)
  • Market capitalization (higher means higher probability of distress)
  • Stock price under $15? (yes means higher probability of distress)
  • Cash and near cash as a fraction of total assets (lower means higher probability of distress)
  • Market to Book (higher means higher probability of distress)

Most of these make intuitive sense.  The one for market capitalization doesn’t except the the effect of a stock being under $15/share is more closely related to distress.

One thing that might make you change you mind is if a new management team is brought in.  Every quarter I pull together a list of companies that have fired or replaced their CEO, and I throw them in as competitors against the existing companies in my portfolio.  [there were about 80 over the last three months] A fresh set of eyes, a fresh mind can change things, but analyse to see whether the new man or team has the right ideas.

SEASTo close with an example: don’t buy Seaworld [SEAS] after the negative surprise of yesterday, at least not yet.  Analyze for solvency.  Try to figure out whether the actions management is proposing will actually make things better, or whether the company’s prospects have been permanently reduced.

Don’t try to catch a falling knife.  Rather, analyze, and if it makes sense when the panic has died down, buy some as a part of a diversified portfolio.

PS — In distress, the real pros look down the capital structure to see whether the preferred stock, junior debt, senior debt, bank loans, or trade claims look attractive.  That’s beyond the average investor, but in times of distress, those securities trading at a discount may be where the real action is.  The securities that get hurt but not destroyed will typically control the firm post-bankruptcy.

Full Disclosure: No holdings in any securities mentioned

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.

A Few Investment Notes

Saturday, August 9th, 2014

Just a few notes for this evening:

1) I’ve been a bull on the long end of the Treasury curve for a while.  It’s been a winning bet, and the drumbeat of “interest rates have nowhere to go but up” continues.  Here’s an argument from Jeffrey Gundlach on why long rates should remain low, and maybe go lower:

Gundlach, however, was one of the very few people who believed rates would stay low, especially with the Federal Reserve committed to keeping rates low with its loose monetary policy.

It’s important to note that U.S. Treasuries don’t have the lowest yields in the world. French and German government bonds have yields that are about 100 basis points lower than those of Treasuries. In other words, those European bonds actually make U.S. bonds look cheap, meaning that yields have room to go lower.

This will trend toward lower rates will eventually have to end, but neither GDP growth, inflation, or business lending justifies it at present.

2) From Josh Brown, he notes that correlations went up considerably with all risk assets in the last bitty panic.  Worth a read.  My two cents on the matter comes from my recent article, On the Recent Anxiety in High Yield Bonds, where I noted how much yieldy stocks got hit — much more than expected.  I suspect that some asset allocators with short-dated or small stop-loss trading rules began selling into the bitty panic, but that is just a guess.

3) That would help to explain the loss of liquidity in the bond market during the bitty panic.  This article from Tracy Alloway at the FT explores that topic.  One commenter asked:

Isn’t it a bit odd to say lots of people sold quickly *and* that there isn’t enough liquidity? 

Liquidity means a number of things.  In this situation, spreads widened enough that parties that wanted to sell had to give up price to do so, allowing the brokers more room to sell them to skittish buyers willing to commit funds.  Sellers were able to get trades done at unfavorable levels, but they were determined to get the trades done, and so they were done, and a lot of them.  Buyers probably had some spread target that they could easily achieve during the bitty panic, and so were willing to take on the bonds.  Having a balance sheet with slack is a great thing when others need liquidity now.

One other thing to note from the article is that it mentioned that retail investors now own 37% of credit, versus 29% in 2007, according to RBS. Also that investment funds has been able to buy all of the new corporate debt sold since 2008.

There’s more good stuff in the article including how “matrix pricing” may have influenced the selloff.  When spreads were so tight, it may not have taken a very large initial sale to make the estimated prices of other bonds trade down, particularly if the sales were of lower-rated, less-traded bonds.  Again, worth a read.

4) Regarding credit scores, three articles:

From the WSJ article:

Fair Isaac Corp. said Thursday that it will stop including in its FICO credit-score calculations any record of a consumer failing to pay a bill if the bill has been paid or settled with a collection agency. The San Jose, Calif., company also will give less weight to unpaid medical bills that are with a collection agency.

I think there is less here than meets the eye.  This only affects those borrowing from lenders using the particular FICO scores that were modified.  Not all lenders use that particular score, and many use FICO data disaggregated to create their own score, or ask FICO to give them a custom score that they use.  Again, from the WSJ article:

Fair Isaac releases new scoring models every few years, and it is up to lenders to choose which ones to use. The new score will likely be adopted by credit-card and auto lenders first, says John Ulzheimer, president of consumer education at CreditSesame.com and a former Fair Isaac manager.

Mortgages are likely to lag, since the FICO scores used by most mortgage lenders are two versions old.

The impact of the changes on borrowers is likely to be significant. Accounts that are sent to collections, including credit-card debts and utility bills, can stay on borrowers’ credit reports for as long as seven years, even when their balance drops to zero, and can lower their scores by up to 100 points, said Mr. Ulzheimer.

The lower weight given to unpaid medical debt could increase some affected borrowers’ FICO scores by 25 points, said Mr. Sprauve.

But lowering the FICO score by itself doesn’t do anything.  Some lenders don’t adjust their hurdles to reflect the scores, if they think the score is a better measure of credit for their time-horizon, and they want more loan volume.  Others adjust their hurdles up, because they want only a certain volume of loans to be made, and they want better quality loans at existing pricing.

Megan McArdle at Bloomberg View asks a different question as to whether it is good to extend more credit to marginal borrowers?  Didn’t things go wrong doing that before?  Her conclusion:

That in itself [DM: pushing for more loans to marginal borrowers as a matter of policy] is an interesting development. Ten years ago, politicians were pressing hard for banks to extend the precious boon of homeownership to every man, woman and shell corporation in America. Five years ago, when people were pushing for something like the CFPB, the focus of the public debate had dramatically shifted toward protecting people from credit. Oh, there were complaints about the cost of subprime loans, but ultimately, on most of those loans, the problem wasn’t the interest rate but the principal: Too many people had taken out loans that they could not realistically afford to pay, especially if anything at all went wrong in their lives, from a job loss to a divorce to an unexpected illness. And so you heard a lot of complaints about predatory lenders who gave people more credit than they could handle.

Credit has tightened considerably since then, and now, it appears, we’re unhappy with that. We want cheaper, easier credit for everyone, and particularly for the kind of financially struggling people who have seen their credit scores pummeled over the last decade. And so we see the CFPB pressing FICO to go easier on people with satisfied collections.

That’s not to say that the CFPB is wrong; I don’t know what the ideal amount of credit is in a society, or whether we are undershooting the mark. What I do think is that the U.S. political system — and, for that matter, the U.S. financial system — seems to have a pretty heavy bias toward credit expansion. Which explains a lot about the last 10 years.

Personally, I look at this, and I think we don’t learn.  Credit pulls demand into the present, which is fine if it doesn’t push losses and heartache into the future.  We are better off with a slower, less indebted economy for a time, and in the end, the economy as a whole will be better off, with people saving to buy in the future, rather than running the risk of defaults, and a very punk economy while we work through the financial losses.

Industry Ranks August 2014

Saturday, August 9th, 2014

Industry Ranks 6_1521_image002My main industry model is illustrated in the graphic. Green industries are cold. Red industries are hot. If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?” Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted. Yes, things are bad, but are they all that bad? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

You might notice that I have no industries from the red zone. That is because the market is so high. I only want to play in cold industries. They won’t get so badly hit in a decline, and they might have some positive surprises.

If you use any of this, choose what you use off of your own trading style. If you trade frequently, stay in the red zone. Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion. I generally play in the green zone because I hold stocks for 3 years on average.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh? Why change if things are working well? I’m not saying to change if things are working well. I’m saying don’t change if things are working badly. Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes. Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then. This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year. It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology stocks here, some industrials, some healthcare and consumer stocks, particularly those that are strongly capitalized.

I’m looking for undervalued industries. I’m not saying that there is always a bull market out there, and I will find it for you. But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive. I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting. The red zone is pretty cyclical at present. I will be very happy hanging out in dull stocks for a while.

That said, some dull companies are fetching some pricey valuations these days, particularly those with above average dividends. This is an overbought area of the market, and it is just a matter of time before the flight to relative safety reverses.

The Red Zone has a Lot of utilities and other dividend-paying industries; as I said, be wary.  What I find fascinating about the red momentum zone now, is that it is loaded with cyclical companies.

In the green zone, I picked almost all of the industries. If the companies are sufficiently well-capitalized, and the valuation is low, it can still be an rewarding place to do due diligence.

Will cyclical companies continue to do well? Will the economy continue to limp along, or might it be better or worse?

But what would the stock screening model suggest that I have displayed the last few times I have done this post?

Wish I could tell you.  In an “upgrade” Value Line’s stock screener can’t do the Value Line subscription that it used to, because its 3-5 Year Projected Annual Total Return field is blank for the screening software.

Maybe next time, but until then, play it conservative in your industry and stock selections — look for companies that can easily survive if industry conditions worsen.  Once weaker players are marginalized, they will do well.

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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