For public companies in the US, what is the breakdown by state and then by sector, as measured by market capitalization:

Quite a graph.  Some states are like the US Average Sector mix, and some are very different. This set of two graphs will tell the story:

These are broad generalizations, but why are do some states have a set of publicly traded companies like or unlike the national average?

• Larger states tend to have larger cities, which nurture more diverse business ecosystems.
• States with notable educational institutions tend to produce more diverse business ecosystems.
• Some state cultures are more entrepreneurial, and tend to produce more diverse business ecosystems.
• Some states, because of the natural resources that they were endowed with, tend to have more companies in the area of the resources involved.  That seems to be especially true when it comes to the energy sector, which explains Wyoming, Oklahoma, and Texas.
• Much can be blamed on historical accident.  Why should Delaware have DuPont, except that that is where the founder lived and worked.
• Or, why should Nebraska be so big in financials?  Who could have expected 40 years ago that Warren Buffett’s Berkshire Hathaway would prosper so much, and that Warren would not move the business to a larger city?  But Buffett believed that it was an advantage to be away from Wall Street; it aids in independence of thought.
• That retailing marvel, Dillard’s Wal-Mart, is based in Bentonville, Arkansas, because the founder started it there.  Again, he could have moved, but the initial genius of Wal-Mart was focusing on under-served rural areas, without attracting competition from larger retailers.  Then when their purchasing power exceeded that of the legacy retailers, they competed against them directly in the major cities.
• To toss out one more, Green Mountain Coffee Roasters is based in Vermont, far from where coffee is grown, but that is where the company started, and the culture of the state that they initially served, Vermont,  helped shape the company that it became.
• The utility industry is space-limited, and is mostly regulated by the states, at least in terms of delivery to local clients.  Thus a state like New Mexico has PNM Resources, which mostly provides electricity and natural gas in New Mexico and Texas.  Similarly, North Dakota has MDU Resources which serves North Dakota, and parts of South Dakota, Wyoming and Montana.  Same for South Dakota, with Northwestern Corp, and Black Hills Corp.
• Then there are network effects, sometimes aided by regulation.  Nevada has the lion’s share of the gambling industry.  Regulation allowed for it, but once it got started, it became a destination for it, fixing it the minds of those that like to gamble.  Even as gambling regulations have declined in many states, it would be very difficult to dislodge Nevada’s first mover advantage.  The same logic applies to Wall Street, though New York State has a diverse economy.

Disclaimer and Summary

Now, remember the limitations here.  Private companies are equally important in the US, and so is the non-profit sector.  The reason that I work with the publicly traded companies, is that the data is readily available, and there is an easy summary statistic that is a proxy of the long-term value of the firm, equity market capitalization.  Maybe I should have used enterprise value, but I think that would have given undue weight to financials.

There are other ways to define value to society, each with its own set of flaws and data dirtiness problems.  This is just one simple way of trying to show the diversity of business in the US, segmented by sector and state.

One final note: I had to have a size cutoff in my study.  I used companies that had a market cap greater than $125 million on 2 September 2010.

More to come in Part 2.

New Buys:

• 5/19/2010      Petrobras
• 7/9/2010        Goldman Sachs Group Inc
• 8/31/2010      American Electric Power
• 8/31/2010      Corn Products International
• 8/31/2010      Zhongpin
• 8/31/2010      PC Connection
• 8/31/2010      Stancorp Financial

New Sales:

• 8/31/2010      Goldman Sachs Group Inc
• 8/31/2010      Dominion Energy
• 8/31/2010      PPL Inc.
• 8/31/2010      Sempra Power
• 8/31/2010      Safeway Inc.

Rebalancing Buys:

• 5/19/2010      Ensco International Inc
• 6/1/2010        Noble Corporation
• 6/29/2010      Computer Sciences Corp
• 6/30/2010      Industrias Bachoco
• 6/30/2010      Northrop Grumman
• 6/8/2010        Safeway Inc
• 7/6/2010        National Presto
• 8/12/2010      Constellation Energy Group

Rebalancing Sales:

• 8/2/2010        Noble Corporation

Thoughts

1)  I try not to trade too much.  For those that are new to my writings, rebalancing buys and sells are meant to bring the positions back to target weight after they have moved 20% away from the target weight.  As it is, for three months, I have not made a lot of trades.

2) I reduced utility exposure, it seems to have gotten relatively expensive amid the yield craze.  I have added cheap, well-financed names in a number of areas.

3) Assurant and National Western are double weights.  The rest of the portfolio is equal-weighted aside from that.  Note that National Western is quite illiquid.  Do not place market orders to buy or sell.

4) I flipped my momentum factor from small negative to moderate positive.  I have concluded that in a touchy macro environment like this, it is wise to consider return momentum.

5) I still don’t trust the financial sector aside from insurers here.

6) I had some runners-up in my analyses: AXS EDS TRH DFG

7 ) Some thoughts on the 8/31 buys:

• PC Connection is a net-net, illiquid, but makes money.  Unusual to have a company that trades for less than its net assets, and makes money.  THIS IS ILLIQUID.  NO MARKET ORDERS.
• Stancorp Financial is a well-run insurer trading at a discount.  Issues: Commercial mortgage exposure high, and disability may prove problematic during recessionary conditions.
• American Electric Power was cheaper than the utilities it replaced.
• Zhongpin sells pork in China.  Seems cheap, and has a decent amount of growth potential.  The financials look clean, but I am still reviewing it.
• Corn Products seems cheap, and its products are needed globally.

8 ) I have roughly 11% in cash.  If I find a really good idea, I might bring that down to 8%.  At present, my stocks are nearer to the high end of their rebalancing bands, so I am more likely to be doing a little selling than buying of my existing stocks in the short-run.

9)  Here was the last update.  Comments welcome.

Full disclosure (here is the whole portfolio): COP SBS DIIBF IBA VLO NTE SAFT RGA ESV ALL PRE PEP GPC LNT AIZ ADM CVX NE ORCL NWLI CB CSC NOC NPK SCG TOT SENEA CEG PBR AEP HOGS PCCC SFG CPO

I haven’t written about my portfolio management methods in a while.  I’ll be writing on this a few more times over the next week or so.  The eighth rule of my investing is:

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

First I have to get new ideas.  I have two sources for that:

• My industry rank study.  Within those industries chosen, I run a screen that uses financial strength, valuation, and growth potential to highlight promising names.  Of the 34 current names in the portfolio, the screen chose 10 of them, out of 79 suggested names.
• Trolling around on the web and talking to friends.  When I hear a promising idea, I print it out or write it down, and put it in a pile to wait for the next reshaping.  This helps me to forget who suggested it and why, so that I am forced evaluate it independently.  If I don’t fully understand it, I will not know when to buy more or sell it.  That generated 40 additional names.

Anyway, here are the tickers for the replacement candidates:

ABFS ACM AEP AFL AMGN APA APC APOL ATPG AXS BCE BDX BHI BRY BT CAG CALM CAM CDI CL CLX CNQ CPO CVS DFG DLM DO EGN ENR ESLT FDP FISV FLIR FRX FST FTO GD GLRE GMXR HAL HOGS HRL HSII IP JBL KELYA KEX KFT KHDHF LLL LNC LPX MDT MDU MET MMM MOG/A MOT MRO MUR MWV NBR NEMNLC NOV NVDA OCR OII OSG PCCC PG PRU PXD PXP RAH RDS/A RE REP RIG RNR RTN SJM SPR SU SUN SXT TDW TDY TEG THS TK TLM TMK TMO TRH TRP TSO TTI UNM V VZ WAG WAT WMT WPP WY YUM

I will run my quantitative model on these companies versus the current companies in the portfolio, and kick out companies I now own that score poorly and buy some the score well.  This procedure is not absolute; there are often bits of data  that the quantitative factors ignore.  But when all is said and done, I buy companies that I think are better than those that I am selling.

This also forces me to review the whole portfolio, and be dispassionate about what gets sold.  It also forces me to take things slow, and not make hasty decisions.

What factors exist in my scoring model:

• Valuation – Earnings, Book, Sales
• Momentum
• Earnings Quality
• Sentiment indicators — neglect, volatility, etc.

I change the weights over time.  I ask myself, “What is working now?” and, “What has or hasn’t been working for too long?”  What working now should get extra weight, while leaning away from ideas that are too popular, and leaning toward those that are unfairly tarred as dead.

But this is only an aid and a guide.  If I put something into the portfolio, it has to pass my qualitative reasoning tests, which admittedly are subjective, but encompass my reasoning as a businessman.

In short, that is what I do.  I hope to give you an update in a few days to explain how this practically worked out in this reshaping.  If you have other tickers that you think I should consider please let me know in the comments, and I will toss them into the mix.  Thanks.

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My 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.”

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.

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 wth more potential over the next 1-5 years.

I still like energy names here, some utilities, and reinsurers, particularly those that are strongly capitalized.  I’m not concerned about hurricanes for the strongly capitalized (it’s not likely to be a strong season anyway; if it hasn’t been strong yet, it likely will not be); they will be around to benefit from the increase in pricing power after any set of hurricanes.

I’m looking for undervalued and stable industries.  Human resources — sure, more part time workers.  Healthcare information?  A growing field, even with the new “health bill.”  Same for Biotech.

Even in a double dip, toiletries will still be purchased.  Phone calls will still be made, and the internet will still be accessed.  Perhaps life insurers are worth a look here; after all, the Bush tax cuts are expiring, and there will be more demand for tax avoidance.

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 more highly cyclical than I have seen in quite a while.  I will be very happy hanging out in dull stocks for a while.

Illiquidity is an underrated risk.  Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.  Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don’t trade often.

So where do we see failures due to illiquidity?

• Banks — too numerous to mention, though FDIC insurance restrains it now.
• Life insurers, particularly those that write a lot of deferred annuities.
• AIG and the GSEs — abominations all.
• Bear and Lehman — waiving the leverage limit was one of the stupidest regulatory decisions ever.
• Hedge funds – LTCM was the granddaddy of failures, but many have choked because redemptions forced liquidation of assets at unfavorable prices.
• No colleges, though those college that were too aggressive on illiquid assets got whupped in 2008.  Some were forced to raise liquidity in costly ways.  Same for many overly aggressive pension plans, many of whom came late to the game with Venture Capital, Hedge Funds, Timber, Commodities, etc.

Face it.  Most alternative asset classes involve additional illiquidity.  That is an additional risk, and when evaluating those investments, the expected rate of return must be greater than that for liquid investments.

As an aside, there is another factor to be considered with alternative investments.  That factor is strategy capacity.  Alternative investments do best when they are new.  Here is my version of the phases that they go through:

• New — few know about it except some business-minded investors.  Only the best deals get done.
• Growing — a modest number know about it, and a tiny number of consultants.  Only very good deals get done.
• Comes of age — many know about it, and most consultants pitch it to their clients as the way to go.  Good deals get done.
• Maturity — almost everyone knows about it, and it is a standard aspect of asset allocation for consultants, who have their means of differentiating between different providers, based on metrics that will later be revealed to be useless.  All reasonable deals get done.
• Post-maturity — Late bloomers make it to the party, and beg to get in, thinking that past is prologue, and do not realize that deal quality has eroded severely.
• Failure, which brings maturity — deals fail, leading the market to scrutinize all investments, leading to true risk-based pricing.  Later adopters abandon the market, and take losses.  Earlier adopters sharpen practices, and prepare for a more normal asset class.

So, when looking at illiquid assets, how do you determine how much to invest?  First determine how much of your funding base will never leave over the next 10 years.  When I was a corporate bond manager, that was 25% of the assets that I was managing, because of structured settlements and immediate annuities.

For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield.  Invest that much in short to intermediate bond investments.  You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.

But after that, there is an additional way of controlling illiquidity risk — time once again for the fusion solution! Money market funds run a ladder of maturities.  Stable value funds run a longer ladder, as should commodity ETFs, rather than floating at spot.  Then there are clever advisers who run municipal and other bond ladders for wealthy and semi-wealthy clients.  Running a ladder of maturities is one of the most robust management techniques as far as interest rate risk is concerned.  There is always money coming out and in every year, which slowly leads the portfolio yield in the direction of average rates.

Now, if these bonds are less liquid muni bonds, but the credit risk is low, you don’t care as much about the illiquidity, because the ladder produces its own liquidity as bonds mature.  The key question is sizing the length of the ladder, which comes down to a question of analyzing the liquidity/income needs of the client, combined with a forecast on the secular direction of rates.  The forecast is the least important item, because it is the toughest to get right.  (An aside: who has been right on bond yields consistently for the last 20+ years?  Hoisington, my favorite deflationists.  Wish I had listened more closely.)

The same principle applies to pension funds, endowments, life insurers with a few twists.  Divide your liabilities in two.  What obligations do you know cannot be changed, except at your discretion?  That group of liabilities can have illiquid assets to fund them.  Try to match the payout streams, but if not, try to match them in broad with a ladder, keeping in mind what mismatches you will likely face over the next 1-2 years in order to properly size your cash position.

The rest of the liabilities need more intensive modeling, analyzing what could make them change.  You can try to buy assets that change along with the liabilities, but in practice that is hard to do.  (That said, there are no end of clever derivative instruments available to solve the problem in theory.  Caveat emptor.)  The assets have to be liquid for this portfolio.  Other aspects of portfolio choice will depend on valuation parameters, credit spreads, yield curve shape, market volatilities, as well as macroeconomic factors.

Three Closing Notes

1) Now, all that said, just because you can take on illiquidity doesn’t mean that you should.  A good manager has a feel from history for what the proper liquidity give up is in valuations for stocks and other risk assets, and credit spreads for fixed income assets of all sorts.

Was it worth moving from the:

• Relatively liquid AAA tranche to the illiquid AA, A or BBB tranche for 0.10%, 0.20%, 0.40%/year respectively?  As a bond manager at much larger insurance company said back in 2000 — “It’s free money.”  (That is almost always a dangerous phrase.) My view was there was more illiquidity and credit risk than we could consider.
• Relatively liquid large-issue BBB bank bond to the relatively illiquid small-issue BBB bank bond for 1% more in yield?  Hard to say.  There are a lot of factors involved here, and your credit analyst will have to be at the top of his game.  It also depends on where you are in the speculation cycle.
• Liquid public equities to private equity or hedge funds with lockups?  Tough question.  Try to figure out what the unlevered returns are for comparative purposes.  Analyze long-term competitive advantage.  Look at current deal quality and valuation metrics.  For hedge funds, look at how credit spreads moved over their performance horizon.  Anyone can make money when spreads are tightening, but who makes money when spreads are blowing out?  Analyze them over a full credit cycle.

2) Institutions that did not previously do more liquidity analysis because we had been in near-boom conditions for decades need to at least do scenario testing to assure that they aren’t overplaying their hands, such that they might be forced to make bad decisions if liquidity gets tight.  Safety first.  (This applies to governments and industrial corporations too, as we will experience over the next three years.)

3) Finally, if you decide to make a large illiquid purchase like Mr. Buffett did last year, make triple-sure of your logic and your liquidity positioning.  Nothing lives forever, but you can prolong the life of the institutions you serve by careful reasoning and planning, particularly regarding liquidity.  Get financing when you can, not when you need it. It takes humility to do so, but it yields the quiet reward of continued existence at a modest price.

1) Kind of like my thesis that the States give a better picture of the economy than the Federal Government, I agree with the idea that small banks better represent that health of the US economy.  Most small an medium-sized businesses rely on small banks.  Growth in employment relies on small and medium-sized businesses, because they typically have more room to expand.

2) I’ve been arguing for a weak economy before the double dip concept was derided.  Not that I make the Philly Fed survey a big part of my analysis, but the weak report is consistent with my view that the US economy is weak.

3) All developed markets where there is still confidence are finding long government yields hitting new lows.  No surprise, with so many investors and nations scared, that many would focus on sovereign governments for repayment.

4) So there are failures to deliver in the MBS market.  Part of it is due to the Fed sucking up a large part of the market.  Part due to the low cost of short term funds.  My question to anyone reading, are there any significant costs?

5) A crisis like this is divisive.  In the US, it separates the strong versus the weak states.  In the EU, it separates the strong versus the weak countries.  That is the nature of financial crises — they divide the healthy from the sick,with some slight tweaking from government action.  As it is now, there is a divergence where countries with some flexibility fight to maintain their independence.

6) Jake makes the argument that one would pay a lot for certainty of return of principal in this environment. SO, don’t sniff at low short term rates.

7) Ordinarily I agree w/Jesse.  For example, I agree that there could be a lot more extracted from the rich in taxes.  But I don’t think it would succeed.  There are too many holes in the tax code, and the wealthy would hire bright people to make the tax obligation go away.  I speak as one that has seen this in action.  Rich people are much smarter than poor people when it comes to money. It would take radical tax reform to change matters.

8 ) The ultimate stories on GM and AIG, as well as FNMA and FHCC, is that the government loses money on the deals, but spins them positively, in saying, “look, they are operational again.” Truth, better that they all failed, but the government aims at fixing things, even when it can’t.

9) This piece gets it right on Social Security in minor, blows it in major.  Yes, the bonds built up over the last 20 years will be paid out of current tax revenues, but will the US Government be able to bear the total burden as Medicare expenses go through the roof?

10) What a fight on stocks vs. bonds.  I favor bonds in the short run, stocks in the long run.  Where I disagree with both is that government action is needed to preserve value.

11) Are we turning into Japan? I have argued yes for some time because we are following the same government actions that Japan did.

12) How bad is the economy?  Bad enough that average people are liquidating 401(k)s.

13) China might finally be getting smart on population policy.  But getting women to have more kids once you have convinced them of the short-term value of not doing it — you will have a better career, and the long-term benefit of not doing it — we have too many people for the planet already; it’s pretty tough.  They take the easy road of not having kids, and it doesn’t matter how many economic incentives get kicked up — once women decide they don’t want to have children, there is no amount of economic policy that will change their minds.

But, there are other ways to do it: show reruns of happy families with many kids.  Waltons, Brady Bunch, Eight is Enough, etc.  We had eight kids, (we adopted five) and there is a lot of value in the many relationships that exist in a large family.

Okay, enough for now.  Time for sleep.  Just don’t go shorting bonds thinking I told you to do it.

1) I am not a Treasury bond bull, per se, but I am reluctant to short until I see real price weakness.  And some think that I am only a fundamentalist value investor.  With bonds, it is tough to catch the turning points, and tough to grasp the motivations of competitors.  Better to miss the first 10% of a move, than miss it altogether.  And consider this teardown of the past bear case here.  Or look at the bull case here.  Or, look at Japan supporting us as China sells.

But are there enough buyers out there for Treasury notes on the current path of deficits? At present interest rates, the answer is likely “no,” after some time.  The US is going to have to change its behavior, and shrink deficits, especially expenses from defense and entitlements.

2) To Narayana Kocherlakota: Yo, man, time to grow up.  Markets are what they are.  They react to what you say, not what you mean.  But beware the the day that you say what you mean, lest the market go bonkers.  What, you say that is unfair? Feh, sir, welcome to the markets.  We understood what you meant.  There is no document so analyzed as the FOMC statement.  If it is misanalyzed in your view, it is your fault for sloppy language.

3) Hitting a 10 out of 10 on the “Hooey scale,” this piece at Martin Wolf’s forum rings the bell. Quantitative easing has lowered rates in Japan, but has not helped employment to any degree.  The same will be true for the US.  Hint: lowering discount rates raises the value of existing enterprises, but does little for new enterprises because new enterprises need equity finance.  There is no evidence that lower interest rates, of themselves, will lower unemployment.

4) If someone had said to me that I would say something nice about Basel III soon, I would have growled.  But I was wrong, Basel III limits short-term leverage.  Very nice, would that Dodd-Frank had been equally useful.  (I wrote about this many times.) The thing that still gores me about the Basel standards is that it is wrong to rely on companies for credit analysis.

5) When the debt reacts bad on a merger, so do I.  So it is for American General Finance.  Fortress may want to buy it, but do they really get the lending to AIG?  The bad experience on subprime lending, etc.

6) We have already had one lost decade, the question that we have is whether we will have two decades. We may have recognized some losses faster than Japan, but the policies that we are pursuing of stimulus, running deficits, and forcing high quality interest rates lower is the same strategy that failed in Japan.  The government needs to stop hogging the liquidity through QE, and let private markets allocate liquidity.

7) Corporations act to protect their interests, regardless of those who follow them.  Google aside, few CFOs want to take risk with their excess short term assets. Flexibility is a real asset in volatile times, so good CFOs keep their powder dry rather than stretch for yield.

8 ) Saw this cute piece on residential real estate prices in the US.  There is still room for prices to fall.  A house is a place to live; under ordinary circumstances it is not an investment.  That said, though low rates aren’t stimulating a lot of buying, they are leading to a decent amount of refinancing.

That’s all for now.  Gotta go help my oldest daughter move out.

Here are my thoughts on the markets, in no particular order:

1) Momentum draws investors.  Long treasuries have run hard, and people like them now.  My view is, if you want to short them, wait until they rise 0.1% more in yield, then short.  There are a lot of weak longs to shake out.

2) That said, long rates are generally falling in the developed world.  Gives a real feel of global debt deflation.

3) Not that the yen sees any problem here for now.  This makes me more bullish on the yen; few nations are willing to allow their currency to appreciate.

4) Arguments over residential mortgages. Geithner sees room for a federal role. Gross want the Feds to make mortgages full-faith-and credit obligations of the US Government.  A shameful statement from a man who built his wealth through free markets, and now looks to protect it through Socialism. John Carney is far better, though he flounders over what to do.  To me it is obvious — take Fannie and Freddie through Chapter 11 after their debt guarantees are gone, and let the market buy up the pieces.  Fannie and Freddie have lost money for the US over their existence; they have served no useful function, any more than some misbegotten tax incentive might have done.  And, as Kid Dynamite has put it, “The problem is that home prices are too high.  We need more deflation, and more debt reduction.

5) Physics is the wrong analogy for economics.  Ecology is the right analogy.  Like ecologies, economies resist prediction and control.  People adapt, inanimate objects don’t.  So you might enjoy these articles from FT Alphaville and Bookstaber.

6) As I commented today on Twitter: “Get ready for the bookstore massacre http://bit.ly/cywtPT $BKS fiddles with its capital structure, while it gets outcompeted by $AMZN.”  I mean it.  The problems of Barnes & Noble are organic problems of competing against Amazon and losing.  Who controls B&N is less important than what strategy they take from here.  It is a lousy time for B&N to be consumed with a noneconomic issue, when they are getting killed.  And forget BGP… they are dead too.

7) Matthew Lynn hits the nail on the head.  Additional debt does not promote recovery.  If true in Europe, then true here as well.

8 ) The Dallas Fed questions whether we can stimulate our way to prosperity.  My answer: the more we place the decision in the hands of individuals the better the decisions will be.  We know what we need better than the government does.

9) Did we misunderstand the Fed’s recent FOMC non-action?  I don’t think we did , but Federal Reserve Bank of Minneapolis President Narayana Kocherlakota thinks that we did.  I think he has to understand the markets better — we work off of changes in expectations.  We expected the Fed to do nothing again.  Now that you are buying in more Treasuries, we know that the economy is weak, and we buy long fixed income as protection.  At least we are front-running you.

10) Hey, another blogger summit at the Treasury, and this one has three of the originals there (but not me).  Comments from Marginal Revolution as well.  One participant told me it wasn’t worth it to be there and the Treasury was not prepared to answer questions, but who can tell?  I have an idea: let the Treasury webcast the meeting.  I know from the first meeting that neither the Treasury nor the bloggers would have been dominant.  At least it would be transparent; isn’t transparency what the Obama Administration is about?

11) Cramer has ten reasons that the market won’t blow up.  Good.  I am 80% invested.  All I will say is that the rules are different when debts are being deflated.  Things don’t behave the same way as when debts are growing.

12) TIPS are in an awkward spot here.  Negative yields on the short end imply that buyers are looking for more inflation.  I might think that in the long run, but would be reluctant to bet on that over the next five years.

“How can I beat the Lehman Aggregate?” a bond manager friend recently asked me.  Tough question in this environment; I’m still musing about it.  It’s a tough market.

Start with Treasuries — they are the bedrock of the market.

Here is the Treasury yield curve at 4 polar moments in the last two years.  Two times where no one doubted that the economy was bouncing back: 6/10/2009 and 4/5/2010. One time where everyone thought the end was near: 12/18/2008.  Then there is now; the front five years of the curve is like the panic.  7-20 years is like 75% of the panic.  30 years is half of the panic, relative to the last two years.

So what to make of it?  Despite the Fed’s willingness to buy twos through tens, I think the thirties look attractive versus twenties and tens.  The curve typically peaks near 20 years, and that’s not true now.

Are things as bad as at the panic point in December 2008?  No, but the front-end thinks so.  I would be inclined to try a barbell where thirties and bills are overweighted, and twos through twenties are underweighted.  How big to make the bet?  That is up to your risk appetite.

Now remember, this is a trade, not a long-term investment.  Sometimes I think that government policy tends to turn us into speculators and traders… the first intentionally, the second by accident.

Now all of this is amid China lightening the boat on Treasuries.  That did not stop the rally.  As the article said:

For one thing, Japanese investors have steadily bought more U.S. debt as China has shrunk its portfolio. Japanese holdings rose to $803.6 billion in June and have increased by $82.7 billion since last July.

Domestic buyers have also helped fill the gap. U.S. household ownership of Treasurys in the first quarter was $795.7 billion, the highest in a decade, according to the latest Federal Reserve data available. Private pension funds, life-insurance companies and commercial banks have also raised their holdings to record or multiyear highs.

China favoring the Euro at this point is an interesting move, contrarian from an investment standpoint, but seeking European favor from a political standpoint.  Politics and economics go together in China, given the crude top-down planning they impose on the economy.

But what kind of market is it when both long Treasury bonds and gold rally at the same time?  It is a fear market that does not know what to fear.  “We fear ‘flation!!!”  Which kind of ‘flation, they are not sure, but things look bad.  Makes me want to short them both, but let the momentum die first…

Agency mortgages are problematic because of the weakness in home prices leading many mortgages to be not refinancable.  Thus the bonds trade at low interest rates, but high spreads to Treasuries.  Personally, I don’t think a mega-refinance is possible legally, but that makes the bonds a little cheap to Treasuries.  This would be an area to analyze collateral, and buy selectively.

One thing that is different from the panic in December 2008 is that corporate spreads are tighter now.  BBB bonds still look attractive, but with junk, you have to be selective.  I would focus on highest quality, and BBBs, and underweight the rest.  Consider buying the bonds of Moody’s.  Quite a spread at 3%, and unless something weird happens, it is still quite a franchise.

Beyond that there are always issue-specific bonds that seem to be undervalued.  Those are worth tossing in, and adusting the rest of the portfolio to adjust duration and credit quality.

Some closing notes:

• Why is Google issuing commercial paper?  Please, tell me.  They have no lack of short-term liquidity.  Are they aiming for financial profits like a hedge fund would?  In some ways they are already– take note that they are doing securities lending to pick up additional yield (see my comment after the article). If this becomes a large part of Google, the P/E multiple on Google should come down, because financial entities arbing credit spreads do not deserve high multiples.  Better Google should pay out the excess cash to policyholders as a special dividend in 2010.
• As an aside, I would add that the financialization of profits in general brings down the P/E multiples of industrial companies.  It looks so easy at the beginning.  Just finance the purchases of your own products through a captive subsidiary, and the extra profits roll in, with a small drop in the P/E.  That’s fine as far as it goes, but it usually doesn’t stop there; the division head of the finance sub seeks new vistas — if he can lend successfully in one area, he can do it in others.  We’ve got the infrastructure; why not use it?  The result at best is a GE or a Textron — two stocks that have gone nowhere over the last 14-15 years.
• Many people in the US are selfish and want to decrease spending on others, but not themselves.  We see that through both of our clueless parties arguing over priorities, and people who want to see the deficit cut, but not in their prized areas.  The logic of shared pain has not yet arrived.  Things haven’t gotten bad enough to drive real spending or tax reform yet.
• Last note: this is a period where people are demanding certain yield, thus bidding up bond prices versus stocks.  It reveals a lack of certainty about the future.  It makes some stocks look attractive — in many cases corporate bond yields are below stock earnings or cash flow yields, and even below dividend yields in some cases.  This article is an example of this phenomenon.  The key question is how long profit margins can remain elevated.  With labor plentiful relative to work, that could be a while, leaving aside risks in the financial system.

So, what should I tell my friend?  Maybe this:

• Duration: emphasize short and long.
• Credit: emphasize highest quality and some BBBs
• Underweight financials with weak liability structures (I.e., the too big to fail banks) for now.
• Mortgages: play carefully, but play.
• If you don’t get a big yield premium for illiquidity, don’t play in illiquid bonds.
• Can you do a little foreign? If so, diversify a little into the developed world fringe currencies outside of the US Dollar, Euro, UK Pound and Yen.

These are tentative conclusions that I would have to work out further — I don’t have my thoughts together on CMBS, Munis, etc.  That’s all for now.

Insect bites, bruises, sore feet, tiredness, happy sons… I am back from backpacking.

Whenever a financial product is plentiful, it is usually time to avoid it.  Tonight’s poster child for such nuttiness is junk bonds.  If you are a speculator, you can own junk bonds, and the stocks of the companies that are issuing them, because the market is hot for now, but be ready to sell; have your stop orders ready.  Fundamental investors would need to be more careful.  Though default rates may be declining, there is no guarantee that that will continue to be so; given troubles at the banks, cautious stance is warranted.

If looking at individual issues, those aiming for organic growth are better candidates than those that are doing mergers, paying special dividends, or just levering up.  So be wary, and realize that conditions could change rapidly.  Stick to sounder credits, including investment grade issues.  There is more juice to be squeezed in the long end of investment grade, then in shorter junk issues.

My second point for the evening is avoid the equities of scale acquirers.  In general, acquirers of large entities overpay, and execution after the acquisition is tough because it is tough to integrate:

• Management teams — different views are often incompatible, and the victor looks down on the company acquired.
• Cultures — same thing.  Cultures encompass the ways that a broad body of people implement the views of management.  Incompatible cultures are tough to merge; usually that of the acquirer must die, much like ancient war that destroyed losing cultures.
• Systems — rarely compatible.  It takes a lot of effort to make all of the critical computer systems speak the same language.
• Marketing — different philosophies lead to a need for the best to remain, and the worst to die.
• Finances — easy, except that differing practices must be integrated.  Accounting is often more liberal coming out of an acquisition, because of the need to make the acquisition look good.

The best acquisitions are small, incremental, and facilitate the organic growth of the acquirer.  They add new products that can be sold through existing infrastructure.  They add new markets to sell existing products to.

In an environment like this, focus on organic growth, and perhaps those companies likely to be acquired.  Organic growth because it shows where there is real and perhaps repeatable growth in the economy; targets because if capital is cheap, there may be future companies bought out by fools who serve themselves and not their shareholders.

All for now.  Back on Monday.