I thought I did worse this quarter, but I ended up trailing the S&P 500 by less than 50 basis points. That meant that I trailed the S&P 500 for the first year in eight by somewhat less than 1%. So goes the streak.
On the bright side, it happened in a period where growth was trouncing value, and large capitalization stocks were trouncing the small.? My investing style is value-oriented, and all-cap, so I will always be smaller than the S&P.? I did better than value indexes, and better than small caps.? Is this examination of factors an excuse?? I don’t know.? The wind was at my back for the last seven years, and it is in my face now.? What I do know is that I’ve had my share of bad decisions, and I will try to rectify them in 2008.? The next reshaping is coming up soon, and I am gathering my tickers and industries.
But winning big and failing small should be good for anyone. With that, I wish you a Happy New Year.? Let’s make some serious money in 2008, DV.
When I was seven years old, my parents gave me a colorful wind-up alarm clock. I thought it was beautiful. They taught me how to wind it up each evening so that I would wake up to go off to first grade. Being a boy, after a while, I wondered how tight I could wind it, but there seemed to be a limit to that. One night, I found I could wind it one “click” tighter than usual. A week or so later, another “click” tighter. After some time, I wound it one click to many, and I heard a snap, after which the clock rapidly moved in reverse for about 30 seconds, and then moved no more. I was heartbroken, because I really liked the clock. Perhaps its “death” was not in vain, because it is a great analogy for a full swing of the credit cycle. The spread tightening in the bull phase of the cycle is initially relatively rapid, and gives way to smaller bits of incremental tightening, until it is too much, or an exogenous force acts on it. Eventually, when cash flow proves insufficient for debt service, the credit cycle turns, and the move to spread widening is rapid. Once spreads get really wide, the cycle can resume when those with strong balance sheets can tuck bonds away and realize a modest return in the worst scenario, if they just buy-and-hold. Though it did not happen for me, it would be the equivalent of buying the little kid a new clock. Then the cycle begins again.
Economically, Japan has had a lost decade. It is beginning to verge on two decades. During this time, interest rates have been low, and growth has not been forthcoming. The main reason why low rates did little to stimulate the economy is that the banks were impaired, and could not lend. The secondary reason was demographic; equity markets tend to do well when there are more savers versus spenders. For Japan, that peaked in the early 90s. For the US, that will peak in the early teens. Now, it is possible that the more market-oriented culture of the US has reacted to this factor faster than Japan would, thus the relatively stagnant equity market in the 2000s in the US. This is also a cautionary note to those that thing that lower short-term rates will benefit the US markets; after all, what good have they done for Japan?
Thanks to all my readers, and especially my commenters. You make the blog worthwhile to me. I hope to better for all of you in 2008. Happy New Year to all of my readers, whether here, or at other sites that use my posts. May God bless you richly in 2008.
In 2002, we used to comment at the office that unless a company was dead, it could always get financing through a convertible bond offering.? The more volatile the situation (up to a point), the more the conversion option is worth, which can significantly reduce the effect of higher credit spreads, at a cost of possible dilution.
So, with the difficulties in getting financing at present, is it any surprise that we are having record issuance of convertible bonds?? I expect to see more of it, particularly for areas involved with housing, commerical real estate, mortgage finance, financial guarantee, and the investment banks.? High volatility and a need for financing begets convertible bond issuance.? That’s where we are now.
Remember, this can be used two ways. In the short run, the “hot industries,” the ones in the red zone, can be bought if one follows a fast turnover momentum-type strategy. For those of us with lower turnover value-type strategies, we buy industries in the green zone, but insist on quality, and attempt to analyze how transient the industry troubles are likely to be. Note that I’m not looking at all industries in the green zone — areas affected by the housing and finance sectors, for example.
One more brief note, since a couple of readers e-mailed me on this. It looks like the forced sellers of National Atlantic are done. Also, the compensation decisions for the three senior executives give them some compensation if a deal goes through. I’m not smiling on this one yet, and things could still go badly wrong. Use caution here.
I’m not sure what to title this piece as I begin writing, because my views are a little fuzzy, and by writing about them, I hope to sharpen them.? That’s not true of me most of the time, but it is true of me now.
Let’s start with a good article from Dr. Jeff.? It’s a good article because it is well-thought out, and pokes at an insipid phrase “behind the curve.”? In one sense, I don’t have an opinion on whether the FOMC is behind the curve or not.? My opinions have been:
The Fed should not try to reflate dud assets, and the loans behind them, because it won’t work.
The Fed will lower Fed funds rates by more than they want to because they are committed to reflating dud assets, and the loans behind them.
The Fed is letting the banks do the heavy lifting on the extension of credit, because they view their credit extension actions as temporary, and thus they don’t do any permanent injections of liquidity.? (There are some hints that the banks may be beginning to pull back, but the recent reduction in the TED spread augurs against that.)
Instead, they try novel solutions such as the TAF.? They will provide an amount of temporary liquidity indefinitely for a larger array of collateral types, such as would be acceptable at the discount window.
We will get additional consumer price inflation from this.
We will continue to see additional asset deflation because of the overhang of vacant homes; the market has not cleared yet.? Commercial real estate is next.? Consider this fine post from the excellent blog Calculated Risk.
The Fed will eventually have to choose whether it is going to reflate assets, or control price inflation.? Given Dr. Bernanke’s previous statements on the matter, wrongly ascribing to him the name “Helicopter Ben,” he is determined not to have another Depression occur on his watch.? I think that is his most strongly held belief, and if he feels there is a modest risk of a Depression, he will keep policy loose.
None of this means that you should exit the equity markets; stick to a normal asset allocation policy.? Go light on financials, and keep your bonds short.? Underweight the US dollar.
I have not argued for a recession yet, at least if one accepts the measurement of inflation that the government uses.
Now, there continue to be bad portents in many short-term lending markets.? Take for example, this article on the BlackRock Cash Strategies Fund.? In a situation where some money market funds and short-term income funds are under stress, the FOMC is unlikely to stop loosening over the intermediate term.
Clearly there are bad debts to be worked through, and the only way that they get worked out is through equity injections.? Think of the bailing out of money market funds and SIVs (not the Super-SIV, which I said was unlikely to work), or the Sovereign Wealth Fund investments in some of the investment banks.
Now, one of my readers asked me to opine on this article by Peter Schiff, and this response from Michael Shedlock.? Look, I’m not calling for a depression, or stagflation, at least not yet.? At RealMoney, my favored term was “stagflation-lite.”? Some modest rise in inflation while the economy grows slowly in real terms (as the government measures it).?? A few comments on the two articles:
?First, international capital flows from recycling the current account deficit provide more stimulus to the US economy than the FOMC at present.? Will they stop one day?? Only when the US dollar is considerably lower than now, and they buy more US goods and services than we buy from them.
Second, the Federal Reserve can gain more powers than it currently has.? If this situation gets worse, I would expect Congress to modify their charter to allow them to buy assets that it previously could not buy, to end the asset deflation directly, at a cost of more price inflation, and spreading the lending losses to all who hold longer-term dollar-denominated assets.? If not Congress, there are executive orders in the Federal Register already for these actions.
Third, in a crisis, the FOMC would happily run with a wide yield curve — they will put depositary institution solvency ahead of purchasing power.
Fourth, the Fed can force credit into the economy, but not at prices they would like, or on terms that are attractive.? In a crisis, though, anything could happen.
Fifth, I don’t see a crisis happening.? It is in the interests of foreign creditors to stabilize the US, until they come to view the US as a “lost cause.”? Not impossible, but unlikely.? The flexible nature of the US economy, with its relatively high levels of freedom, make the US a destination for capital and trade.? The world needs the flexible US, less than it used to, but it still needs the US.
One final note off of the excellent blog Naked Capitalism.? They note, as I have, that the FOMC hasn’t been increasing the monetary base.? From RealMoney:
The Fed Has Shifted the Way it Conducts Monetary Policy
12/21/2007 11:56 AM EST
Good post over at Barry’s blog on monetary policy. Understanding monetary policy isn’t hard, but you have to look at the full picture, including the presently missing M3. I have a proxy for M3 — it’s total bank liabilities from the H8 report –> ALNLTLLB Index for those with a BB terminal. It’s a very good proxy, though not perfect. Over the last years, it has run at an annualized 9.4%. MZM has grown around 12.8%. The monetary base has grown around 3%, and oddly, has not been spiking up the way it usually does in December to facilitate year-end retail.
The Fed is getting weird. At least, weird compared to the Greenspan era. They seem to be using regulatory policy to allow the banks to extend more credit, while leaving the monetary base almost unchanged. This is not a stable policy idea, particularly in an environment where banks are getting more skittish about lending to each other, and to consumers/homebuyers.
This has the odor of trying to be too clever, by not making permanent changes, trying to manage the credit troubles through temporary moves, and not permanently shifting policy through adding to the monetary base, which would encourage more price inflation. But more credit through the banks will encourage price inflation as well, and looking at the TED spread, it seems the markets have given only modest credit to the Fed’s temporary credit injections.
I am dubious that this will work, but I give the Fed credit for original thinking. Greenspan would have flooded us with liquidity by now. We haven’t had a permanent injection of liquidity in seven months, and that is a long time in historical terms. Even in tightening cycles we tend to get permanent injections more frequently than that.
Anyway, this is just another facet of how I view the Fed. Watch what they do, not what they say.
Position: noneThe Naked Capitalism piece extensively quotes John Hussman.? I think John’s observations are correct here, but I would not be so bearish on the stock market.
After all of this disjointed writing, where does that leave me? Puzzled, and mostly neutral on my equity allocations.? My observations could be wrong here.? I’m skeptical of the efficacy of Fed actions, and of the willingness of foreigners to extend credit indefinitely, but they are trying hard? to reflate dud assets (and the loans behind them) now.? That excess liquidity will find its way to healthy assets, and I think I own some of those.
I’ve never enjoyed surprise lists that much.? The concept is this: name a bunch of things that you think there is a better than 2/3rds chance of occurring that the market seemingly has less than a 1/3rd probability on.? Here are my problems with the concept:
First, the probabilities are squishy.? Who’s to say what the probability of a given event is?? Even if you have a prediction market going, those are subject to a variety of biases.
?Second, often the interpretation of whether one is correct or not is fuzzy as well.? Not all of the surprises are sharp events.
Third, an unlikely event can be more likely than it seems if it is spread across multiple parties, or if there are multiple legs to the prediction.? As an example, a prediction that “a major country will drop its dollar peg in 2008,” should be regarded as a decent probability, if only by accident.
Finally, I don’t find them easy to make money from.? Many of them are either not very actionable, or my relative payoff from being right versus wrong does not seem to compensate for the large number of times that the conventional wisdom proves correct.
All that said, surprise lists make for excellent journalistic copy because that have many “man bites dog” sound-bites.? That’s why we hear about them, and why they get promoted for publicity purposes.? But as for so many aspects of speaking/writing on investments, it is mostly theater, and shouldn’t be taken too seriously by serious investors.
Well, my CDO model is complete for a first pass. There is still more work to do. Imagine buying a security that you thought would mature in ten years, but two years into the deal, you find that the security will mature in twenty years from then, though paying off principal in full, most likely. Worse, the market has panicked, and the security you bought with a 6.5% yield is now getting discounted at a mid-teens interest rate. Cut to the chase: that is priced at 40 cents per dollar of par. Such is the mess in some CDOs today.
Onto the topic of the night. There have been a number of articles on volatility as an asset class, but I am going to take a different approach to the topic. Bond managers experience volatility up close and personal. Why?
Corporate bonds are short an option to default, where the equity owners give the company to the bondholders.
Mortgage bonds are short a refinancing option. Volatile mortgage rates generally harm the value of mortgage bonds.
Even nominal government bonds are short an inflation option, should the government devalue the currency. (Or, for inflation-adjusted notes, fuddle with the inflation calculation.)
Why would a bond investor accept being short options? Because he is a glutton for punishment? Rather, because he gets more yield in the short run, at the cost of potential capital losses in the longer-term.
Most of the “volatility as an asset class” discussion avoids bonds. Instead, it focuses on variance swaps and equity options. Well, at least there you might get paid for writing the options. Bond investors might do better to invest in government securities, and make the spread by writing out-of-the-money options on a stock, rather than buying the corporate debt.
I’m not sure how well futures trading on the VIX works. If I were structuring volatility futures contracts, I would create a genuine deliverable, where one could take delivery of a three month at-the-money straddle. Delta-neutral — all that gets priced is volatility.
Here’s my main point. Volatility is not an asset class. Options are an asset class. Or, options expand other asset classes, whether bonds, equities, or commodities. Whether through options or variance swaps, if volatility is sold, the reward is more income in the short run, at the cost of possible capital losses in asset classes one is forced to buy or sell at disadvantageous prices later.
Over the long term, in equities, unlike bonds, being short options has been a winning strategy, if consistently applied. (And one might need an iron gut to do it.) But when many apply this strategy, the excess returns will dry up, at least until discouragement sets in, and the trade is abandoned. For an example, this has happened in risk arbitrage, where investors are short an option for the acquirer to walk away. For a long time, it was a winning strategy, until too much money pursued it. At the peak you could make more money investing in Single-A bonds. Eventually, breakups occurred, and arbs lost money. Money left risk arbitrage, and now returns are more reasonable for the arbs that remain.
Most simple arbitrages are short an option somewhere. That’s the risk of the arbitrage. With equities, being perpetually short options is a difficult emotional place to be. You can comfort yourself with the statistics of how well it has worked in the past, but there will always be the nagging doubt that this time it will be different. And, if enough players take that side of the trade, it will be different.
Like any other strategy, options as an asset class has merit, but there is a limit to the size of the trade that can be done in aggregate. Once enough players pursue the idea, the excess returns will vanish, leaving behind a market with more actual volatility for the rest of us to navigate.
I’m not a maniac on avoiding taxes.? Living through the 80s and 90s, I saw many cases where people bought financial products that made them less after-tax money than many fully-taxable products would have made them.? Limited partnerships, life insurance, annuities, etc… I never saw the value in focusing on what the government would not get.? I was more focused on what I would get after taxes.
That doesn’t mean there aren’t clever strategies to avoid taxes, particularly if you are rich.? For the rich, taxes can be more of a negotiation.? How much work will the IRS have to go through in order to drag incremental dollars out of me?? (The same logic applies to corporations… I have seen it in action.)? Perhaps Leona Helmsley had a point, even if she overstated it, “Only the little people pay taxes.”? Maybe it should be, “Only the little people pay sticker price on taxes.”
Now, as for me, I have a Health Savings Account, a Rabbi Trust, IRAs for me and my wife, and a Rollover IRA from all of the jobs I have worked at.? It’s not as if I don’t try to manage my tax position.? But I don’t let it drive my investment decisions on its own.? I own my house free and clear.? I enjoy the benefits of flexibility in my finances; I have not used 529 plans, for example.? Where the investment fits my overall goals and objective, then I will consider how it affects my tax position.? In general, the higher dividend stocks go into my Rollover IRA, the lower dividend stocks into my taxable account.? I also gift appreciated stock through my taxable account to charity.
At present, I don’t own any munis.? That’s something I’ll have to revisit.
Now, here are two things to be careful about.? If IRAs grow too big there can be additional taxes on them.? I’m not too clear on the rules, perhaps readers can more fully flesh that out.? The other is that taxes are likely to be higher in the future, so avoiding taxes today may lead to more taxes tomorrow.? Also, I would question whether our government will honor the concept of a Roth IRA.? Social Security benefits were not supposed to be taxed, but today they are mostly taxed.? The same might happen to Roth IRAs at some point in time. ? Congress giveth, and Congress taketh away.
My closing point here would be to not overcommit to any single tax strategy.? Congress changes the rules so often, that it is difficult to make long term decisions.? Stay flexible, and avoid taxes where it does not compromise your flexibility.
Prior to the market hitting a spate of turbulence, for the last four years, I had rarely heard anyone say something bad about a buyback or a special dividend.? At that time, I tried to point out (at RealMoney) that buybacks are not costless:
They reduce financial flexibility.
They lower credit ratings and can raise overall financing costs, if overdone.
They can become a crutch for weak management teams that aren’t active enough in looking for organic growth opportunities.
They often don’t get completed, leading to some disappointment later, after the initial hurrah.
They can be a clandestine way of compensating employees, because they hide the dilution that occurs from shares received through incentive payments.? In a sense, shares are shifted from shareholders to management.? Buffett has the right idea here: pay cash bonuses off of exceeding earnings targets.? Nothing motivates like cash, there is no dilution, and managers don’t get compensated/punished for expansion/contraction in the P/E multiple.
A higher regular dividend could be more effective in some cases
Finally, does management want to make a statement that they don’t see any good incremental opportunities for their business on the horizon?? That’s what a large buyback implies.
But after reading a glob of articles criticizing buybacks, it makes me want to take the opposite side of the trade.? (Where were these writers during the bull phase?)? Buybacks can instill capital discipline, as regular dividends do.? A good management team, when considering an acquisition, should at the same time run the same numbers on their own common stock, to see whether the acquisition is an effective way to deploy capital.
The best buybacks are valuation-sensitive.? The company has an estimate of its private market value, and the buyback only goes on while at or below that value.? When a cheaper opportunity shows up to acquire a block of business, or a new line of business, or a whole business, the buyback stops, and the acquisition is executed.
Much of my thinking here boils down to how good the management team is.? A management team of moderate quality should not keep a lot of excess capital around, because they might make a dumb move with it.? A high quality management team can run with more excess capital.? In one sense, moderate quality managements should shrink their businesses, while high quality managements should try to grow their businesses organically, and through small in-fill acquisitions that enable? them to access new countries, markets, products, and technologies cheaply, that they can then grow organically.
There is no simple answer here.? Buybacks can be smart or dumb, depending on management talent, what external opportunities exist, and where the private market value of the company is.? We can entrust Berky and Assurant with excess capital; it will get used well eventually.? Other companies, well, there are some that should keep the capital tight, because the management teams are not good strategic thinkers.
For the less competent management teams, (and, no, you don’t know who you are, that’s part of being less competent), you can look at the problem this way: either you shrink your company through buybacks, or activists will come and try to force you to do it, ejecting you in the process.? That may not sound fair, but hey, this is the public equity markets.? Sink or swim.
Full disclosure: long AIZ, and a critical admirer of Buffett.? Ticker mentioned: BRK/A
Look, Barron’s can say what they want about Warren Buffett, and his company Berkshire Hathaway, but I have just one thing to say here: Berky is the ultimate anti-volatility asset.? When the hurricanes hit in 2005, I told my boss that the easy money, low-risk, low-reward play was to buy Berky.? My boss liked to take risks, so that idea was shelved. Too bad, it was easy money.? After all, who could write retrocessional coverage (Reinsuring reinsurers) except Berky?? Every other writer was broke or disabled…
Now we have a different type of hurricane.? Prior bad lending practices are destroying lending/insurance capacity in mortgages and elsewhere.? This could be an investment opportunity for Berky.? Thing is, outside of the Sovereign Wealth Funds, Berky has one of the biggest cash hoards around, and during times of panic, where assets get sold at a discount, cash is valuable.
So during times of panic, we should expect Berky’s valuation to expand.? This is one of those times.
One final note: suppose Buffett, much as he doesn’t want to be an asset manager, decides to take Ambac private.? How would he do it?? Think of what he has done in other cases: he creates a nonguaranteed downstream holding company, capitalizes it to a level necessary for a AAA rating, and buys Ambac.? Warren never guarantees the debt of subsidiaries that he buys.? Why should he reward bondholders of his target companies?? Isn’t it enough that he pays the debts?
Well, yes, sort of.? Warren has never sent a subsidiary into insolvency, but he clearly reserves the right to do that.? Bondholders have given him that right, and I would not blame him for using that right under extreme circumstances.
That said, Berky’s excess cash offers opportunities at present, because Buffett can use that cash to snap up distressed assets when he chooses to do so, and at minimal risk to Berky if an acquisition fails.
