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The Rules, Part LXI (The End… of the Past)

Tuesday, March 11th, 2014

Rule: every rule has exceptions, including this one

In the long-run, and with hindsight, most actions of the market make sense.  Sadly, we live in the short run, and our lives may only see one to 1.5 full macro-cycles of the market in our lives.  We live in a haze, and wonder what useful economic and financial rules are persistently valid?

We live in a tension between imitation and thought, between momentum and valuation, between crowds and lonely reasoning, between short-term thinking and long-term thinking.

It would be nice to be like Buffett, who has no constraint on his time horizon, managing to the infinite horizon, because he has so much that setbacks would mean little to him.  But most of us have retirements to fund, college expenses, a mortgage, and many other things that make us far more subject to risk.

Does valuation matter?  You bet it does.  When will it matter next?  Uh, we can’t answer that.  When we come up with a good measure of that, people begin using it, and the system changes.

My personal asset allocation for most of my life has been 75% risk assets/25% cash.  Especially now, when bond yields are so low, I don’t see a lot of reason to extend the maturities of my bond portfolio, aside from a small position in ultra-long Treasuries, which is a hedge against deflation.

Investment reasoning is a struggle between the short-term and the long-term.  The short-term gets the news day-by-day.  The long term silently gains value.

If you invest long enough, you will have more than your share of situations where you say, “I don’t get this.”  It can happen on the bull or bear sides of the market, and you may eventually be proved right, but how did you do while you were waiting?

Thus, uncertainty.

Is there a permanent return premium to investing in equities?  I think so, but it is smaller than most imagine, particularly if compared against BBB/Baa bonds.

I’m not saying there are no rules.  Far from it, why did I write this series?!  What I am saying is that we have to have a firm understanding of the time horizon over which the “rules” will work, and an understanding of market valuations, sensing when valuations are high amid a surging market, and when valuations are low amid a plunging market.  There are times to resist the trends, and times to embrace the trends.

The rules that I embrace and write about are useful.  They reduce risk and enhance return.  I once said to Jim Cramer before I started writing at RealMoney that the rules work 65% of the time, they don’t work 30% of the time, and 5% of the time, the opposite of the rules works.  This is important to grasp, because any set of tools used to analyze the market will be limited — there is no perfect set of rules that can anticipate everything.  You should expect disappointment, and even embarrassment with some degree of frequency.  That’s the way of the market even for the best of us.

Hey, Buffett bought investment banks, textiles, shoes and airlines at the wrong times.  But we remember the baseball players who had seasons that were better than .400, and Buffett is an example of that.  In general, he made errors, but he rarely compounded them.  His successes he compounded, and then some.

The rule I stated above is meant to be a paradox.  In general, I am a long-term oriented, valuation-driven investor who seeks to maximize total return over the long haul, with significant efforts to avoid risk.  Do I always succeed?  No.  Do I make significant mistakes?  Yes.  Have my winners more than paid for my losers over the 20+ years I have been an active investor? Yes, yes, and then some.

But this isn’t about me.  Every investor will have days where they will have their head in their hands, like I did managing the huge corporate bond portfolio in September 2002, where I said to the high yield manager one evening as we were leaving work, “This can’t keep going on like like this, right?  We’re close to this burning out, no?

He was a great aid to my learning, an optimist who embraced risk when it paid to do so.  At the time, he agreed with me, but told me that you can never tell how bad it could get.

As it was, that was near the bottom, and the pains that we felt were those of the market shaking out the crud to reveal what had long lasting value.  Or at least, value for a time, because the modus operandi of the Fed became inflating a financial/housing bubble.  That would not work in the long run, but it would work for a time.  After that, I worked at a place that assumed that it would fail very soon, and was shocked at how far the financial excesses would eventually run.  I was the one reluctant semi-bull in a bear shop that would eventually be right, but we had to survive through 4+ years of increasing leverage, waiting for the moment when the leverage had gone too far, and then some.

Being a moderate risk-taker who respects risk is a good way to approach the markets.  I have learned from such men, and that is what I aim for in my investing.  That means I lag when things are crazy, and that is fine with me.  I don’t play for the last nickel — that nickel may cost many bucks.  Respect the markets, and realize that they aren’t here to serve you; they exist to allocate capital to the wise over the long run.  In the process, some will try to profit via imitation — it’s a simple strategy, and time honored, but when too many people imitate, rather than think, bad things happen.

The End, for Now

This post is the end of a long series, and I thank those who have read me through the series.  I think there is a lot of wisdom here, but markets play havoc  with wisdom in the short run, even if it wins in the long run.  If I find something particularly profound, I will add to this series, but aside from one or two posts, all of the “rules” were generated prior to 2003.  Thus, this is the end of the series.

The Rules, Part LX

Saturday, March 8th, 2014

Rapid upward moves in volatility almost always presage a bounce rally.

Again, I am scraping the bottom of the barrel, but this is a common aspect of markets.  When things get tough, scaredy-cats buy put options.  That pushes up option implied volatilities.  The same doesn’t happen when prices are rising, because that happens slower.  Prices fall twice as fast as they rise in the stock market.

Emotions play a big role with options, and many do not use them rationally.  Rather than using them when the market is rising in order to hedge, more commonly they hedge after the market has fallen.

As implied volatility rises, the ability to make money from hedging falls, as the cost of insurance goes up.  As a result, hedging peters out, and the market will be receptive to positive news, given that most who want to hedge have hedged.  Their pseudo-selling is over, and a bounce rally will happen.

Volatility tends to mean-revert, and as the reversion from high levels of volatility happens, the value of stocks rise.  People buy equities as fears dissipate.

Volatility, both actual and implied, are tools to have in your arsenal to help you understand when markets might be overvalued (low volatility) or undervalued (very high volatility).  Use this knowledge to guide your portfolio positioning.  At present, it is more reliable then many other measures of the market.

Next time, I end this series.  Till then.

The Rules, Part LIX

Saturday, March 8th, 2014

Productivity increases are only so when they result in an increase of desired consumer goods purchasable at prior prices.

As I commented in my last piece, I’m scraping the bottom of the barrel as I come to the end of this series.  I’ll keep this short.  The concept of hedonics has some value as it tries to adjust price indexes for quality improvements.  Where it goes wrong is equating technical improvement with usefulness.  With products where technology is improving rapidly, often hedonic improvements cannot be measured, because the prior product is no longer being sold.  If it were being sold, it would provide significant information about how much people value product improvements.  As it is, sometimes economists try to estimate improvement in value off of technical improvements.

A computer that is twice as fast, with twice the RAM and twice the storage, is not twice as valuable.  To the degree that hedonics takes shortcuts  to estimate value, it overestimates how much value is added by technological improvement.

The Rules, Part LVIII

Friday, March 7th, 2014

Can contingent claims theory for bond defaults be done on a cash flow/liquidity basis?  KMV-type models seem to fail on severely distressed bonds that have time to breathe and repair.

We’re getting close to the end of this series, and I am scraping the bottom of the barrel.  As with most aspects of life, the best things get done first.  After that diminishing marginal returns kick in.

Here’s the issue.  It’s possible to model credit risk as a put option that the bondholders have sold to the stockholders.  As such, equity implied volatility helps inform us as to how likely default will be.  But implied volatilities are only available for at most two years out, because they don’t commonly trade options longer than that.

Here’s the scenario that I posit: there is a company in lousy shape that looks like a certain bankruptcy candidate, except that there are no significant events requiring liquidity for 3-5 years.  In a case like this, the exercise date of the option to default is so far out, that the company can probably find ways to avoid bankruptcy, but the math may make it look unavoidable.  Remember, the equity has the option to default, but they also control the company until they do default.  Being the equity is valuable, because you control the assets.

Bankruptcy means choking on cash flows out that can’t be made.  Ordinarily, that happens because of interest payments that can’t be made, rather than repayment of principal.  If interest payments can be made, typically principal payments can be refinanced, unless credit gets tight.

The raw math of the contingent claims models do not take account of the clever distressed company manager who finds a way to avoid bankruptcy, driving deals to avoid it.  The more time he has, the more clever he can be.

This is a reason why I distrust simple mathematical models in investing.  The world is more complex than the math will admit.  So be careful applying math to markets.  Think through what the assumptions and models mean, because they may not reflect how people actually work.


The Rules, Part LVII

Tuesday, October 29th, 2013

The more that markets are united through derivatives, the more systemic risk is created.

Derivatives exist to subvert regulations, at least the regulations that don’t involve derivatives.  Ideally, derivatives allow those that want to take on a given risk, to have the ability to do so.  And the same for laying off risk.

But here’s the difficulty.  You can create all the derivatives you want, but total risk never goes away, it is only shifted.  There are many idiosyncratic risks for which there is no natural counterparty, i.e., one that faces the opposite risk.  What does it take to get someone to speculate on a risk?  Well, you have to offer them good terms, such that on average, they have the expectation of a profit.  The speculator may try to delta-hedge, and/or cross-hedge his risks, or he may not.  But the speculator is usually in a weaker financial position than the hedger.  Let me give an example:

In the insurance world, with a few exceptions, large direct writers have higher ratings than reinsurers.  And for what few reinsurers of reinsurers there are (“retrocessionaires”) they usually have lower ratings than the reinsurers.  There is a tendency for the economic world to arrange itself like a Collateralized Debt Obligation.

Think about it.  In a CDO, the junior tranches insure those that are more senior against loss.  In exchange, they are offered a higher yield.  That’s what goes on with those that speculate with derivatives.  The one being insured typically gives up some economics to the speculator.

Now if this goes on in a small way, there is no trouble.  But if large numbers of parties lay off their risks in this way, a large amount of  risk is in the hands of speculators which don’t have the best balance sheets.  It’s not as bad as people holding stocks in 1929 on 10% margin, but you get the idea.

Anytime risk is concentrated in the hands of those less well capitalized, there is heightened systemic risk.  Think of AIG writing gonzo amounts of subprime AAA RMBS CDS for a pittance.  Everyone on Wall Street took advantage of them, except for one thing — because everyone was insured by AIG, no one was truly insured by AIG.  If the Fed hadn’t stepped in, who knows who could have been insolvent — and that’s what should have happened, with the regulators letting holding companies fail, but protecting regulated subsidiaries, so that ordinary people would not be harmed.

When risks are in the hands of those with weak abilities to bear risk, not only are the weak affected but the strong also.  The strong, thinking their risks are covered, lever up more because they aren’t worried about the risks.  When the weak fail, and the strong find that risk is shifting back to them, they find that they themselves are hard-pressed, because they don’t have so much equity to cushion the losses.

There is no free lunch with risk.  The most we can do is try to analyze who is bearing the risk.  If it is in strong hands, we don’t have to worry.  If it is in weak hands, perhaps it is time to reduce risk, and not synthetically, but by genuine sales of assets.

If we want to solve this problem we should require insurable interest, and only let hedgers initiate transactions.  But who will take on the lobbyists?

The Rules, Part LV

Monday, October 14th, 2013

Financial intermediation reduces volatility.  In bull markets, demand for financial intermediaries drops.

Ordinary people do well if they have a budget and stay within it.  They do even better if they save and invest, but really, they don’t know what to do.  Market returns are like magic to them.  They don’t know why they occur, positively or negatively.  Life would be best for them if a mutual financial company gave them smooth returns 0n a regular basis, and absorbed all of the market volatility over a market cycle.  That would be hard for the mutual financial company to do, because they don’t know what the ultimate returns will be, so how would they know what smooth returns to credit?

There is a reason why banks, mutual funds, money market funds, life insurers, and defined benefit pension plans exist.  People need vehicles in which to park excess cash that are more predictable than direct investing.  Set an average person free to make his own investment decisions with individual bonds an stocks, and he will make incredibly aggressive or scared moves.  Fear and greed will seize him, making him sell low, and buy high.

That’s why entities that reduce volatility, whether absolutely or relatively, whether short-run or long-run, exist.  But there is seasonality to this: average people seek intermediaries during and after bear markets, when they have been burnt.  After losses, they seek guarantees.  That is often the wrong time to seek guarantees, because often the market turns when average people are running.

During bull markets, the opposite happens.  When easy money is being made by amateurs, the temptation comes to imitate.

  • If my stupid brother-in-law can make money flipping houses, so can I.
  • If my stupid cousins can make money buying dot-com stocks, so can I.
  • If my stupid neighbor can make money buying gold, so can I.

First lesson: don’t be envious.  Aside from being a sin, it almost always induces bad investment and consumption decisions.

Second lesson: build up your investment expertise, piece-by-piece.  Don’t follow the crowd.  Develop the mindset of  a businessman who calmly analyzes opportunity, asks what could go wrong, and estimates likely returns dispassionately.  Pretend you are a Vulcan; if they actually existed, they would be some of the best investors, and not the Ferengi.

Third lesson: an experienced advisor can be of value even if he does not beat the market, by avoiding selling out at the bottom, and avoiding taking more risk near the top.

Fourth lesson: remember that market returns tend to be lumpy.  The economy may be volatile, but markets are more volatile, and not in phase with the economy, because markets anticipate.

Fifth lesson: if you can do it in a disciplined way, invest more during bad times, after momentum has slowed, and things cease getting worse.  Also, if you can do it in a disciplined way, invest less during good times, after momentum has slowed, and things cease getting better.

The main idea here is to be forward looking, and avoid the frenzies that take place near turning points.


The Rules, Part LIV

Thursday, September 12th, 2013

When do employee and corporate incentives line up?  Ideally, incentive schemes should reward people with a fraction of the additional profitability that resulted from the additional work that they did.  Difficulties: measurement impossible in many cases, people could receive a bonus when the firm is not profitable, neglects synergies (both positive and negative).

Though I wrote that in 2002, I formulated the idea in the late 1980s.  The concept of how bonus/incentive systems should work intrigued me.  Part of it also stemmed from Warren Buffett’s observation that he would never hand out stock options, because employees can’t control P/E expansion or shrinkage, but employees have some impact on profits, if fairly measured.  So Buffett would offer profit incentives, rewarding employees with a share of the profits over a given threshold.

The first time I mentioned the idea publicly was at the Fellowship Admission Course for the Society of Actuaries in 1991.  The first case study was on a misuse of employee incentives, and I commented something close to “rule” that I mentioned above.  After I said that, a female consulting actuary based in Australia said that it was one of the stupidest comments she had ever heard.  But beyond that, she didn’t explain.  The discussion moved on.  I didn’t make too much of what she said, because she offered no reasons for her opinion.

In 1994, my best boss came to me, and said, “Well, you drew the short straw.  You get to try to redesign our compensation system for our representatives.”  He described to me the current system, and what the overall goals were.  I assented, and he left.  Shortly after that, the division’s Radar O’Reilly, “Roy” came to me and said, “You got the compensation project?”

I told him that I had been given the project, and he told me not to put too much time into it early, or it would suck up gobs of time, and besides, no compensation scheme over the past five years had lasted longer than a year.  I thanked Roy, he was a loyal friend, and never told less than the truth.

But then I had to think.  Surely there had to be a way that would work here, and maybe putting in some development time in on the front end could pay off, maybe?

I had been playing around with reduced discrepancy point sets with my free time.  Like Assurant, my boss gave me eight free hours per week to come up with new ideas, and temporarily, I created the best method of creating structured randomness — how best to have “r” points represent an n-dimensional unit hypercube.  The practical upshot was that I could create scenario analyses that were far more accurate than any others around.  (Note: better methods emerged within 10 years, and I never published my work, because my insights were intuitive rather than provable… but it enabled me to do some amazing things for the next ten years.)

I set up my profit model, and chose my criterion: Try to pay commissions equal to 1.25% of the Present Value of the Gross Value Added.  My model had four components.  I can’t remember all of them now, but the last one was the most significant, an item called the “revenue bonus.”  Over a certain threshold offices (with multiple representatives) would receive extra compensation for exceeding targets.

It leveled out the amount paid versus the Present Value of the Gross Value Added.  Success, except that my best boss ever had one of our two fights over it — he thought it was a horrible idea — we could be paying out too much money in a bad year, or too little in a good year.  I argued  that it was better than what we currently had, and that we could tweak it in future years.  We will learn from the errors of the method.  He told me that it was fine for me to present it to the chief marketing officer and the CEO of the division, but he would not be behind me.

Much as I respected him, I had done my work, so I presented it two days later to the CMO and CEO.  They went gaga for the idea, and in the meeting my boss said “I see it now.”  Later, he came to me and apologized, and as is usual with me, I accepted it, saying it was no big thing.

So what happened?  Not only did the compensation scheme work for a year, it stayed in place for four years without modification, while sales and profitability grew dramatically, and the division grew to be the star of the company.

That said, after the CEO retired, the CMO became the new CEO, and I got transferred to a different division to clean up operations and financials there.  After four years, the representatives complained that the scheme was too tough, and they needed some low hanging fruit to motivate them.  And so my scheme was abandoned, and sales did not improve, but they were worse.

Profit-based incentives work if they are structured right.  You want representative to write good business, and should incent them to do so.  Offering them a percentage of the expected improvement of the value of the company is a smart thing.

The Rules, Part LII

Saturday, September 7th, 2013

ge + E/P > ilongest bond

Let me explain.  The first term is the growth rate of earnings for a company.  The second term is the earnings yield of a company.  The last term is the yield on the longest, most subordinated bond or preferred stock a company has issued.

The idea here, is that the more risk you take with a company, the more return you should invest for.  Bank debt should yield less than senior unsecured debt, which should yield less than preferred stock, which should yield less than the expected total return from the common stock.

This is a simple idea, but it can occasionally yield good buy or sell ideas when the equation seemingly does not work.  If it does not work, consider buying the bonds and/or selling the stock.  On the other hand, when the equation works, and the gap is wide, consider buying the stock and/or selling the bonds.

The idea is to look for the best risk-adjusted returns, and not be wedded to one particular type of asset.

Another way to think about it is when a company would buy back its shares.  Would it buy them back when it costs more to borrow on safe terms than the company is earning, including likely increases  in earnings?  No, that’s not likely, they might even issue more shares in such a situation.  Buying the shares back requires that the debt or excess cash is less valuable than the stock being bought.

The main point of this rule is to think through the capital structure of a corporation, and look at the relative valuations.  Deviations of expected returns from likely risk deserve attention.

Here’s an example: my boss called me one day and told me he sold short two stocks that afterward doubled on him.  What should he do?  I looked at the bonds of the stocks and saw that they were trading above par.  He thought they were going bankrupt, but the bond market did not agree.  I told him to cover.  He objected, but I said, do you want to cover at a higher level?  Eventually he covered.

Pay attention to all of the securities in the capital structure of companies that you own (or short).  They may give you valuable data that the stock market does not know.


The Rules, Part L

Friday, August 30th, 2013

Countries are firms that produce claims on assets and goods

If I were rewriting this today, it might read, “Countries are firms that produce claims on assets, goods, and income, and anything else they can dream of, in order to retain their privileged position.”

Countries exist for defense and internal justice.  That’s the bare minimum; think of it this way: can there be rivals for defense and internal justice without a civil war?  With many other issues, countries may be willing to share the load — charities that deal with the poor, in addition to welfare programs.

Countries have unique taxation rights, and though big businesses and other interest groups may bend countries to their will, the countries still have their rights.  In a crisis, that could be significant.

FDR confiscated gold during a crisis.  Cyprus swiped bank deposits in a crisis.  Argentina meddles with pension monies.  What could governments do as entitlement (welfare) payments rise more rapidly than taxes?  I don’t know for sure, but you can bet there will be some desperate moves made, tapping many sources of income, transactions, and assets, as well as limit benefits via benefits taxation and other methods.

You could even see widespread purging of the SS Disability Insurance [SSDI] rolls in a real crisis.  I think of an former neighbor, on SSDI because of a bad back who was regularly on his roof putting up and taking down Christmas lights.  He always seemed hale & hearty to me, but there he was on the government dole.

To the extent that they can, countries establish the rules of the economic game. reserving the right to change the rules.   It has to be this way, because aside from God, there is no greater power that can make countries change their ways by fiat.  Yes, there are wars and civil wars, but those have no determinate outcome.  No one orders a country around directly.  Indirectly, things are different, as diplomacy may bring pressure that makes another country compromise.

The model where countries rule over others to get “a piece of the action” is a fair approximation economically of how countries act.  Consider it as you invest, especially with foreign investing.

The Rules, Part XLVIII

Tuesday, July 30th, 2013

If an asset-backed security can produce a book return less than zero for reasons other than default, that asset-backed security should not be permitted as a reserve investment.

Compared to most of my rules, this one is a little more esoteric, so let me explain.  Reserve investments are investments used to back the promises made by a financial institution to its clients.  As such, they should be very certain to pay off.  In my opinion, that means they should have a fixed claim on principal repayment, with risk-based capital factors high enough to take away the incentive invest too much in non-investment grade fixed income claims.

Other assets are called surplus assets.  There is freedom to invest in anything there, but only up to the limits of a company’s surplus.  After all, surplus assets are the company’s share of the assets, right?

If I were rewriting regulation, I would change it to read that only “free surplus” is available to be invested in assets that do not guarantee principal repayment.  Free surplus is the surplus not needed to provide a risk buffer against default on the reserve assets.

But back to the rule.  I think the reason I wrote it out 10+ years ago was my objection to interest only securities that received high ratings, despite the possibility of a negative book yield if prepayments accelerated, and they were rated AAA, and could be used as reserve assets with minimal capital charges.  Buying an asset that can lose money on a book basis for a non-default reason is inadequate to support reserves.  (This leaves aside the ratings’ arbitrage of interest only securities, where defaults hit the yield.  Many have negative yields at levels that would impair related junk rated securities)

This can be applied to other assets as well.  Reverse convertibles that under certain circumstances can be forcibly converted to a weak preferred stock or common stock should only be allowed as surplus assets.  Risk based capital formulas should consider the greater possible risk and adjust required capital up.

Now, maybe this is a rule for another era.  Maybe there aren’t as many games being played with assets today, but games will be played again — having some sort of rule that stress-tests securities to see that they will at least repay principal (leaving aside default), would prevent a certain amount of mischief the next time Wall Street gets creative, putting other financial companies at risk in the process.


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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