Every hundred or so posts, I take a step back, and try to think about broader issues about blogging about finance.  Tonight, I want to explain to new readers what the Aleph Blog is about.

There have been many new followers added to my blog recently,  through e-mail, RSS, and natively.  This is because of this great article at Marketwatch, which builds off of this great article at Michael Kitces’ blog.

I am humbled to be included among Barry Ritholtz, Josh Brown, and Cullen Roche, and am genuinely surprised to be at number 4 among RIAs in social media influence.  Soli Deo Gloria.

What Does the Aleph Blog Care About?

I’m writing this primarily for new readers, because I’ve written a lot, and over a lot of areas.  I write about a broader range of topics than almost all finance bloggers do because:

  • I’m both a quantitative analyst and a qualitative analyst.
  • I’m an economist that is skeptical about the current received wisdom.
  • I like reading books, so I write a lot of book reviews.
  • I’m also a skeptic regarding Modern Portfolio Theory, and would like to see it discarded from the CFA and SOA syllabuses.
  • I believe in value investing, in both the quantitative and qualitative varieties.
  • I believe that risk control is a core concept for making money — you make more money by not losing it.
  • I believe that good government policy focuses on ethics, not results.  The bailouts were not fair to average Americans.  What would have been fair would have been to let the bank/financial holding companies fail, while protecting the interests of depositors.  The taxpayers would have been spared, and there would have been no systematic crisis had that been done.
  • I care about people not getting cheated.  That includes penny stocks, structured notes, private REITs, and many other financial innovations.  No one on Wall Street wants to do you a favor, so do your own research and buy what you want to own, not what someone wants to sell you.
  • Again, I don’t want to see people cheated, so I write about  insurance.  As a former actuary, and insurance buy-side analyst, I know a lot about insurance.  I don’t know this for sure, but I think this is the blog that writes the most about insurance on the web for free.  I write as one that invests in insurance stocks, and generally, I buy the stocks because I like the management teams.  Ethical, hard working insurance management teams do the best.
  • Oddly, this is regarded to be a good accounting blog, because as a user of accounting statements, I write about accounting issues.
  • I am a skeptic on monetary and fiscal policy, and believe both of them tend to sacrifice the future to benefit the present.  Our grandchildren will hate us.   That brings up another issue: I write about the effects of demographics on the markets.  In a world where populations are shrinking in developed nations, and will be shrinking globally by 2040, there are significant economic impacts.  Economies don’t do well when workers are shrinking in proportion to those who are not working.  (Note: include stay-at-home moms and dads in those who work.  They are valuable.)
  • I care about the bond market.  There aren’t that many good bond market blogs.  I won’t write about it every day, but I will write about i when it is important.
  • I care about pensions.  Most of the financial media knows things are screwed up there, but they do not grasp how bad the eventual outcome will likely be.  This is scary stuff — choose the state you live in with care.

Now, if you want my most basic advice, visit my personal finance category.

If you want my view of what my best articles have been, visit my best articles category.

If you want to read about my “rules,” read the rules category.

Maybe you want to read some of my most popular series:

My blog is not for everyone.  I write about what I feel most strongly about each evening.  Since I have a wide array of interests, that makes for uneven reading, because not everyone cares about all the things that I do.  If that makes my readership smaller, so be it.  My blog expresses my point of view; it is not meant to be the largest website on finance.  I want to be special, even if that means small, expressing my point  of view to those who will listen.

I thank all of my readers for reading me.  I appreciate all of you, and thank you for taking the time to read me.

As one final comment, I need to say this.  I note people unfollowing my blog at certain times, and I say to myself, “Oh, I haven’t been writing about his pet issue for a while.”  Lo, and behold, after these people leave, I start writing about it again.  That is not intentional, but it is very similar to how the market works.   People buy and sell investments at the wrong times.

To all my readers, thank you for reading me.  I value all of you, and though I can’t answer all e-mails, I read all e-mails.

In summary: the Aleph Blog is about ethics and competence.  I want to do what is right, and do what gives the best investment performance, in that order.


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.

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.

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.

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 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?

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.


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.

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.


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.