For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.? In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.? Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.? Fortunately, the piece I wrote was generic, and can benefit investors anywhere.
Notes on Stocks and the Fed
On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.? It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.? This wasn’t just true of the US, but of most global equity markets.
So, if we are going down further, the market will have to rest a while.? That said, valuations are more compelling than they were, especially compared to Treasuries.? Compared to BBB corporate yields, they are still attractive.? I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.
One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.
It just shows how high the pressure on the FOMC is, if they have to peremptorily act one week ahead of their regularly scheduled meeting.? Again, one week doesn’t matter much in terms of actual policy impact.
Yet, they may do more at their meeting.? Though I called for a 3.00% Fed funds rate in 2008, I wasn’t thinking of the beginning of the year… more like the middle-to-end.? Now it seems to be a first quarter phenomenon.? And, as I have said since the beginning of this move, given that the FOMC has been willing to use crude policy tools like the Fed funds rate to try to reflate areas where credit stress is high, they will overshoot.? The lags in the action of monetary policy versus the immediacy of political pressure forces the overshoot.
My questions: how low do we go with the Fed funds rate, and how much will price inflation run in the process?
I have a filing system that I designed to help me save time.? I have a box in my bedroom that I toss papers that I might need into.? Any paper with sensitive personal data goes in there as well.? Once or twice a year, I go into that box and sort through the papers.? I sort the papers into various piles:
Insurance
Bank Statements
Brokerage
Taxes, last year
Taxes, this year
Not needed
Not needed, and shred, due to sensitive data (SSN, address, monetary data, identifying information)
Art that my children have given me
Articles that I wanted to keep a permanent copy of
Other, etc.
Typically, I retain the year-end statements for mutual funds, and monthly statements for banks and brokerages.? The rest I shred.? Rather, my 9-year old shreds… she does a very good job, and does it happily. :)? Roughly half gets shredded, and one-quarter gets thrown away.? The rest gets filed.
I store the long term financial data in file folders until they get large, and I bind them into binders.? I retain tax data for personal reasons, though there is little reason to go beyond seven years.? About once every decade, I go through all of my files, and pitch stuff mercilessly, retaining only what is best.? I did that two years ago.? 2016 is a long way away.
The idea here is to minimize my time spent filing, retain critical data, shred data that would be harmful in the hands of data felons, and make sure that I know where to find something that is truly needed.? So far this system has worked very well for me, and I have been using it for about 20 years.
Anyway, I went through this process yesterday, and now it is great to have things organized again.? 2007 was a memorable year for me, and it was fascinating to consider all of the things that happened, including starting this blog.? (Yes, I found those papers as well.)
Some of the commentary regarding inflation and deflation misses the point.? We are presently faced with both rising consumer price inflation and asset deflation.? Not a fun combination, to say the least.? It puts the FOMC into a real box.? To borrow an analogy from the Bible, Greenspan ate sour grapes, and Bernanke’s teeth are set on edge.
So what does the FOMC do in such a situation?? We don’t have that much history to work with, but during the ’70s, the FOMC generally loosened.? Fixed income portfolios should tilt toward shorter duration, even though you are losing income, and away from the dollar.? It is probably still too early to begin taking a lot of additional credit risk, but the bet is getting more attractive by the day.
Now, there are a number of commentators that can’t wait one week, and say the FOMC should act now.? The economy is not like someone that you have to take to the emergency ward; one week makes little difference, and the FOMC will do better work if they are meeting each other face-to-face under normal meeting conditions, than over a conference call.
Given the present equity market distress, should we assume that the FOMC will do more than 50 basis points in January? Had you asked me last week, I would have said “no.”? The political pressure is a lot higher now, so I would say yes, they will do more.? It won’t help the areas under credit stress, but it will make it look like they are serious about “fixing the economy.”
We could see a move of either 75 or 100 basis points.? I debate internally how good Fed funds futures are in abnormal environments like this.? Under Greenspan, I sometimes felt that monetary policy had been privatized, and whatever the futures market said, the FOMC would do that.? I don’t know if Bernanke has the same faith that futures traders know what the right monetary policy is.? If I were a Fed Governor, I certainly would not have that confidence.? Once the yield curve gets to a certain slope, the recovery will come in time.? Making the curve steeper won’t make it any faster.
People are impatient, and their complaining causes the FOMC to overshoot on policy decisions.? The lag that monetary policy has is significant, and the FOMC in recent years has made it even slower through their policies of incrementalism.
There are several possibilities here for the FOMC action:
They hold firm, and don’t lower much (50 bp), because price inflation is a concern.
They take the judgment of the futures traders, and move a full 100 bp.? Or, they conclude that asset deflation is a bigger risk, and decide to make a bold statement.? After all, isn’t Bernanke the guy who never wants to see the Great Depression recur, and loose monetary policy can prevent that?? (I don’t think that’s right, but…)
They split the difference, make bows to both camps in their language, and do a 75 bp cut.
The last of those seems most likely to me.? I have said in the past that the FOMC is:
Being politically forced to loosen more than they would like, and
Dragging their heels in the process.
That’s why I think we end up on the low end of where Fed funds futures will likely point tomorrow.? 75 basis points does not trip off the tongue, but will be a compromise position in the minds of Federal Reserve Governors who are puzzled at the present situation.? Because of political pressure, they know that they have to move big, but consumer price inflation will make them less aggressive.
Eddy Elfenbein at Crossing Wall Street has put forth the concept of a “bond bubble” over at his blog.? I support the concept in part, but I need to modify it.? Let’s call it a Treasury Bond Bubble, because other classes of intermediate term debt have significant yield spreads over Treasuries because of the current economic volatility.
Should 2-year Treasury notes yield less than CPI inflation? No, and CPI inflation is not going down.? Scarcity of food and fuel are normal conditions in our growing world.? We can only extract so much out of the planet in the short run.? Why lend to the government at a loss?? Better to invest in a money market fund, or perhaps, the stock of a business that is inflation-sensitive, or TIPS.
Can 2-year yields go lower?? You bet they can.? The Fed is flooding the short end of the yield curve with liquidity for now, until inflaton pressures become intolerable.? In the present political environment, the Fed is incented to loosen, even in the face of rising inflation.? Remember my “pain model” for the Fed.? They move in the direction that avoids the most political pain.? People are screaming over a weak economy now, and no one complains about inflation.? Thus they loosen.? How much at the end of January?? Uh, that is up for grabs.? My view of the Fed is that they want to drag their feet, because they see inflation rising, so even if Fed funds futures indicate a 75 basis point cut, my current view indicates 50 as more likely, again, with language in the statement that indicates even-handed risks.
One final note: the concept of a bond bubble sounds a little like the Austrian school of economics.? The central bank pushes interest rates below the natural rate of interest (i.e., the one that would exist in an free market equilibrium), in order to stimulate the economy.? Bonds would be worth more than their long-term intrinsic value in such a scenario.? That’s true today, with one modification, because of the credit stress, only the highest quality borrowers get those rates.
Bouncing off Adam?s comments on the XLF, the insurers in the index are getting drubbed, and in my opinion, for little good reason. On an earnings basis, many of them are the cheapest I have seen maybe ever, and while some of their earnings prospects will be diminished by the fall in the market, and difficulties in the bond market, in general, the asset side of their balance sheets are in good shape. So, if you are looking for ideas, here are a few I am looking at: MetLife, Hartford, Travelers, Lincoln National, ACE, Chubb, Principal and XL. Hopefully this will do as well as my PartnerRe trade last August.
Position: Long LNC
I would add to that list SFG and DFG. After some thought, I acted:
Lincoln National was a rebalancing buy, Hartford is a new position. Both are quality competitors with good balance sheets. The only possible drawback is in a protracted decline, earnings from variable products could suffer.
Fitch downgrades Ambac to AA from AAA. Stock has a temporary rally. Is this a great country or what? Because of the social dynamic of the rating agencies, and the existence of one downgrade, the dike has been breached, and I would expect more downgrades.
Hey, maybe it?s time for the financing of last resort: Ambac could issue a convertible surplus note. Maybe even sell it privately to Buffett, who could own 30% of the company if things turn around. He won?t delta-hedge common against it. They might even be able to get away with a coupon below 15%. Package it with a reinsurance agreement, and the NY State commissioner smiles on it.
Okay, I went overboard there, but there was no reason for Ambac to have its short-lived rally. That?s probably why it didn?t stick.
Position: none
My last note was half-whimsical and half-serious. Buffett likes convertibles, particularly if they offer attractive optionality at the right price. The question is how big the problems are at Ambac relative to their small capital base.
I should also add that there are reinsurance issues among the financial guarantee companies have reinsurance issues.? I mentioned Channel Re, which mainly provided insurance to MBIA.? MBIA and Ambac, from what I remember, mutually reinsure about 10% of each other’s liabilities.? Beyond that, you have poor RAM Re:?
RAM Re attempts to absorb a quote share of the liabilities of the primary financial guarantors.? I met their management team during their IPO.? They seemed to be good people, and talented managers.? But having a quota share of the seven soon-to-be-formerly-AAA guarantors is a ticket to not being AAA oneself.? They face risks of insolvency of primary writers, which could lead to their own insolvency.
What I am trying to convey here, is that stress at one guarantor could have ripple effects at other guarantors.? The least affected would be Assured Guaranty, FSA (a Dexia subsidiary), and Berky (of course).
As for the recent Barron’s article on MBIA, I would only say that it all depends on structured finance losses.? If losses on CDOs are severe, MBIA could be a sell even at these levels.
These are unusual times, and it pays for investors to avoid for the most part the financial guarantee space (mortgage and title too).? Other insurers (life, health, P&C) are likely better than other financials, and generally cheap; I own a bunch of them.
Full disclosure: long LNC HIG
Tickers mentioned: SCA RAMR AGO ACAH MBI ABK BRK/A BRK/B HIG LNC MET PFG DFG SFG CB TRV MET ACE XL
Hi David,? I really enjoy your blog very much.? Your recent post regarding AAA bonds brings up a question for me and I’ve seen several different answers in the press and on TV.
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I have?about 35% of my portfolio in triple AAA muni bonds–most insured, but not all.? My intention with insured AAA bonds was to not have to worry about them.
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I’m now reading about the potential bankruptcies of the muni insurers–AMBAC, etc.? I heard on the tube today that “we will?see a muni bond crash” if the ratings on these insurers are lowered.? After the close I saw where one was lowered to a AA rating.? This is not what I like to hear and I suspect with further reading that the comment was overblown, possibly irresponsible.?
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I hold my bonds to maturity with my principle concern of income generation. Is this something one should be worried about?? Anything specifically about the individual bonds that should raise read flags?? As I live in Arkansas, most are Ark. munis although I’ve got some from Puerto Rico.? Thanks for any insight on this.??And keep your great posts coming.
I don’t think you should be very worried.? Municipalities rarely default.? When they do default, it is typically for a little while, and then payment resumes.? So long as a municipal bond has an economic purpose behind it — a necessary city, county, state, or project, defaults are rare.
The financial guarantee is a way of making the bonds thought-proof.? Bond mangers don’t have to do credit analysis; the guarantee is enough.? The guarantors aren’t dumb (at least with respect to municipals), they know what doesn’t deserve a guarantee.
Without knowing exactly what you own, I can’t say it with certainty, but I can say it is likely that you will come out okay if all you hold are munis that have an economic purpose. ? (Be careful on the Puerto Rican issuers, I know little there.)? That said, the market value of your bonds have likely declined a little due to the possible loss of insurance protection.? If you are truly, buying and holding economically necessary issuers, you should end up fine.
In the center of the picture to the left are my friends Bill and Margie Wright. They have been dear friends of our family for eight years. Their kids have played with ours; they have ten, we have eight.
They’re special people. Margie has homeschooled all of their children (so far), and Bill has built a thriving enterprise, Wright Manufacturing, which makes the best commercial lawn mowers in the world. (Full disclosure: I own a little less than one percent of his private firm.)
Wright Manufacturing is unusual because it is a very innovative firm. They manage the business well with a series of principles borrowed from some of the best Japanese manufacturers, but then marry that to the exceptional innovative engineering talent of Bill Wright and his staff. Many of his competitors license his patented technologies.
Oh, the person on the far right of the picture is, yes, President Bush. He came to visit Bill’s factory today, and gave a brief talk on the economy, and the proposed stimulus package. Here’s what he said:
1:55 P.M. EST
THE PRESIDENT: Let me tell you why I’m here. This man started his own business. He’s a manufacturer, he employs over a hundred people, and he represents the backbone of the American economy. And today I talked about our economy, and the fundamentals are strong, but there’s uncertainty. And there’s an opportunity to work with Congress to pass a pro-growth package that will deal with the uncertainty.
Any package has got to remember that jobs are created by small businesses. A good package will have incentives for investment. The package we passed early in my administration helped him. He bought some equipment and made his firm more productive, kept him in business. And that’s the same spirit that needs to be in this next growth package.
The other thing is, is that we got to make sure that we benefit consumers. We want our consumers out there spending, and the best way to do that is broad-based tax relief. Now, this plan ought to be broad-based, it ought to be simple, and it ought to be temporary.
I had a conversation, Congressman, with the leadership on both sides of the aisle yesterday, and I was encouraged by what I heard. And I believe we can come together on a growth package very quickly. We need to. We need to get this deal done and get it out and get money in the hands of our consumers and our small business owners to help this economy.
I’m optimistic, I truly am. One reason I’m optimistic is because I understand we got all kinds of Americans just like this man here, working hard to provide a living for folks and to make a product people want.
And so, while there’s some uncertainty right now, if we act quickly and in a smart way that helps growth, we’re going to be just fine.
Anyway, thanks for letting me come by. I’m proud to be — I love the entrepreneurial class in — I love people who have a dream and work hard to achieve the dream.
And so — a fine-looking machine you got here.
MR. WRIGHT: Thank you. It’s a team effort. We thank you, thank you for all your work, too.
THE PRESIDENT: Do you wonder where they got the name “Wright?” That’s his name. And his wife is the co-founder of the company. And this is — it’s really great to be with you.
And, Congressman [DM — Roscoe Bartlett, another good guy with a big family], thank you for being here. I’m proud to be with your workers. You’ve got some fine workers.
MR. WRIGHT: We’ve got a great team here, don’t we?
THE PRESIDENT: Yes, you do. And if they get a little more money in their pocket as a result of the growth package, it will help make sure this economy continues to grow.
Anyway, thank you all very much.
END 1:59 P.M. EST
Bill, for all of his accomplishments, is a humble guy. He and Margie went through many lean times during the early years, and they bore with it well. The business began as a lawn mowing business, and then broadened out to software for managing lawn mowing businesses, together with grass catching attachments. That started the manufacturing. Bill developed a wide number of innovations, from zero-turning radius mowers, to sulkies, and more.
In my opinion, President Bush could not have picked a better place to visit. It is an example of American manufacturing at its best, and Bill Wright is a great example of American entrepreneurship. I am proud to be a part owner of the firm, and to have been able to help Bill at times on financial issues.
Now, for further coverage of the visit of President Bush:
As far as I am concerned, the stimulus package is hooey; what stimulus occurs now will be funded by debt and a cheaper dollar later. There is nothing wonderful there. There is something wonderful about the Wrights though, and I am happy to be a small part of that.
In the past, when I hit a major downdraft in the market, I find myself debating whether I should reduce the number of positions in my portfolio, or shrink the mean position size.? The latter is the easier choice, which is why I take the former, and shrink the number of positions, forcing me to eliminate marginal names in the portfolio.
Today I added to Nam Tai Electronics and Deerfield Capital, bringing my over all cash position down to 8%.? As I work through my reshaping, I expect my cash level to decline further, but I would probably liquidate one of my 35 stocks without replacement to help fund the reshaping and rebalancing.
At times like now, this is a process that hurts, and sometime next week, I will announce my portfolio shifts.? That said, the portfolio has held up better versus the market recently.
One piece that I wrote three years ago for RealMoney has relevance today in a new way. Stable Value Funds often invest in AAA securities (some are solely invested in AAA securities), and some funds will have above-average exposure to securities credit-wrapped by the financial guarantors, and possibly, to some asset-backed securities that were rated AAA at issue, but don’t deserve that rating now. For those who have exposure to stable value funds through their defined contribution plans, it might be wise to check what exposures your funds have to the guarantors, and to AAA structured securities that are trading significantly below amortized cost. The summary statistic to ask for (not that they will give it to you) is the market-to-book ratio of the fund. If it gets lower than 97%-98%, I would avoid the fund.
Now for the good news: If a stable value fund breaks, the total loss is likely to be small, like that of a busted money market fund. The one exception would be if a stable value fund manager tried to meet withdrawals while facing a run on the fund, and ratio of the market value of the assets to the book value of the assets kept falling.
In such an event, better for the fund manager to stop withdrawals early and announce a new NAV that counts in the loss.
I don’t know of any stable value funds that are in trouble, so take this with a grain of salt. Most stable value funds are managed conservatively, so any testing will likely reveal that most of them are fine. There may be a few that aren’t fine, though, so a little testing is in order.
If you do find a need to move, money market and high quality bond funds are an excellent substitute for stable value funds. Be aware that you might have to leave funds in a non-competing fund option for 90 days to get there. In this market, the risks there could be as great as the losses on the stable value fund, so think out the full decision before making any change.
Position: none
That was my post at RealMoney today.? I wrote it with some degree of uncertainty, because stable value funds have a defense mechanism.? They can lower the crediting rate to amortize away the difference between book value and market value, and in a crisis, many will not argue with the credited rate reductions.? They are just happy to preserve capital.
Do I think this is a big problem?? No.? Do I think that no one is talking about this?? Yes.? The thing is, a lot of things can be hidden by the various wrap agreements that stable value funds employ.? If I were a stable value fund, I would not want to publish my market value to book value ratio.? If it’s above one, the fund will attract inflows, diluting existing investors.? If it’s below one, net outflows will increase, threatening a run on the fund.
Just be aware here, because if you can’t get a feel for the underlying economics of your stable value fund, you should probably seek another investment in the present environment.
In the center of the picture to the left are my friends Bill and Margie Wright. They have been dear friends of our family for eight years. Their kids have played with ours; they have ten, we have eight.
MR. WRIGHT: We’ve got a great team here, don’t we?