May 2008 – Page 2 – The Aleph Blog

Malthus, the False Prophet

Posted on 28 May 2008 by David Merkel

For those with access to The Economist, I would advise reading Malthus, the false prophet.? In one sense, Malthus was a guy who ran afoul of the idea that you shouldn’t make predictions about the long term, or, assume that people can’t make changes to solve problems.

This is one reason that I rarely go in for “total disaster” scenarios.? Disaster, yes.? Big problems, sure.? But total collapse-type scenarios rarely happen because people act individually, corporately, and through their governments (which want to stay in power).? There are rare cases of failure — for a recent one, think of the fall of the Soviet Union after the failure of Chernobyl.? And, that was a relatively benign failure in aggregate.

To give another example, the Y2K problem was real, but the hysteria over it drove companies, politicians and bureaucrats to solve the problems, and the problems were largely solved with a year to spare.

The current worry is that high energy and food prices will get worse as our world continues to grow, and that poverty will increase as some can’t buy necessities.? Metal prices will rise as well as there will be more need for construction materials.? Who knows?? Perhaps timber and cement will come into short supply as well.

High prices will help solve these problems.? We have many bright businessmen that want to make money off this, who will drive scientists and applied technologists to find ways of meeting the needs at lower costs.? In the 1970s, once the drive to become less energy-intensive? got going, it was hard to stop.? The R&D kept going for a while even after energy prices started falling, leading demand to fall further.? Also, sustained high prices will lead old technologies like wind and solar to become economic.? I sort of predicted this on RealMoney two years ago:

		David Merkel
		Peak Oil, Socialistic Governments, and Crisis
		5/9/2006 3:31 PM EDT

Now, I’m not an expert on energy like Chris Edmonds, so don’t take what I write here too seriously. I write this because of some things I read by some doom-and-gloomers on energy over the weekend. I thought the stuff was nonsense, so I’m not even publishing a link to the articles.

In general, I tend to agree more with the “peak oil” theory than disagree with it, mainly because there haven’t been a lot of new big oil finds, and depletion of old fields continues. “Peak oil” means that global output of oil will not increase beyond a certain level, which either has been reached, or will be reached in the next five years.

Beyond that, the behavior of socialistic governments like Venezuela and Bolivia tend to reduce oil output because they don’t manage the oil and gas deposits as well as those that they replaced. Beyond that, they reduce the incentive to search for new deposits, because the profit motive is reduced, if not eliminated.

So, I’m not optimistic about supply issues in energy, and I haven’t mentioned instability in other oil and gas producing nations. That said, I don’t believe that we are headed for a crisis, as some doom-and-gloomers forecast. If/when oil gets over $100/barrel and stays there, a combination of coal, nuclear, solar and wind will be used to generate electricity, and electric cars will become more common. Coal will be gasified as well. Ethanol will be a marginal contributor to the mix, because it takes a lot of energy to produce.

So, life will change some, and energy will become more expensive, but it won’t be the end of the world by any means. And, the scenario I posit above is a bearish one; things could end up better than that over the next two decades.

Position: none mentioned

Now, I’m not in the camp that says that the prices of food, energy and raw materials are coming down soon.? Changing the behavior of a culture takes time; changing technologies takes time.? The progress will likely come, though, and the process of meeting human needs as our world develops will persist, leading to better overall lives on our planet.

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PS — It will be interesting to see how our world copes with zero population growth.? One of the dirty secrets of economics is that economies tend to do better with younger overall populations that are growing.? I can see governments, even China’s, adopting tax schemes that favor having large families.? I can also see governments becoming a lot more lenient about immigration for people under the age of 30, and families with children.

Now, this is utter heresy, because at present fertility projections our global population should top out at 9 billion around 2050.? My guess is that many governments will panic between 2020 and 2030, and promote fertility and immigration of the young.? Now, whether you can convince young women who have shed the idea that having and raising children is a large part of what life is about to change their minds is another matter… my guess is that the schemes will amount to little.? But who can tell?? Obviously, I haven’t fully learned from Malthus’ error: I’m on the other side of the debate, but still, I made long term guesses of what might happen.

PPS — Malthus was a minister, but unlike many ministers, he lacked confidence in the providence of God.? As an odd historical aside, that lack of confidence had a surprising effect — much later, another young man considering the ministry read the writings of Malthus, and doubted the goodness of God.? That man was Charles Darwin.? History is more complex than we could make up in a fictional work.

Avoid Investment Scams and Bad Advice

Posted on 27 May 200822 June 2017 by David Merkel

There is one fundamental rule on the idea generation process to get across to new retail investors:

Buy what you have researched.? Don’t buy what your friends are buying, or even worse, what someone is trying to sell you.

(For those with access to RealMoney.com, you could review my Using Investment Advice series.)

The point here is to become capable of doing the basic research necessary to make reasonable decisions.? You don’t have to make great decisions in order to succeed.? You do have to avoid making major errors, which requires a degree of skepticism toward the opinions of your non-expert friends, and modest hostility toward those selling investment products.

What led to this article was a eight-page glossy advertisement from a publication that I do not deign to name (I worry about lawsuits), about a company called GTX Corp [GTXO].? Now, maybe I need to refresh my free subscription to the direct mail preference service, which really cuts down on the amount of junk mail that I receive.

GTX Corp is an example of a company with a high valuation, and uncertain prospects.? There is no provision for adverse deviation.? It trades on the Bulletin Board, and here is its business:

GTX Corporation integrates global positioning system (GPS) technology into consumer electronics devices.? The technology allows for real-time oversight of loved ones.

Now, why don’t I like this company, aside from the advertisement that did not mention valuation, balance sheet strength, or any other risk factors?

It trades at a high ratio of book, and trailing earnings don’t exist.
It was created out of a merger with a failed mining company.
Its recent financing this month offered equity interests far cheaper than the current market price.
Their auditor is not a major auditing firm.
Give the auditor credit though, they did not give them a “going concern” opinion, but instead expressed doubts.
The stock is on the Nasdaq’s Threshold Securities list, so finding shares to short is problematic.
Major shareholders are doing a secondary offering.
The advertiser was paid $186,000 to do the ad by a third party.

I have no idea how good their GPS technology might be, but there are too many risk factors here to make me even consider a long position.

I am not here to beat on GTX Corp.? I am using them, and the guy who advertised them as an example.

The advertisement had all manner of positive things to say about the technology and what it could do.? That’s fine, but what has it done?? Why doesn’t this corporation have significant revenues?
Why does the ad use the scam language “as featured on” and “as seen in,” naming prominent publications and channels, when all he likely did was buy some slack advertisements at a late hour, or in regional editions?
The ad compares the company to Garmin and other successful companies.
The ad uses a bunch of emotive problems that the technology could solve.
The ad puts forth a target price of $12 without any justification.

Buyer beware, and don’t listen to strangers giving you advice.? Cultivate networks of knowledgeable friends who are trustworthy, and avoid getting taken for a ride by slick-talking (writing) hucksters who pitch clever ideas to you.? Do your work, and buy cheap, boring ideas like I do.

Facilitating the Dreams of Politicians

Posted on 25 May 2008 by David Merkel

I’m a life actuary, not a pension actuary, so take my musings here as the rant of a relatively well-informed amateur.? I have reviewed the book Pension Dumping, and will review Roger Lowenstein’s book, While America Aged, in the near term.

First, a few personal remembrances.?? I remember taking the old exam 7 for actuaries — yes, I’ve been in the profession that long, studying pension funding and laws to the degree that all actuaries had to at that time.? I marveled at the degree of flexibility that pension actuaries had in setting investment assumptions (and future earnings assumptions), and the degree to which funding was back-end loaded to many plan sponsors.?? I felt that there was far less of a provision for adverse deviation in pensions than in life insurance reserving.

I have also met my share (a few, not many) of pension actuaries who seemed to feel their greatest obligation was to reduce the amount the plan sponsor paid each year.

I also remember being in the terminal funding business at AIG, when Congress made it almost impossible for plan sponsors to terminate a plan and take out the excess assets.? Though laudable for trying to protect overfunding, it told plan sponsors that pension plans are roach motels for corporate cash — money can go in, but it can’t come out, so minimize the amount you put in.

The IRS was no help here either, creating rules against companies that overfunded plans (by more than a low threshold), because too much income was getting sheltered from taxation.

Beyond that, I remember one firm I worked for that had a plan that was very overfunded, but that went away when they merged into another firm which was less well funded.

I also remember talking with actuaries working inside the Social Security system, and boy, were they pessimists — almost as bad as the actuaries from the PBGC.

But enough of my musings.? There was an article in the New York Times on the troubles faced by some pension actuaries who serve municipalities.? For some additional color, review my article on how well funded most state pension and retiree healthcare plans are.

Pretend that you are a financial planner for families.? You can make a certain number of people happy in the short run if you tell them they can earn a lot of money on their assets with safety — say, 10%/year on average.? Now within 5 years or so, promises like that will blow up your practice, unless you are in the midst of a bull market.

Now think about the poor pension actuary for a municipal plan.? Here are the givens:

The municipality does not want to raise taxes.
They do want to minimize current labor costs.
They want happy workers once labor negotiations are complete.? Increasing pension promises little short term cash outflow, and can allow for a lower current wage increase.
A significant number of people on the board overseeing municipal pensions really don’t get what is going on.? It is all a black box to them, and they don’t get what you do.
You don’t get paid unless you deliver an opinion that current assets plus likely future funding is enough to fund future obligations.
The benefit utilization, investment earnings, and liability discount rates can always be tweaked a little more to achieve costs within budget in the short run, at a cost of greater contributions in the long run, particularly if the markets are foul.
There are some players connected to the pension funding process that will pressure you for a certain short-term result.

Even though I think pension plan funding methods for corporate plans are weak, at least they have ERISA for some protection.? With the municipal plans, that’s not there.? As such, more actuaries and firms are getting sued for aggressive assumptions, setting investment rates too high, and benefit utilization rates too low.

The article cites many examples — New Jersey stands out to me because of the pension bonds issued in 1997 to try to erase the deficit they had built up.? They took the money and invested it to try to earn more than the yield on the bonds — the excess earnings would bail out the underfunded plan.? Well, over the last eleven years, returns have been decidedly poor.? The pension bonds were a badly timed strategy at best.

Now, like auditors. who are paid by the companies that they audit, so it is for the pension actuaries — and there lies the conflict of interest.? One of my rules says that the party with the concentrated interest pays for third-party services, so it is no surprise that the plan sponsor pays the actuary.? I’m not sure it can be done any other way, unless the government sets up its own valuation bureau, and tells municipalities what they must pay.? (Now, who will remind them about Medicare? 😉 )

The suits against the pension actuaries and their firms could have the same effect as what happened to Arthur Andersen.? These are not thickly capitalized firms, and many could be put out of business easily.? For others, their liability coverage premiums will rise, perhaps making their services uneconomic.

Finally, the flat markets over the last ten years have exacerbated the problems.? Partially out of a mistaken belief that the equity premium is large (how much do stocks earn on average versus cash), actuaries set earnings rates too high.? The actuarial profession offers some guidance on what rate to set, but the reason they can’t be specific is that there is no good answer.? With all of the talk about the “lost decade,” well, we have had lost decades before, in the 30s and 70s.? Even if the statistics are correct for how big the equity premium is, equity performance comes in lumps, and in the 80s and 90s, when we should have taken the returns of the fat years and squirreled them away for the eventual “lost decade,” instead, politicians increased benefits as if there was no tomorrow.

The states and smaller government entities have dug a hole, and they will have to fill it somehow.? Lacking the ability to print money, they will raise taxes as they can, and borrow where they may.? We are seeing the first pains from this today, but the real crisis is 5-10 years out, as the Baby Boomers start to retire.? You ain’t seen nothin’ yet.

Blowing the Bubble Bigger

Posted on 24 May 2008 by David Merkel

Maybe there is something different about the way that neoclassical economists and historians approach things. I am a bit of a generalist, so I try to look at things from many angles. The two books that I cited in my recent book review on bubbles were written by historians, not economists. Let me cite my summary of Kindleberger’s paradigm:

Loose monetary policy
People chase the performance of the speculative asset
Speculators make fixed commitments buying the speculative asset
The speculative asset?s price gets bid up to the point where it costs money to hold the positions
A shock hits the system, a default occurs, or monetary policy starts contracting
The system unwinds, and the price of the speculative asset falls leading to
Insolvencies of those that borrowed to finance the assets
A lender of last resort appears to end the cycle

That’s not the way a neoclassical economist views the world. Either men are rational, or, their errors tend to cancel each other out in the short run. Certainly there are never destabilizing feedback loops. Errors on the part of one person don’t lead others to make the same errors.

It is said that neoclassical economics cannot explain the existence of marketing and financial markets, without relaxing their rationality assumptions significantly. As an economist trained in the neoclassical school, I think we forget that these are assumptions that are made in order to get the math to work, not the way things actually work in the world. People are influenced by other people, and they do stupid things as a result, even when there is money on the line. (Maybe, especially when there is money on the line, due to the effects of fear and greed.)

Anyway, when I wrote my last post, I figured that someone would take issue with the concept of bubbles. The commenter raises a few issues, some of which are answered in the article itself.

What’s the definition of a bubble? When does something become a bubble?
When did housing become a bubble? Who identified it?

Another commenter, more polite, poses these questions:

Don’t they effectively borrow to finance the oil futures market?
Was the internet a bubble?
Isn’t housing unique, in that the speculators can walk away so easily?

In an attempt to answer these questions, “What’s the definition of a bubble? When does something become a bubble? Was the internet a bubble?” consider this piece from RealMoney’s Columnist Conversation:

		David Merkel
		Bubbling Over
		1/21/05 4:38 PM ET
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems: 1) Lack of data on private transactions. 2) Lack of divisional data in corporations with multiple divisions. 3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc. 4) Lack of data on corporations as they get dissolved or merged into other operations. 5) Survivorship bias. 6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided? This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified. To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well. Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue. It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.

In the internet bubble, there wasn’t that much debt, aside from vendor financing. Some faced the obligations of paying taxes on employee stock options, without having the cash to do so. Others speculated on margin, favoring the long side, of course. The real bubble was the low cost of equity capital, which led to the creation of dubious businesses, and weird stock price movements at IPOs. Say what you want about the present era, the IPO market is relatively calm, and the few deals getting done seem to have some quality.

Regarding the oil futures markets, yes, many participants are levered, but the commodity funds which are huge typically are not. Most of the selling to them comes from the oil companies, which find it profitable to lock in prices at $60, $70, $80…. $130, you get it. In that sense, I don’t think the majority of the activity is coming from levered players that are active investors — the commodity funds are passive hoarders, and the oil companies have a commercial interest.

For another example, consider the silver bubble in the late 70s / early 80s. The Hunt brothers tried to corner the silver market. In the process, the price of silver touched $54/ounce. What stopped them?

COMEX limited their ability to hold silver futures.
The Fed tightened monetary policy.
Silver came from everywhere to meet demand. People sold the family silver, mines that were closed reopened, mines that were marginal began producing like the was no tomorrow.

That last point is why I think it is very hard to corner any commodity, and why bubbles don’t last. Supply overwhelms speculative demand. The speculative demand in this environment is coming from a bunch of nerds who advise pension funds. This isn’t hot money.

This brings me to the last point, regarding housing: “When did housing become a bubble? Who identified it? Isn’t housing unique, in that the speculators can walk away so easily?”

Housing became a bubble when lenders loosened underwriting standards and offered lending terms that were atrocious — what lender in his right mind would ignore equity, recourse, and amortization? Yet in a mania to earn current profits, many lenders did. The bubble started in 2003, and crested in 2005. I posted on this for four years 2003-2007. I posted at RealMoney as it was cresting, with my main article in May 2005, and several more through the remainder of the year.

There were many others who also pointed at the bubble, but as with all bubbles, the naysayers are at the fringe. It can’t be otherwise.

Regarding the ability of the housing speculators to walk away, I like Tanta’s line at Calculated Risk that there aren’t many true walk aways. Most people abandoning their former homes have tried to keep them, and have lost a lot in the process. Away from that, the lenders do screen delinquencies for likely ability to pay. If there are significant assets in a state that allows for recourse, you can bet the lawyers are active.

In closing, I think the concept of a bubble is meaningful. It is a series of two self-reinforcing cycles, one positive, and one negative. These cycles occur because market players chase past performance, suffering from greed as prices rise, and fear as they fall. Any lending to finance the speculation intensifies the size and the speed of the event.

PS — if it helps at all, my equity investing methods borrow from these ideas. I am always trying to analyze industry cycles, to make money and avoid losses. So far it has worked well.

Toiling Over Bubble Troubles

Posted on 23 May 200823 May 2008 by David Merkel

There is a religious war aspect to what I will discuss this evening. It surprises me, but there are many people who believe that bubbles cannot exist, because economic players are rational in aggregate. I question the latter assumption — anyone who follows the equity markets understands the fads that sweep through the markets, leading to a lot of disappointment later.

From one of my comments in the RealMoney Columnist Conversation:

		David Merkel
		Housing Bubblettes, Redux
		10/27/2005 4:43 PM EDT

From my piece, “Real Estate’s Top Looms“:

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow’s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

I’m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.

That’s why I think the hot coastal markets are bubblettes. My position hasn’t changed since I wrote my original piece.

Position: none

(If you have a subscription to RealMoney, you should look at the Real Estate piece. It was prescient. I occasionally get things right.)

At present, we are hearing murmurs about a crude oil bubble. Here’s my initial question: Who is borrowing money to buy oil? When we had the housing bubble, we had many investors that had to feed their properties to keep them afloat. They were relying on capital gains to keep themselves solvent. That is always a sign of an overheated market. With the tech bubble, we had vendor financing, and stock options on which people had a hard time affording the taxes. In the commercial real estate bubble 1989-92, rents were not sufficient to cover financing costs.

Think of it this way: at the end of a bubble, someone looks at buying an asset, and concludes that it is not worth buying because of the likely stream of payments he will have to make after the initial purchase.

But what of crude oil? There are a number of noises over short covering in the press. The futures curve looks like a bowl, with the far distant futures higher than spot. Crude oil has had a vicious move upward over the last three months. That doesn’t bother me because vicious moves are common in markets where supply and demand are inelastic in the short run.

But there are speculators. Not your common run-of-the-mill speculators, but ones that dress in fancy suits, and have fancy asset allocation equations. Pension funds, and other long term investors are buying commodities and hoarding them, because they think the commodities will be more valuable in the future. But, they are not borrowing to do it, are they? Er, no, not exactly, but yes, in practice. Every pension plan is borrowing implicitly at the discount rate specified by their actuary. If you don’t earn that rate, you fall behind. For now, ignore the correlation arguments that are meaningless because correlations aren’t stable, and think in absolute terms. Every investment that my pension plan invests in should aim to beat the actuarial funding rate.

Will crude oil appreciate at an 8% rate for the next 10 years? Maybe. Can the pension fund emotionally survive a 40% drawdown? Probably not; most pension trustees are scaredy-cats. They will sell oil during the panic. The consultants, with new statistics, will help them do it.

Now, in the present environment, I think that oil has some bubble in it, but it is not the majority of the recent move. As in the late 70s and early 80s, conservation moves slowly, but it does grind prices down. What is different here is that there are many countries willing to take up the slack near current prices, thank you.

So, I don’t buy the bubble rhetoric for crude oil here. Supply and demand are tight, and over time, high prices will create new technologies that use less fuel. But it will take time. For the next few months, will be volatile, but the one scenario I don’t think will happen is a large fall in the price in the short run.

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Before I leave for the evening, one last comment from the past on bubbles from me:

Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go? Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back. Perhaps another possibility is when a country?s currency is being used more and more as a shadow currency, like the US in the Third World. But even that will come home someday.

The Glass Ceiling Revisited

Posted on 22 May 2008 by David Merkel

After seeing this article from Dealbreaker, I felt that I had to bring out a very old piece of mine.

In late 1997, Gene Epstein of Barron’s wrote an article called “Low Ceiling.” I wrote a letter to the editor:

To the Editor
The “Glass Ceiling” will always exist for women — and men, for that matter — who are principled enough to care for their children. There are jobs that demand so much time that a conscientious parent cannot take them.

Childrearing is aided by at least one parent sacrificing monetary income for the sake of time to spend with the children. It makes a big difference in quality of life, particularly for the children. The main determinant of a child’s future success is parental input. Without that parental effort, which is economically unprofitable in the short run, the future is not as economically bright, nor as friendly.

Perhaps it should not surprise us that standard educational achievement scores have dropped as the incidence of two-income families has risen. The pattern goes back for centuries. Wealthy parents get so busy that they cannot raise their children, so they hand the kids off to those who are often far less capable. It is no surprise that their familial wealth rarely lasts past the third generation.

DAVID J. MERKEL
Aston, Pennsylvania

I have worked with many bright, capable women in the workplace, some in the firm that I worked for, and some outside.? Most of them wanted a family and productive work, as I did, which often led to lasting friendships.? But it cuts against advancement in the workplace, which tends to go to men, and the few women who are willing to sacrifice their families for material advancement.

Women have it worse than dedicated men, because they have to bear the children, and that involves unavoidable pains and delays, and considerably more guilt feelings over whether they are doing it right for their children.? Men in general don’t have those doubts.

I have turned down jobs that would take me away from my family, and as a result, I am less wealthy.? I don’t care — my wife and kids are happy, in general, and that is what counts.? Though I love writing about economics and finance, I am not a slave to greed, and that enables me to be happier than many in my field.

We also have to recognize that good men and women are both similar and different.? Similar, in that they care for their families.?? Different, in that children require care that differs for each sex.? Fathers can’t nurse, and aren’t as compassionate, on average.? They are also better at dealing with boys as they age.? Women are better with the girls as they age, and better at the early nurture — I changed my share of diapers, but most men are clueless with little kids.

I leave this possibly controversial piece here — children need care, and parents need to provide it.? That will inhibit your careers, but leave you qualitatively richer in the long run.? I am happy with the sacrifices that I have made for the good of my wife and children.

On Industry Selection

Posted on 22 May 2008 by David Merkel

Recently I received an e-mail:

David,
Always enjoy your blog – very thought provoking, and I’ve learned a lot from reading you across a variety of topics. Assuming I haven’t missed this in an older post… one thing you mention as a key investment strategy is finding the right industry at the right time, and I’ve never seen a very good explanation of how one goes about that. In one of Jim Cramer’s recent books he offered a sort of stylized graph outlining a general playbook to that effect – I’ll send it to you if you’d like – but I’d like to get a primer on how you go about industry over/underweights.

Thanks and Best,
JC

It made me think that I should go through my basic principles of industry selection, and explain them.? JC mentions Cramer’s “playbook” — that’s the classical guide to what industries do best in an “ordinary” business cycle.? Personally, I think Cramer’s views on industry selection are more complex than that, largely for the reason that I don’t follow the “playbook” in any strict sense: global demand is more important than US demand alone for many industries.? The old playbook is no longer valid, until we get a totally integrated world economy.? (Side note: we will never get that — some war will upset the globalization — it is the nature of mankind.)

Anyway, I have four basic tenets when looking at industries:

Buy strong companies in weak industries when the industry pricing outlook seems hopeless.
Buy moderate to strong companies in strong industries where the earnings power and duration are underestimated.
Underweight/Ignore/Short industries where pricing power is likely to be negative for several more years, and especially industries that are in terminal decline.
Avoid fad industries.? There are P/E levels that no industry can grow into.

My best example of #1 is the P&C insurance industry in early 2000.? Total gloom.? I bought a lot of The St. Paul then.? Another example: Steel in 2001-2002.? I bought Nucor.

For #2, think of the energy industry — current stock prices embed oil prices far below current levels.? Or, think of the life insurance industry — low P/Es, but the demographic trends are in their favor.

On the third one, think of newspapers, whose richest revenue sources are getting eaten up by the internet.

For the last one, think of the internet/tech bubble 1998-2000.? Very few companies that were hot then are at higher prices now.

I share the results of my industry model once a quarter at minimum.? But I don’t use my model blindly.? For example, lending financials and housing have been cheap for some time, but I have avoided them.? They are cheap for a reason.

My main model uses the Value Line ranking system, and uses the nominal rank, and how it is different from the average historical rank.? It can be used in two ways: highly rated industries can be analyzed to see where the pricing power is not reflected in the stock prices yet.? Low rated industries should be analyzed for the possibility or reversal due to undeserved hopelessness.

But you can create your own model just from a series of index prices.? The idea is to look at industries that either have strong momentum that you think is deserved, or industries with weak momentum where things seem very bad but not terminal.? You can even modify it to look at industries that have bad performance over the past 3-5 years, but have rebounded over the past 6-12 months.

Behind all of that, remember my rule: sharp movements tend to mean-revert, slow, grinding, fitful movements tend to persist.? Things that are too certain tend to disappoint, while those things that are less certain tend to surprise.

One reason I have done well over the past 7+ years is that I have been willing to let my industry selection vary considerably from where the indexes have been.? If you think that you have insight into the longer-term earnings power of industries, then take your opportunity, and deviate from market weightings.

CPDOs: Can Profit-lust Destroy Obligations (to Honesty?)

Posted on 21 May 200822 June 2017 by David Merkel

Take some low single-A or high-BBB rated debt, lever it up 15 times.? If spreads back up, lever up more, and buy more at the higher spreads, and hope spreads don’t continue to rapidly widen, such that you have to break the deal and realize the losses.? If spreads tighten enough, de-lever, and declare victory.? That is a great bull market strategy to make money in investment grade credit, but it is not a high quality strategy.

If I created a Collateralized Debt Obligation [CDO] out of similar instruments, with what would be light leverage of 15 times, and it had just two tranches — 94% senior, 6% junior, the senior obligations would get a AAA (probably), but the junior obligations would be rated BB or so — just my back-of-the-envelope guess, but consistent with my experience.

But for Constant proportion debt obligations [CPDOs], they were not rated BB but AAA, because the dynamic portfolio management would allow the structure to survive modest bear markets in credit.? Unfortunately, when a lot of parties lever up credit, the historical statistics on how the credit markets behave at lower leverage levels don’t apply.? The odds of a sharp self-reinforcing bear market in credit rise.

So, it is not a surprise that I was an early bear on CPDO structures.? Here’s a summary piece on what I wrote, and when I wrote it.

Now today it gets revealed in the Financial Times that Moody’s had a mistake in their ratings model for CPDOs that allowed them to offer ratings equivalent to those of S&P.? Needless to say, this is getting a lot of coverage today, from:

There are conflicts of interest in the way that ratings agencies get paid by the issuers, and the CPDO debacle highlights them.? I don’t think you can create a system where the users of ratings carry the full weight of the ratings process.? The issuers have the concentrated interest in a way buyers do not.

But maybe there is a way to re-align matters.? What if the ratings agencies received half of their fee by receiving interests in the juniormost class?? (For non-structured deals, make that a subordinated interest strip.)? My, but I think that subordination levels would rise.? Also, I think the ratings agencies would become more generally cautious.

From my angle, though, the CPDO debacle is more egregious than other rating failures, because the agencies deviated from their normal way of rating debt, seemingly just to make more money.? Well, they made the money, but how much is a reputation for quality ratings worth?? In the long run, the CPDO deals will be net losers for Moody’s and S&P, and a net win for skeptics like Fitch and Dominion.

How Far We Have Come

Posted on 21 May 200822 June 2017 by David Merkel

Okay, here is the S&P 500 over the past year:

We haven’t quite made it back to the highs made in July or October. But the VIX has normalized:

And the spread between A2/P2 commercial paper and the two-year Treasury has narrowed as well. Normalcy has returned to the lending markets?

Well, sort of. The question remains as to what happens when the Fed ends their new lending programs, that is, if they can end them. As with many government programs, they take on a life of their own, and they are difficult to end. If the Fed can’t end the new facilities, can they really say that they have ended the crises?

As for market sentiment, consider this graph:

This is a knockoff of the oscillator that Cramer cites. How accurate is it? Over +/- 500, Cramer comments that there are extreme readings. But as for now we are near zero — this indicator tells us nothing here.

So, what am I saying? We have rallied a great deal, and a lot of fear has come out of the markets, but we still have not eclipsed the highs of July or October. My sense is that we will muddle from here and not do much on net for the next three months. Fear has ended too quickly.

More on AIG

Posted on 21 May 2008 by David Merkel

Aside from Abnormal Returns (one of my favorites, good to see him back), my comments on AIG were also cited by Felix Salmon at Market Movers.? I tried to post this comment there, but the software would not let me, and I have no idea why:

Thanks, Felix.? With the Wells Notice served to Hank Greenberg, this chapter of the AIG story is not over yet.

Sometime in the future, I’ll find and post a copy of the memo where Hank Greenberg discovered the massive under-reserving at ALICO Japan, giving his response to the problem… but given the billion dollar hole, it was amazing that AIG did not miss earnings that quarter, because it was much larger than their quarterly earnings.

And some of my insurance analyst friends wonder why I don’t find AIG to be cheap…

But, regarding the recent AIG news flow, my timing is not something that I attribute to skill.? I don’t believe in luck, but that Greenberg would get the Wells Notice so soon, that AIG would indicate willingness to sell off non-core units, or that they would raise significantly more capital than they previously indicated was not something I would have expected would happen the next day.

As I mentioned at RealMoney back when Greenberg left AIG, my experience in my three years inside AIG was that we (the small actuarial unit that I was in in Wilmington, Delaware) found five reserve errors worth more than $100 million, but none of them ever upset AIG’s quarterly earnings.? That is why I remain a skeptic on AIG.