1) The Modigliani-Miller Theorem asserts that the value of assets at a firm is independent of how they are financed.? The dirty truth is that less levered public firms are more profitable, and generally better investments than highly levered public firms.? Why?? High levels of debt often lead managements to think short-term, and they make more errors.? Yes, some firms will do amazing things when the debt gun is pointed at their head.? More will fail, or muddle.? Perhaps this is a place where private equity does better than heavily indebted public companies, because they are out of the spotlight.? Equity Private, if you are listening, what do you think?
2) Too many foxes, not enough rabbits?? Perhaps true for now.? There is a lot of money in vulture funds relative to the opportunities at present.? That might change as we get near the nadir of the credit crisis, but it does set up an interesting dynamic.? If you were managing a vulture fund, when would you deploy your cash?? It’s a tough decision — too early, and you don’t get the good deals, and the same if you are too late.? Personally, I would do a time-scale, and allocate relatively evenly over the next 18 months.
3) Counterparty risk is still a threat.? Well, sort of.? The investment banks are pretty sharp at limiting their own risks to their clients.? The real risks are the willingness of the investment banks to offer credit to each other.
4) Securitization will come back.? It is too powerful of a technology for it not to come back.? The only question is when.? Deals are still getting done where the GSEs guarantee the risk.? Beyond that, little is getting done.? Better disclosure will help in the long run, but in the short run, it doesn’t mean much.
5) The credit crisis is over!? Well, not according to Caroline Baum and David Goldman.? Both are acquaintances of mine.? Many know Caroline Baum, whose ability to explain the Fed and the credit markets is superior.? David Goldman is less well known, but this is what I wrote at Barry’s site today:
David Goldman is a bright analyst and underrated. I met him back when he was with First Boston, and I was a mortgage bond manager. His commentary at CSFB and BofA helped make me a better investor.
I don’t normally push multimedia, but I thought the interview was a good listen.
6) Default rates are rising on junk grade corporates.? Odds are they will be higher still in 2009.? When junk grade default rates move up, it is typically for three years or so, and in this case, we have more low-rated debt as a percentage of the market than at any time in the past.? Is it possible that we could eclipse the default rate of 2002?? Yes, but I would not put a lot of money on that; I feel the odds are 50/50.? Many corporations are highly levered but prospering from global demand, not US demand.
7) As I suggested regarding ACA Capital Holdings, they ended up owned by their policyholders, who get an equitable interest in the assets of the company, though not enough to settle their claims.? For the bond insurers that are insolvent, this is the paradigm that will be followed as bad guarantees get settled.? And, this will probably be applied to Bluepoint, Wachovia’s subsidiary.? I agree with Calculated Risk, it is an interesting statement that Wachovia would not put fresh capital into it.? Just another sign that the equity is worth zero to Wachovia.
8) The bond insurers aren’t totally dead, though.? They are finding ways to exit debt they have guaranteed, and convert it to more liquid, valuable debts. Hey, every bit of risk shed is a plus, and they can report income in the short run from that.
9) The asset sales go on, as investment banks reconcile their SIVs and CDOs.? The tough part is taking the losses (surprise).? This is normal, because in illiquid markets where there is a lot of credit risks, there are few trades, and when things go bad, prices shift dramatically lower.
10) I have a bias against universal finance.? No company can manage all financial businesses well.? There are different risk control disciplines in different areas of finance, and when you put them together, risk control gets neglected in some businesses.? This was true at UBS, and now they are unwinding the mess.
I’ve been mulling over whether I should write about insurance M&A.? Ugh, yes, I should say something.? What pushed me over the edge was a piecein the WSJ on the purchase of Philadelphia Consolidated.? When I first heard about the deal, I blinked, and said, “Foreign acquirer overpays to enter the US.”? Is Philly a good company?? It’s a great company, but it may not be so under foreign ownership.? And, the price was well in excess of what it would have taken to create/attract the talent for a new venture.? Paying 2.7x book is not a winner.
But, the have been other missteps as well recently.? Liberty Mutual buys Safeco and Ohio Casualty for 1.8x and 1.6x book.? High prices for the assets obtained, and Liberty Mutual can’t lever that much as a mutual company.? It feels like the current management is going for growth at all costs, and the only losers will be the participating policyholders, who will eventually get a lower dividend stream.
I’m also not into funky holding company structures, for example, where a mutual company sells off a piece of a subsidiary to be publicly traded.? In that sense, it was good of ALFA to buy in their stock subsidiary (2.0x book), and now Nationwide is doing it as well (1.6x book).? Someone buying Nationwide Financial Services at the IPO earned an 8.7% annualized returnto the buyout.? ALFA shareholders did better, but I am not sure how much better, because I can’t tell how many times the stock split.? Both beat the returns on the S&P 500.? (I won’t mention the details of how Provident Mutual took Nationwide to the cleaners when they sold themselves; that had an effect on the returns.)
But, think about it from the perspective of the participating policyholders, who nominally own the mutual insurance companies.? That was expensive capital that diluted the dividends that they would have received.? But, mutual policyholders are sleepy, and mutual company managements take advantage of them.
I will mention three more deals before I close.
Commerce Group sold itself to Mapfre SA (1.6x book).? Another foreign company overpaying for a US presence.? I like the deal, because Safety Insurance will out-compete Commerce/Mapfre.
Midland Companies was bought by Munich Re for 2.0x book.? Midland was well-run, but I don’t see the fit with Munich Re.
Castlepoint Holdings was bought by Tower Group at 1.0x book value.? Perhaps a little incestuous, because it was Tower Group’s main reinsurer, but Tower helped bring th IPO to market, and I can’t tell whether this is a bright or dumb idea.
Insurance accounting is opaque to outside experts, and sometimes even to those doing the figures inside the companies.? Management often see marketing or cost synergies in doing deals, but my experience says those aren’t common.? Also, diversification benefits have to be weighed against lack of focus.? It is very difficult to manage disparate business lines.
To those are getting bought out, or who have been bought out, I encourage you to be grateful for the gift that you have received.? For those who own the acquiring company, I must say that the return performance for acquiring companies has been poor.? Consider investing in companies pursuing organic growth, which is often a better idea.
At the end of a business day, the business press has to sum up why the market did what it did.? This is sometimes the worst business journalism.? Why?? Because there often is no good reason for why the market did what it did.? So, we make something up, because we have an assignment to write the closing report.? It can be hard to write when the market moves a lot for no apparent reason.? It can be hard to write when the markat doesn’t move much.? How easy is it to say, “Nothing material happened today. We now return you to your regularly scheduled programming.”
People have a bias for wanting to see cause-and-effect.? Partly, it is because there are causes for each effect, but discerning causes in complex systems is tough.? Perhaps if we lengthen the time horizon, we can make more sense out of monthly, quarterly, and yearly moves, than to agonize over daily moves.
Personally, I try to tune the daily noise out, and focus on the intermediate term.? I think that is the most useful posture for investors, and would encourage you to do the same.
When I review books, I don’t just review new books.? I try to share with my readers the books that have helped me become a better thinker on investments.? Fortunately, in this case, the 1984 book Super Stocks was reprinted in 2007.? Perhaps that validates my opinion that this is a valuable book.
Ken Fisher focuses on the concept of Price to Sales [P/S] ratios as a means of analyzing cheapness in companies.? Cheapness, yes, but predicated on the concept that a new product, process improvements, or better management will make more profits from the sales, or improve sales volumes and perhaps profit margins.
Though the examples are from the early 80s, the writing is clear enough that one can get the idea of how it might apply today.? You would get the same feeling from Ben Graham’s classic The Intelligent Investor, where the examples were from the 50s and 60s, but the truths are timeless.
Why choose this book to review now?? Profit margins are artificially high, and will come down somewhat from here, even if they remain above average.? How can we find cheap stocks when profit margins are so high?? Use P/S, or Price-to-Book [P/B].
My own investing looks at a wide number of valuation figures, but across an economic cycle, I give more or less weight to each variable.? When things are bad, I give more weight to P/S and P/B.? During the recovery, I emphasize P/E on a forward basis.? When the bull market is in full swing, I let industry selection dominate, which gives me more market sensitivity. As another example, I play up EV/EBITDA when buyouts are becoming common, and drop it as a criterion when buyouts are not being funded.
So, unlike Peter Lynch, paying attention to the macroeconomic environment can positively affect your performance, if you do it intelligently.
Super Stocks is very consistent with my eight rules, particularly the rules:
Stick with higher quality companies for a given industry.
Purchase companies appropriately sized to serve their market niches.
Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
Fisher spends a decent amount of time on balance sheets, market share, competitive advantage, and use of cash flow for future investment.? Though I don’t endorse everything in the book, like his price-to-research ratios, there are a lot of good concepts for the average investor to consider, and benefit from.
Full Disclosure: If you enter Amazon through any of the links on my site (mainly on the leftbar) and buy anything, I get a small commission.? This is my version of the tip jar, and it doesn’t increase your costs at all.
This will be short.? A warning to those who are looking for a quick recovery in residential real estate prices: don’t expect a quick recovery.? There are many dscouraged sellers who would like to sell, but have pulled their properties off the market, waiting for a better day.? For many of them, stabilization of prices may be that better day, and more supply will come when the bottom comes, extending the length, but not the depth of the bottom.
In value investing, it is imperative that one considers the state of the industry invested in, the balance sheet of the company, and earnings quality.? These are basic concerns for any investor, and all of my failures in investing can be be linked to neglect of one of these three items.
Ben Graham used the phrase “margin of safety.”? Actuaries, even less poetic, use “provision for adverse deviation.”? In either case, the idea is investing in such a way that you won’t get badly hurt if you are wrong.? It handles risk at the security selection level — choose your companies carefully; make sure they are survivors.
Does the industry have pricing power?? Is it under pressure from rising costs?? (Credit losses are a cost for financials.)? Pricing power, and lack thereof, should be considered in valuation decisions.? Are things so bad that companies are going bankrupt?? Perhaps it is time to buy the strongest one in that industry, because it often takes defaults to make pricing power turn.? Fewer competitors means profit margins can rise.
Does the company have a lot of debt?? Is the tangible net worth small relative to the liabilities?? Be careful, because a small negative change in the economics of the business could kick the company over the edge.
Do the earnings come from cash earnings, or do accruals dominate the earnings?? Cash earnings are always higher quality than accrual earnings.? This is one reason why financials almost always trade at a discount, becausethey are a bag of accruals.? Also, with financials, the quality of the accrual entries affects valuations.? Asset managers will have higher valuations than long-tail P&C insurers.? Who knows whether the reserves are right or not?
All that said, it was with sad amusement when I heard on the radio this afternoon that Legg Mason had become the largest shareholder of Freddie Mac.? Is Bill Miller (or Private Capital) doubling down?? He will look like a genius or a fool after this, depending on the outcome.? I think it is foolish, and an willing to say that he doesn’t understand the credit risk in the current environment, and should get advice from someone who gets the current credit crisis better, like me, or Eric Hovde.
Value investors often invest in financial stocks.? That is their undoing in the present market, as earnings and net worth get eaten by credit losses.? But to any value investor that does industry analysis, this was avoidable, because the risk of credit losses to the banks grew as the banks were willing to lend on terms that were loose.
As a value investor, I have been able to avoid the current crisis.? I avoided credit-sensitive financials, and have bought cheap names among industrial stocks.? But that was yesterday, what of tomorrow?? I don’t think the credit crisis is done, and so I urge a conservative posture at present.
Pensions are complicated.? Necessarily so, because of the wide numbers of parties involved, and the contingencies involved (mortality, morbidity, asset returns, insolvency) over a long period of time.? Anyone who has had a cursory look at the math (or regulations) behind setting pension liabilities, contributions, etc., knows how tough the issues are, and why real experts need to handle them.
I’ve worked at the edge of the pension business for much of my career.? I have designed defined contribution plans, created stable value products, done asset allocation for defined benefit [DB] plans, terminal funding, and other incidentals.? That said, I am a life actuary [FSA], not a pension actuary [EA].
Tonight’s main issue revolves around a good article by the estimable Matthew Goldstein of Business Week.? Steve Waldman, filling in at Naked Capitalism, commented on the article as well.
Here’s my take: it is legal today for companies to shift their pension liabilities to life insurance companies in the Terminal Funding business.? All they have to do is send a description of the liabilities of the plan to the dozen or so companies that are in the business with adequate claims paying ability ratings, and the companies will send back an estimate of what they would require as a single premium payment to take on the liabilities.? Low bidder wins (and loses — he mis-bid).
So, why don’t plan sponsors take the life insurers up on this?? Easy.? The cost of buying the annuities from the insurers is more expensive than the amount of assets in the trust.? For those companies that are overfunded, they don’t care to terminate — it is a great benefit for their employees.
Terminal funding was most common in the late 80s, when companies could terminate DB plans, and any excess assets would revert to the company.? Then the law changed, and most excess assets would be taken by the Federal Government.? Another reason why overfunded plans do not terminate — the excess assets are valuable to the plan sponsor, but are trapped assets.? They are valuable because they give flexibility, and reduce future contributions.
Why is it more expensive to buy annuities from insurance companies than the assets on hand in the trust?
The main reason is that the plan sponsor gets to assume the rates he will earn on plan assets (within reason).? That rate will almost always be higher than the rate that an insurance company can invest at after expenses.? Pension funding rules are significantly more liberal than life insurance reserving and risk-based capital rules.
Insurers must mainly invest in bonds, whereas pension funds can invest in any asset class, subject to the prudent man rule.
Insurers must keep surplus assets to keep the company sound through downturns.? Pension plans have no such requirement.
Insurance companies have profit margins and overhead that pension plans do not.
Often there are funky, hard-to-value benefits in the pension plan.? Subsidized early retirement is the simplest of those.? The insurance companies don’t have a good way of pricing them, so they toss out some guesses.? Often the winner is the one that ignored the cost of the odd ancillary benefits.
Now, for a proposal from the Treasury to be effective, they somehow have to wave their hands at the issues that I just put forth.? Even if they allow other regulated financial companies to take over pension plans, they have the following issues:
Who is responsible for shortfalls?
Does the company taking over the plan have to put in some subordinated capital to give them “skin in the game.”? (Essentially, the life insurers have to do that today.)
How do profit incentives work?? Do they accrue inside the plan as a buffer against shortfalls, or do excess earnings (however defined) get immediately? or over time paid to the buyer of the pension liabilities?? (You can guess what the liability buyers want.)
How do underfunded plans get transferred compared to adequately funded plans?? Hopefully the plan sponsors of the underfunded plans have to pony up to fund them at levels that are adequately funded, then they can transfer them.? It would be a sham to transfer underfunded plans to an entity that says that can fund the plans because they have an ultra-aggressive investment strategy.? The blow-up will leave behind even bigger deficits.
Call me a skeptic here, while I call the head of the PBGC a Pollyanna.? To Bradley Belt: If you think this will solve your underfunding/insolvency problems, think again.? Only through high risk investment strategies succeeding can all of the underfunding be invested away.? Ask this: how would you feel today if the plan sponsors of underfunded plans all adopted highly risky investment strategies?? You would worry.? Well, unless the liability buyers have skin in the game, you will worry just as much after the sale of liabilities.
Sometimes I think politicians/bureaucrats believe in magic.? Some little tweak, a loosening of regulations, and poof!? The problem goes away.? It is rarely that simple, particularly when you are dealing with the math and complexities of long term compound interest, which in my opinion are inexorable.? (Kind of the inverse of compound interest being Einstein’s eighth wonder of the world — it is a wonder when you are compounding assets looking forward, without liabilities to fund, but when your discounted liabilities are greater than your assets, my but that eighth wonder of the world fights you fiercely.)
Now, I’m not going to discuss this at length, because I am getting tired, but the Wall Street Journal had another pension article this week.? A good article, and I must say that I don’t get how the practices described are legal.? The anti-discrimination rules were put into place to deter this issue.? Why they are not enforced here is a mystery to me.? Regulated pension plans should not be able to invest in the debts of non-regulated pension plans.? To allow anything else, is to make a mockery of the regulations.? (Another reason why regulated and non-regulated financials should be separated.)? The Treasury has anti-abuse rules that they can invoke against such practices.? Why don’t they use them?
My guess is that the Bush administration doesn’t care about the issue.? Perhaps the next President will care more.? And, with respect to the sale of pension liabilities, my guess is that that gets left to the next President and Congress, who will not allow the practice as proposed.
PS — One last note: what would be fair, if pension liability buyouts are allowed, is to allow participants the option to roll their net assets into a rollover IRA.? Back in the 80s, many people got burned by less than creditworthy companies who bought their pension liabilities and went belly-up themselves.? It is a normal aspect of contract law that you can’t take a debt and transfer it to another party unilaterally, unless the creditor consents.? So it should be in pension liability transfers.
Every 100 posts, as WordPress counts, I take a moment out to reflect on my life , my blog, the markets, and more.? My blog is usually a reflection of me as an investor and businessman, but it is not a reflection of me, the whole person.? This is my chance to speak my mind more broadly.? (By the way, it is amusing to be doing post 800 on 08/08/08.)
Hasn’t the market been volatile lately?? I feel like a yo-yo.? Ordinarily my sector rotation methods help my portfolio to be less volatile than the market, but at present my “beta” feels like 1.3.? Now, on the plus side, I am underweight energy for the first time in six years, starting in mid-July, and my energy exposure has a large refining component through Valero and ConocoPhilips. Beyond that, I am in the plus column again for 2008, though returns on Monday could reverse that with ease.
That’s the market.? Only invest what you can afford to lose.
Writing this blog interfaces with the print/online world in a variety of odd ways.? I talk to reporters fairly frequently, and give them a good amount of my time.? So, I want to thank my contacts at the CNN/Money, Fortune, Bloomberg, TheStreet.com, The Wall Street Journal, Business Week, and the Associated Press.? Other interested writers/reporters, e-mail me, and we can talk.
Ordinarily, when I write these posts, I cite those who have driven traffic my way, but right now, my internet connectivity is not cooperating with me.? Instead, I will mention the blogs that are not on my blogroll that I admire: World Beta, Felix Salmon, Information Arbitrage, and Interfluidity.
I remain most grateful to my readers.? I can’t respond to every e-mail, but I do read all of them.? Thanks for taking the time to read my writings.? I enjoy doing it because it gives something back to the broader investment community; retail investors don’t have many friends.
I leave you all with this.? I know my blog is eclectic; I cover a number of issues, and less well than some blogs that are more focused on single issues.? If you have ideas that you want me to write about, please e-mail me.
May the Lord bless you in your endeavors, and grant all of us wisdom in what I expect to be turbulent times in the markets.
A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.
Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.
Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.
As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.
I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.
Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.
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
I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?
The Investor Base Becomes Fundamentally-Driven
1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.
2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.
3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.
4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.
5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.
6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.
7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.
8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.
9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.
10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.
11) Value investors find no lack of promising ideas, only a lack of capital.
12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.
14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
8 ) High quality companies keep buying back stock, not aggresssively, but persistently.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.
Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
I appreciated Steve Waldman’s article at his excellent blog Interfluidity, which was also posted at Naked Capitalism.? I have a slightly different take on the topic, which I expressed in the comments section of each blog:
Steve, I think we had two, maybe three things go on here. First, the “originate to sell” model failed because basic underwriting was not done well. The incentives against failure were not left with the originator, i.e., having to hold onto a large equity piece.
If the underwriting had been done well, the next problem would be weak financing structures on the part of the certificate buyers. Many were leveraged higher than prudent, even on “super seniors.”
Finally, the servicing models are often flawed. There has to be adequate pay for servicing and special servicing, or else loss mitigation efforts will be poor.
Risks were taken and avoided, but many of the seemingly avoided risks come back when the one guaranteeing the avoid risk cannot perform.
It is true that there was a lot of demand for AAA assets, but there was also a lot of demand for mezzanine and subordinated assets out of complex debt structures.? Within all investor classes, there was a hunger for excess yield, whether it was a little extra at the AAA level, or a lot extra for subordinated and equity levels.
The demand for AAA assets, whether senior or super-senior, was often driven by leveraged investors, seeking to profit from being able to arbitrage the AAA securities versus their funding rate.? Safe assets were turned into unsafe assets by the added leverage.
And in this sense, the rating agencies are culpable, because they let the concept of a AAA, which means capable of surviving a depression, drift to a lesser standard.? They trusted simple mathematical models, and did not spend enough time on the quality of underwriting.? Of course, that takes time, and profits for the rating agencies comes from cramming as many deals out the door as they can.? That is, if you don’t care about your franchise.
When I was a mortgage bond manager, I spent time on any deal, even at the AAA level by asking, “Who has skin in the game?”? If they were credible underwriters, I had greater comfort, but if the originator was selling and retaining little exposure to the outcome, I did not tend to buy.
Deal structure cannot make up for bad underwriting, usually.? Lousy assets lead to lousy returns for everyone in the capital structure.? I have owned AAA assets that have gone into default.? In every case, lousy underwriting of the original debts, not a bad economy, was the cause of the problem.
The entire period 2004-2007 was characterized by low spreads, as a hunger for yield depressed yields on newly issued corporate and structured debts.? Now we are facing the true value of those debt promises.
Of course after too much risk is taken, the regulators come along and say, “We must tame this!? No more excessive risk taking by investment banks because that leads to systemic risk.”? jck at Alea pokes at the recent efforts to do so, and if you look at the comments, I agree.
It is impossible to separate the desire for high returns from high risk-taking.? Having been a risk manager inside insurance companies, I read with some sympathy this article from The Economist.? Substitute actuary for risk manager, and marketer for trader, and the same situation plays out in insurance companies every day.
The only place that I have worked in that solved the problem bonused both marketers and actuaries on the same formula, offering slightly more reward from sales to marketers, and risk-adjusted profits to actuaries.? It got both sides on the same page, because they were compensated similarly.? I told the head of that division that he was fortunate to have business-minded actuaries.? He choked on his drink when I suggested that we were cheap for what he was getting.
My view is that investors did take too much risk 2004-2007.? They did it in many ways, by not underwriting properly, by levering up too much, by not servicing properly.? We are paying for that now.
When I review books, I don’t just review new books.? I try to share with my readers the books that have helped me become a better thinker on investments.? Fortunately, in this case, the 1984 book Super Stocks was reprinted in 2007.? Perhaps that validates my opinion that this is a valuable book.
.) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
