Hi.? I’m back home, and happy, before a one-day turnaround where I leave again.? We were able to get the business of the church done one day ahead of schedule.? While at the meeting, I had no internet… there is something odd about my laptop that blocked them from connecting me, and, they messed up my laptop in trying to connect me, so that I can’t use my dedicated line.? Kinda sad.
One quick rant because when you get a boatload of e-mail at once, things get clearer.? I think someone has created a mailing list for economics/finance bloggers, because I have a number of semi-interesting press releases in my e-mail.? They would be interesting, but there are over a dozen of them, and none of them really fit my profile, aside from a professor asking me to review an academic finance article. (Me?! I’m on the hinterlands of the profession.)? I appreciate truly personal mail, but the faux personal mail, which is really PR, does not get me to move.
One other note: while I was away, since I did not have internet, during free time, I went through my files to cull through research that I downloaded to be read.? By the time I was done, I went through about 200 articles, and added 20 or so to my research files.? I could do a post on what I think is valuable in academic/professional finance research — I’m not sure how much my readers would value it.? That said, going through the research sharpened my views on what I think is valuable in academic research… so, at least I gained something from it.
I should be able to post more tomorrow, beyond that, I have no idea what kind of connectivity I might have.
I will try to post when I am on the road, but I will be gone for the next sixteen days.? I have no clear idea of how much web connectivity I will have during that time, but to the extent that I can post, I will do so.
Alas, but we are poor creatures, muddling along in a confusing market that denies many the ability to earn money.? WHAT HAPPENED TO THE NINETIES, WHEN MAKING MONEY WAS AS EASY AS HITTING THE BROAD SIDE OF A BARN?!? Uh, that was then, this is now.? We’re in a dead spot, a lost decade; old certainties are being tested, and many clever investors (alas for Bill Miller) are being weighed in the scales and found wanting.
This is actually a good time to become an investor, because it is a bad environment.? You develop your skills when expectations are low, and the battle is tough.? But you have to confront the four stages of investment knowledge.
Stage one is being puzzled, and knowing that you don’t know much.? There is extreme caution and risk avoidance, and so much of the market appears to be random.? But with some drive, there is a desire to learn, and that leads to stage two.
A little knowledge is a dangerous thing.? It can come in the form of articles like “Ten Best Stocks to Buy Now!” or “The Simple Formula That Beats the Market, in One Tiny Book.” Whatever.? The initial knowledge is typically a stripped-down version of what has worked in the past, and past results indicate future performance.
Stage Three is the rare point, because it comes after some failure in stage two, because the world wasn’t as simple as the few experts initially read would indicate.? Stage three admits that the prior knowledge was very limited, and that investing is more complex than previously thought.? This is a time of study, and modest experimenting in investing, learning risk control, and understanding oneself.? What am I good at?? Where do I grasp value better than others?
Stage Four is where the survivors prosper in a limited way.? They know that the market is fickle, and have learned that their methods may be good in the long haul, but may underperform in the short run.? They don’t panic, they keep learning, and they persevere in times of fear and greed.? They invest as if it were a business, and are prepared for bad times, and don’t go crazy during good times.
My own methods are geared to Stage Four.? I’ve been through all manner of markets (minus the Great Depression), and know how badly I can be hurt.? I am ready for losses in the short run, if I know gains are likely in the longer term.? I’ve gotten to the point where losses on individual stocks don’t bother me; I just maximize value from where I am now, without letting past losses or gains prejudice me.
Investing is a business.? Spend time studying.?? Some of the book reviews on my site could be valuable in that respect.? Don’t let a few early losses get you down.? Investing is rewarding over the long haul; you can never tell when the game will get easier.? On a personal note, my worst time in investing was June-September 2002.? I lost big, but I did not lose confidence in my management methods, and made it all back and a lot more by the end of 2003.
Another way to say it is, “Be ready for losses.? Don’t let them knock you out of the game, but budget for them.? It is your market tuition.”? Ah, my market tuition.? Would that I could avoid the occasional “refresher course.”
“Comparable Worth” was a faddish idea for economic leftists that flowered (thankfully it was brief) in the 1990s.? The idea was that you could measure occupations on a technical basis, measuring education, effort, responsibility, and other aspects of the job, and figure out what occupations should be compensated similarly.
That’s a pretty difficult problem to solve in the absence of markets.? Granted, there are some Human Resources (what a phrase) consulting firms that have models in narrow contexts to try to solve salary questions inside similar corporations, but the consultants true up their models to the markets regularly, and are covering a more narrow range of jobs.
I want to muse about a different kind of comparable worth this evening, one that many Americans (and others in “developed nations”) might not like.? It is my guess that we are seeing the slow erosion of wage differentials across developing and developed countries, particularly for goods and services that are part of global trade.
Now, I am not saying that an unskilled auto worker in China will earn as much as a non-union auto worker in the US, which is backed by more capital investment, and requires a smarter worker.? I am also not saying that unionized workers in developed countries won’t earn more.? The viability of the firms their unions serve may be compromised, though.? What I am saying is that global corporations can choose where they produce goods, and on a productivity- and quality-adjusted basis they will use laborers that give them the best deal.
As for jobs that are internal to an economy, such as working at a retail store, the adjustment will be slower.? Internal job wage differentials across countries depend on the overall wage differentials across countries.? As overall wage differentials narrow, so would internal job wage differentials.
Also, given how many commodities are priced globally, and those have become a more important part of the cost structure recently (though the effect is not that bad if one takes a long-term view… increased productivity means we use less commodities to achieve the same ends as 40 years ago), the factor share going to labor in developed countries is probably being squeezed a little.? So, what does this imply for workers in the US and the developed world?
As the rest of the world develops, their living standards will slowly converge with those in the US.? They will demand a greater share of the world’s resources in the process, making the affluent life more expensive.? This will in turn drive more technological innovation to make commodities stretch further.
Now, perhaps some will say that the solution is to cut off or limit free trade.? That won’t work.? The US is so dependent on free-ish trade that any significant reduction of trade would drive inflation up in the US.? Beyond that, the US benefits from its reserve currency status.? Where else does a country get goods and services, and hand over bonds denominated in their own currency?? What a sweet deal for the present — an inflationary pity when it ends.
I started out my career with a goal of being a development economist, and doing work in the Third World.? That ended when I learned that the models used by the development economists did not work, and that capitalism and free trade did work.? When the developing world began to make great strides after the end of the Cold War, I was happy.? I’m still happy about it today; poverty is slowly but steadily being eliminated across a wide swath of the globe, and that is a good thing for most.? But to many Americans (and others in develop nations) who are finding themselves out-competed by foreign competition, this is not a happy time.
Be aware of the global competitive position of your industry, and adjust your career accordingly.? Build up your own ability to deliver special (hard to duplicate) value for your employer and work where your personal competitive advantage is maximized.? That’s not easy, but the easy path probably embeds a future that is less well off.
Selling 70% of my National Atlantic stake freed up cash, and I deployed half of that today in a variety of rebalancing trades.? Today I bought some Jones Apparel, Valero Energy, Hartford Financial Services, and OfficeMax.? I sold some RGA to buy some MetLife, in order to get cheaper RGA.
Today’s actions brought cash in the portfolio from 14% to 11%.? It’s a good time to be adding to positions in a modest way.? If the market declines further, I will continue to slowly reduce cash and add to positions.? One nice thing about the rebalancing discipline is that I don’t time the market, but it often seems like the rebalancing discipline forces buying low and selling high, in ways that most investors would not want to emulate, because I am constantly leaning against the wind.
Starting on Monday, I’m going to be on the road until July 8th.? My ability to blog and follow the markets will possibly be impaired, because I will be busy the first week with the annual meeting (Synod) of my denomination, and the next week, with my parents’ 50th wedding anniversary.? I will be in rural Western Pennsylvania and Northern Wisconsin, respectively.? The first is a lot of work; the second, a lot of fun.? In both cases, Internet access may be spotty.
I’ll leave a few standing orders out to take advantage of further declines in the market, especially if the NAHC deal fails on Monday.? Beyond that, I will start in on the next portfolio reshaping when I return.? For those that want an early preview, here are my current industry ranks.? It’s been a good year so far, but who can tell, the market can spin on a dime, and once again find a new way to make fools out of us all.
Full disclosure: long NAHC JNY VLO HIG OMX MET RGA
We’re not quite to the endgame yet, but the jig is up for MBIA and Ambac, after the downgrades from Moody’s at the holding companies to Baa2 and A3 respectively.? Wait, why I am I mentioning the holding companies?? Isn’t it the operating subsidiaries that matter?
Well, yes, for sales and regulatory purposes, but the ratings at the holding companies matter for a different reason — notching.? But let me tell a story first.
Failure improves markets by introducing risk-based pricing.? In the late 80s and very early 90s, virtually all of the life insurance industry was rated AAA/Aaa, or A+ from A.M. Best.? Taking advantage of the good opinion that the raters had of the industry, many life insurance companies issued Guaranteed Investment Contracts [GICs] to institutions for their Defined Benefit and Defined Contribution pension plans.? The insurance companies levered up issued AAA liabilities, and invested the proceeds in lower rated bonds, commercial mortgages, limited partnerships, and other things yet more risky.? (These were the days prior to risk-based capital.)
After a few failures hit — Pacific Standard (who?), Executive Life, Mutual Benefit, Fidelity Mutual, Confederation, and the near miss on the Equitable (what a story — I was on AIG’s failed takeover attempt team), the rating agencies went into full scale defense mode, downgrading every company in sight.? It was everything a company could do to retain its ratings — and there were almost no ratings upgrades until 1996 or so.
The rating agencies are ratchets. (or, do I mean rackets? 😉 )? Downgrades come easily, upgrades come hard, and almost no corporate credit ever gets upgraded to AAA.? But, in this case, the downgrades have come for this industry in the way that I predicted earlier this year:
When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).
Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)
Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.
Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Position: none
Once your insurance operating subsidiary is downgraded below AAA/Aaa, there are many classes of business that cannot be written anymore.? Revenue dries up.? What’s worse, is that the rating agencies no longer have any practical reason to not downgrade further; the revenue model is broken for the rating agencies, and if there are highly rated new entrants, there is no reason to care about the company; the industry will survive, and the rating agencies will get fees.
Now, supposedly, New York doesn’t want to take the operating subsidiaries into conservation because it would trigger acceleration clauses in the CDS.? If those contracts were written at the operating companies, the insurance commissioner has the power to nullify any seniority those contracts possess — you can’t favor one insurance claimant over another.
Oh, notching — once a holding company is rated lower than Aa3/AA-, there is no way to get a subsidiary to have a Aaa/AAA rating.? The rating agencies will not allow it to happen.
So, I don’t see good things ahead for the guarantors.? Two final notes: Ambac tells Fitch to take a hike.? Fitch won’t do it.? Expect a downgrade soon.? Triad goes into runoff; my old colleague John must be smiling… he always thought they wrote the worst business.
I read this article today, and it made me want to write on the topic.? This is a concept that I learned early in my investment career.? It is worth understanding, so that you can do better in investing.? Inflation is negative for stocks, but it is a small negative — for every 1% that the inflation rate goes up, stocks decline 2% on average.
That’s not very big.? So why do stock investors panic over inflation?? They panic because the Fed might respond to inflation, and raise real (inflation-adjusted) interest rates enough to quell inflation.? Rises in real interest rates are far more negative to the market — a 1% rise in real rates hurts the equity market by 10%.? Why such a big impact?
The impact is large, because when real interest rates are high, capital is scarce.? Go back to my “Fed Model” article which is very different from other “Fed Models.”? High corporate bond rates raise interest costs for corporations, reducing profits, and raising discount rates (cost of equity capital).
At present, real interst rates are negative — in nominal dollar terms, this is not a bad time to own stocks.? Think of the dividend discount model for a moment.? Inflation runs through earnings and the discount rate, so the effect is muted.? Real rates run through the discount rate only — poison.
Is there any hope in an era where inflation is rising, and where real rates may rise?? Value investing always offers some hope, but that’s not my main point here.? Inflation manifests itself differently in different eras.? Look for the areas that are in short supply.? They will be the areas where corporations will have pricing power.? Those areas will outperform the market, even if the market as a whole declines.? At present, I am looking at energy stocks, food stocks, and others.
Inflation is bad for the market, but don’t let that stand in the way of looking for what might offer relative profit in this environment.
I’m waiting for the day when I can write upbeat stuff about housing…? when I can buy homebuilder and mortgage stocks and crow about my gains.? I hope I live two more years. ;)? (Many thanks to Calculated Risk for their excellent coverage of residential housing.)
2) Now, housing prices are likely to fall another 10-15%, which is what I have been saying for a while.? That will lead to more situations where there is negative equity, and more defaults, as they happen with negative equity and negative life events.
5) Labor mobility is limited when housing prices fall.? Pretty normal, if infrequent, in my opinion.? I faced this back in 1989; employers offered limited housing perks to new hires.? In three years, this will be gone.
6) Now, it should be no surprise for lending standards to tighten now.? We always shut the barn doors after the cows are in the fields.
9) It should not surprise us that housing starts are low in an environment like this.? The bigger the boom, the bigger the bust.
10) I am not generally a Tom Brown fan.? He is too perma-bullish for my tastes.? He may have a correct technical point on subprime losses, but it may misrepresent losses for the financial sector as a whole.? Subprime is small.? Alt-A and Prime are much bigger, and losses are growing there.
I’m generally against debt.? I’ve been debt-free for the past five years.? It allows me to take prudent risks with my investments.? So, when I read things like this in The Economist’s Free Exchange Blog, I shake my head.? Here’s the main quotation:
My friends who study humanities are shocked and do not believe me when I, a pension economist, tell them they should not be saving. Prudent advice has become: You should always save some fraction of your income. You should save not only for retirement, but also for adverse income shocks. But, Mr Becker points out, these new lines of credit help workers cope with income shocks.
The pension economist is wrong, mainly.? So is Dr. Becker.? It is reasonable to take on debt to gain an education for a career that is lucrative; it is not reasonable for something that does not pay well.? Following your heart into a career is a good thing, but if the field doesn’t pay well, don’t saddle yourself with debt to get there.? I know too many young people with large debts in their 20s with no reasonable way to pay them off.? They may be in the field that they love, but they are miserable due to the debt.
It is also reasonable to take on debt for an asset that will appreciate over time at a rate greater than the financing rate on the debt.? Note that I did not say housing here, though that is normally the case.
I counsel all of my kids, and all of my friends to avoid debt where it does not pay, particularly for consumption.? Pay off your credit cards in full each month.? If you can’t do that, cut up your credit cards, and learn to make do without them.
The advantage in life always comes to the man who has surplus, who receives a discount for paying upfront, rather than over time.? You should live below your means, and build up a buffer against the future.? Theoreticians like Dr. Becker essentially say, “Don’t worry, they’ll loan you the money.”? Ridiculous.? First, if they do loan, it is at horrendous rates.? Second, during a credit crunch, all cheap sources of financing disappear for all but the most creditworthy borrowers.? Credit disappears when you need it most.
Saving at young ages sets the tone for the rest of life.? The lifecycle saving hypothesis (of Milton Friedman) is wrong, because most people don’t possess the discipline to switch between being a borrower to being a saver.? Many do it, but not the majority. I saved money when I was a grad student, though most of my colleagues did not.
My advice to you is to develop careful spending habits, particularly if you are young.? What you do now will affect your ability to save for the rest of your life.? Borrow for things that have large long-term payoffs.? Delay purchases for short-term gratification.
The last several days have been interesting to me regarding National Atlantic. It started with a discussion with another person who worked for my former employer (no, not the same one as last time). It went something like this:
Friend: Did you see the filing by our old boss?
DM: Yes, but unless he files suit alleging fraud, it is unlikely to amount to much.
F: Good point. What do you think the odds are of the deal going through?
DM: The deal is more likely to go through than not, but if the deal does fail, the stock will fall to $4, and if the deal succeeds it will go to $6.25. The payoff is asymmetric. I think the odds are 65% that the deal goes through.
F: So why are you holding on if the odds are that poor relative to the rewards?
DM: Uh…
So, on Thursday of last week and yesterday, I sold away 70% of my position after voting “no” on the deal. My thoughts: it is quite possible that the deal will get voted down. Sure, it isn’t in the short term interest of stock holders to see the deal fail, but National Atlantic has so annoyed shareholders that many will vote against their short term interests because of the egregiousness of the deal.
As an aside, NAHC is the sort of stock that if you are not careful, a large order can disrupt the market; I ended up using discretionary reserve orders routing through Arca [NYSE Archipelago], which allowed me to show 100 shares with much more behind that, and have discretion to lift bids within a penny of the stated offer. I was able to sell a lot without disturbing the market.
If the deal does get voted down, I will buy back in, at much lower prices. If it succeeds, I will take the small gain and move on.
