Year: 2008

Financial Dominoes

Financial Dominoes

Posted on by David Merkel

Capital structure is relevant.? Promises are significant.? Contracts are definitive.

This will be short (it better be, I’m tired and want to sleep), but I have no end of friends asking me how bad it is out there.? First I tell them my opinion is a minority opinion.? Second, I tell them that debt-laden economies are inherently inflexible.? Third, I tell them that when the banks are compromised, ordinary monetary policy is useless, because there is no way to make a bank that is worried about its solvency lend more.? Fourth, even extraordinary monetary policy may not work, as the Fed tries to target lending markets, and finds that they can absorb bad assets, but can’t readily recycle them.

The aggregate capital structure of the economy is not a matter of indifference.? If there are many debt claims, and firms with debt finance other firms via debt, who finance other firms via debt, etc., then we set up a bunch of financial dominoes, where a disturbance can knock one down and carry others with it.

This is why the total debt to GDP ratio matters so much.? Economies stop functioning when they have high levels of embedded debt and a slowdown hits.? That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression.? Until we get that ratio down from 350% down to 150%, normalcy will not return.? Air is leaking out of the debt bubble, and the ability to reflate is not there, because the market value of the assets have sagged to such a level that even a zero Fed funds rate will not raise the market value to the levels where the assets are booked.

People are not reliable; they sin; they default.? Economic systems that are primarily equity financed are better able to deal with the nature of man, because they have more flexibility.? Economic systems that are more heavily debt financed face more problems when someone cannot live up to his promises, because it means that others relying on the performance may not be able to live up to their promises also.

Things are different now.? In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate.? But now, because of too many fixed committments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.

Thus the task of levering up falls to the Federal government.? But will they be able to honor all the promises that they have made?? Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms.

Sell Stocks, Buy Corporate Bonds

Sell Stocks, Buy Corporate Bonds

Posted on by David Merkel

I have lots of models, but I am only one person, so some of my models sit idle becuase I don’t have time to update them.? Well, today, as I was reading Barron’s, I ran across the “Current Yield” column, and read this:

THE STOCK MARKET IS PRICED FOR a recession, but the bond market is priced for a depression. So says Rob Arnott, the brainiac who heads Research Affiliates, an institutional advisory.

That’s not hyperbole. Corporate bonds rated Baa or triple-B, the low end of investment grade by Moody’s and Standard & Poor’s designations, offer the biggest yield premium since the early 1930s, notes RBC Capital Markets.

That’s a problem for pulling the economy out of the credit crisis, but an opportunity for investors. Indeed, investment-grade corporates with near-record premiums arguably offer better return potential than common stocks, especially relative to their risks. “I haven’t seen this many markets offering double-digit opportunities since 1989-90 or ever so briefly in 2002,” says Arnott.

Part of it reflects the sheer weight of numbers. Corporates rated Baa yield about 550 basis points (5.5 percentage points) more than comparable Treasuries, nearly half again the spread in the 2002 post-WorldCom-Enron debacle and twice the average of post-war recessions.

You have to go back to the early 1930s, when Baa corporates yielded 700 basis points over Treasuries, to find a comparable situation. And notwithstanding all the hyperventilation in the media that this is worst financial crisis since the Great Depression, there’s never been such a full-court response to the threat of debt deflation — the $700 billion TARP, the bailout of Fannie Mae and Freddie Mac, the likelihood of trillion-dollar deficits and a doubling in the Federal Reserve’s balance sheet in just over two months.

I know things are bad in the corporate bond market, but I didn’t think it was that bad.? This made me ask, “Hmm… what about my stocks versus bonds model?”? That article is one of my better ones; a lot of time and effort got poured into that.? So, I sat down and re-engineered the model, since, embarrassingly, the original model was lost.

The key question is whether the yield on BBB corporates is more than 3.9% higher than the earnings yield on the S&P 500.? The answer is yes, and that means we should sell stocks and buy corporate bonds.? But, here is the embarrassing thing for me.? The first recent signal to sell stocks and buy bonds came in mid-August, but since I didn’t track the model regularly, I missed that.? Since the original model worked off monthly data, even selling in early September would have preserved a lot of value.? It is not as if corporate bonds have done well since August, but they have done much better than the S&P 500.

Here’s a graph summarizing 2008 via my model:

When the green line goes over 3.9%, it is time to buy corporate bonds. That is not a frequent occurrence; this model gives of signals only a few times per decade. Check out my original piece for more details.

So, with that, I offer my conclusions:

  • It is still time to allocate money to corporate bonds versus equities.? Where I have flexibility with my own money, I am allocating money away from Equity and to BBB investment grade and high yield corporates.
  • Though there are a lot of reasons to worry, corporate yield spreads discount a lot of trouble.
  • The model indicates a fair value of the S&P 500 at around 700.? Uh, I’m not predicting that, but if we hang around at yield levels like this for long, yes, the equity market will adjust to the competition.? More likely is the equity market treads water while corporates rally.
  • A caveat I toss out is that all areas of the credit markets where the government is not meddling are disproportionately hurt, because investors are fleeing toward guaranteed areas.? Thus, corporates are hurting.
  • College endowments and other investors that hate to buy conventional assets should consider corporates now.? It is my bet that a portfolio of low investment grade and junk grade corporates will outperform a 60/40 portfolio of Stocks and T-Notes.
  • If you have the freedom to sell protection on a broad basket of corporates, this might be a good time to do it, when everyone else is scared to death.? Time to insure corporate credit, perhaps.
  • One more caveat before I am done.? The rule has only been tested on data since 1953.? It is not depression-proof.??? I hope to gather the data from that era and validate the formula, but that will be difficult.

So, be careful out there, and remember that corporate bonds typically do better than stocks in a prolonged bear market for credit.? Yield levels like the present typically bode well for corporate bonds versus stocks.

Bring Out Yer Dead! (thud)

Bring Out Yer Dead! (thud)

Posted on by David Merkel

I’ve been beating the avoid the US automakers drum for six years now.? When I was a corporate bond manager, one of the first things that I did was sell 90% of my Ford and GM bonds that I inherited from the prior manager.? When I began writing for RealMoney, I wrote pieces like this:

David Merkel
Open Letter to General Motors’ CFO
By David Merkel
RealMoney.com Contributor

12/9/2004 11:11 AM EST
URL: http://www.thestreet.com/p/rmoney/davidmerkel/10198313.html

General Motors (GM:NYSE) BEARISH
Price:?$38.14??|??52-Week Range:?$36.90-$55.55

  • GM should refinance at least half its 2005 and 2006 maturities while rates remain low.
  • The company’s future is threatened by any increase in bond yields.

    		•
    Position: None

    Sir: Though I am not as bearish as my friend Peter Eavis on the prospects for your company, I do want to give you some friendly, if unsolicited, advice: Refinance at least half of your 2005 and 2006 maturities while rates remain low.

    With over $50 billion of principal coming due in the next two years, the future of GM (GM:NYSE) is threatened by any increase in bond yields. With the likely weakness in the dollar, yields on Treasury obligations are unlikely to remain this low, in my opinion. Further, though spreads for GM and GMAC are not at historically tight levels, spreads in the corporate bond market are at levels not seen since 1997. Take advantage of the demand (both domestic and international) for yieldy paper while you can. For that matter, do another convert deal. It may put a ceiling over your stock price (but, hey, isn’t there one there now?), but the convertible arbs will give you cheap financing while you figure out how to make your auto operations profitable (and design cars that people crave).

    Though your ratings are stable from Moody’s and Standard & Poor’s at present, who can tell how long that will last? GM and GMAC debt are only one notch above junk at S&P, and I can tell you that you will have a hard time selling debt if you ever do get downgraded by S&P. Even if Moody’s leaves you an investment-grade rating, I will tell you that there is not enough buying capacity in the bond market for crossover credits of your size. Your yields would have to rise to the point where equity investors find your bonds an interesting speculation, as was true of auto bonds in mid-2002.

    Further, do you want to be subject to the vicissitudes of your cousin Ford (F:NYSE) ? If they catch cold, you may too, at least in the eyes of the ratings agencies. But I digress.

    It is always better to seek financing when it is offered, rather than when you need it. Your spreads are not going to get materially tighter, in my opinion, absent a partial refinancing that gives the bond market more confidence in how you will meet your short-term obligations.

    I wish you nothing but the best, if for no other reason than as a U.S. taxpayer, I don’t want to bail GM or Ford out.

    Sincerely,

    David J. Merkel

    P.S. To the CFO of Ford: This goes for you as well. The numbers differ, your spreads are currently tighter than those of GM, but you lack one thing that GM has. GM could sell the non-auto financing assets of GMAC in a pinch, which is presently a very valuable franchise that you don’t possess. Refinance while the bond market is friendly.

    I also wrote pieces like this:


    		 David Merkel
    GM on “Death Ground”
    11/17/2005 5:15 PM EST

    The last time I used the phrase “death ground” it was with respect to Fannie Mae. It engendered some confusion then so let me explain the term. “Death Ground” is a term from Sun Tzu’s The Art of War. It is when a General faces a situation where an army unit is in nearly hopeless shape, and the General manuevers the unit into a place where flight is impossible, so that the unit will fight to the death, because they have nothing to lose. Soldiers that motivated sometimes win; it is a last-ditch strategy.

    That describes GM today. The CEO announced that in a letter posted on the Financial Times website, “I’d like to just set the record straight here and now: there is absolutely no plan, strategy or intention for GM to file for bankruptcy” GM faces a host of issues, revolving around legacy liabilities, poor design, poor marketing (reliance on sales, rather than everyday low pricing), high production costs, low flexibility, and high debt. Almost everything has to go right for GM to survive against much stronger competition; to me, that’s death ground.

    That’s not an exhaustive list. Add into that the possible sale of GMAC, which is the crown jewel of GM, and you can sense the desperation. This is not a company to be playing around with on the long side; truth is, the world doesn’t need GM when it has Toyota. Maybe the US government will bail out GM the way they did Chrysler, but I really wouldn’t expect that.

    Long GM debt was trading in the mid-60s this morning for a 12%-ish yield. It improved after the CEO’s statements this afternoon; the longs got a gift. I would take the opportunity to lighten up on long positions in GM stock, and any bonds dated past 2010. Take the $10-15 buck haircut off par, lest you have to settle for a recovery in the $30s five years out. (The 2036 7.75% zero-to-fulls are trading in the low $20s. Assuming an interest rate of about 7-9%, and a default 5 years out, that discounts a recovery in the mid-$30s.)

    Position: short FNM, long TM

    And this:

    GM: Less Has Changed Than Meets the Eye, by David Merkel

    6/30/2006 8:24 AM EDT

    The story of GM over the past few decades has been to sell off desirable assets to fund the core auto operations, close factories and reduce jobs in North America. Its recent round of adjustments is only different because of the desperateness of the situation. Even with the labor concessions being discussed, GM’s cost structure will remain higher than most of its competition.

    Consider the ratings agencies that are “inside the wall” and possess more information than other market participants. Even after the changes made, GM’s debt is rated Caa1 (negative outlook) by Moody’s and B (negative watch) by S&P. The ratings on GM’s debt reflect a highly speculative company with an uncertain future. The debt of GM, though the price is up from its lows still reflects significant uncertainty of full payment. Long debt trades in the mid-$70s.

    We still don’t know whether the Pension Benefit Guaranty Corporation will go for the sale of 51% of GMAC. GM has only made a dent in the total liabilities that it faces in pension and health care (active and retiree). Does the PBGC want to lose a claim on one of the more valuable aspects of the firm should it go under?

    Finally, sales have been disappointing, and discounting must be resorted to in order to “move the metal.” GM’s offerings have improved of late, but that might only be enough to get someone to buy a GM instead of a Ford. The improvements at GM don’t place the company on the same footing as Toyota or Honda from either a cost or marketability basis.

    GM may be able to eke out a small GAAP operating profit in the short run from the changes made. It is still in a lousy competitive position against firms with stronger balance sheets and lower cost structures. My estimate of the long-run outcome has not changed. Avoid the stock and unsecured debt of GM.

    P.S. At least GM is showing a little vigor relative to Ford (F:NYSE) , but that’s not saying much. Ford’s situation, if judged by the asset markets (stock, bond and credit-default swaps), has worsened relative to GM. Credit-default swaps now show Ford as more likely to default over the next five years than GM. What a mess.

    At the time of publication, Merkel and/or his fund was short GM and Ford, though positions may change at any time.

    FInally there is this piece four months ago, where I said: As I have said many times before GM common is an eventual zero.? Same for Ford.? All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.

    Why throw good money after bad?? Why reward exceedingly lousy managers, and unions that have sucked the carcasses of the auto companies dry? Throw in $25 billion.? It won’t be enough.? Toyota and Honda are so much better managed, that they will win anyway.

    In 2002, we let 20+ steel companies die.? The valuable assets were bought up, union contracts were torn up, and the industry regained sanity.? The industry is in much better shape today, and able to compete against the rest of the world.

    We should do the same with the autos.? Let GM, Ford and Chrysler die.? Let Toyota, Honda, Daimler, Renault, Hyundai, Magna, Kirk Kerkorian (dreamer), etc., bid for the assets in bankruptcy.? Many jobs will be retained, though at fairer levels of compensation.? Remember my piece Rethinking Comparable Worth?? We are facing international comparable worth issues in labor in the auto sector now.

    Before there were the possibilities with government bailouts, GM and Ford said they had more than enough cash.? But when the carrot of cheap financing is in front of them, they tell their tales of woe.? Examples from the media:

    I could add to the examples in other sectors — MBIA and Ambac seem to be? headed to zero as well.? Another set of examples of too much debt and too little transparency.

    But to close on the automakers, I highlight the well-written article at the Curious Capitalist.? The companies are not as critical as their assets, which will be bought by others, and many of the jobs will be retained.? Any bailout will throw good money after bad, and will not preserve the auto industry here in the long run.

    Full disclosure: long HMC MGA

    What Do You Have To Hide?

    What Do You Have To Hide?

    Posted on by David Merkel

    Bloomberg sues the Fed for refusing to disclose what sort of collateral they are lending against.? I come at this from having worked in insurance for two decades.? Insurers have to disclose every asset that they own in their Statutory filings.? When I looked at a bank’s call report recently, I was surprised to see only summary data available.? The insurance industry has high disclosure, and it hasn’t hurt them.? Why should the Fed cower, and refuse to reveal what they are lending against?? Five possibilities, and none of them good:

    • The Fed is breaking its own rules, and lending on collateral that it publicly said that it wouldn’t lend against.
    • They are playing favorites with institutions, and don’t want that to be revealed.
    • The assets in question are technically in compliance with the rules of the Fed, but are worth far less than the amount loaned against them.
    • Certain banks would be embarrassed by revealing what they own.
    • It’s just a power game, and the Fed thinks it is above the law, particularly during a crisis (that it helped to cause).

    For another example, I would be happy to see who they are lending to in their CPFF program.? Are they lending a lot to AIG through CP?? Anyone else notice that AIG is A-/A3 from S&P and Moody’s which would make them A-2/P-2, and ineligible for the Fed to lend to, but S&P and Moody’s still have them at A-1/P-1.? Weird.

    In my opinion, there is no good reason why the Fed can’t disclose the collateral, and the institutions involved.? They assure us that they are being upright and prudent; let them prove it.

    We Have a Debt to Discharge

    We Have a Debt to Discharge

    Posted on by David Merkel

    There is a common error with contrarian investing.? It is not a question of identifying things that people believe that are wrong, but finding things that people rely on that are wrong.? Reliance is the critical component.? I don’t care about what people think if they don’t have any skin in the game.? When someone relies on a certain result happening (or not happening), then there will be series of behaviors that happen as what he believes in fails, from intensifying the bet in the early phases, to throwing in the towel in disgust at the end.

    I’m going to take this idea and twist it a different way tonight.? One thing that the Democrats and Republicans (except Ron Paul) agree and rely on is that they know how to avoid a repeat of the Great Depression.? The textbook answer is:

    • Easy Money
    • Fiscal Stimulus
    • Don’t Raise Trade Barriers

    Ben Bernanke learned this as a young college student, and built it up in his Ph. D. dissertation.? He has the same moral certainty about this that George Bush, Jr. does about fighting terrorism.? And, I’m going suggest that Bernanke, and most of the political establishment (which hasn’t really changed in the last few days) are wrong.

    What is a bubble?? My definition: a bubble is a self-reinforcing cycle where monies invested obtain a negative return in aggregate over the long haul.? It is characterized by significant borrowing at low rates to invest in already appreciated assets in order to profit from a momentum-driven market.? When cash flow is insufficient to pay the interest to finance the bubble, the bubble pops, and a self-reinforcing bear market ensues.? When that bear market encompasses most of the financial system, we call it a depression.

    What is a depression?? A severe recession where the banks are impaired.? In an ordinary recession, lowering the Fed funds rate can stimulate the banks to lend.? Not so now; the banks are licking their wounds, and letting profits grow by financing at lower rates, and sucking in bailout cash to shore up their balance sheets against future real estate lending losses.

    The Great Depression ended when the Debt to GDP ratio dropped below 150%.? When enough debts were extinguished by payoff or default, the system could once again be normal.? Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts.? And now we do the same thing.? We perpetuate the misallocation of resources by trying to keep house prices high, by bailing out institutions that should go through the bankruptcy process.? This fails to convert bad debts into equity in newly solvent businesses.

    All the US government is doing is creating a bigger bubble.? What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic.? We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them.? I don’t like that bet.? Many empires have died choking on debt.? Is the US to be next?

    When I wrote articles opposing the bailout, I did so because I did not think it would work, and that one-off conservations/liquidations would be preferable, but not optimal.? Optimal to me would be using the bankruptcy code on a expedited basis, wiping out junior capital, and making senior capital take haircuts.

    But in the present, we contemplate borrowing to bail out all manner of problems — bail out homeowners, automakers, banks, insurers, guarantors, etc.? The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad.? I have no idea when that time will come, but the dreamy schemes of politicians aiming to solve every financial hurt will help to force such a time to happen.

    How Stocks Work, Sort of

    How Stocks Work, Sort of

    Posted on by David Merkel

    I enjoyed the pieces by Felix Salmon and James Surowiecki, and Eddy Elfenbein on how stocks work.? I have reproduced their arguments here, together with my thoughts.

    Felix Salmon: What’s the relationship, in theory, between a company’s return on equity, on the one hand, and its stock price, on the other? Does a high return on equity mean a rising stock price, or is it a rising return on equity which means a rising stock price? Or, to put it another way: if one company has an ROE which is (expected to be) flat at 4%, and another company has an ROE which is (expected to be) flat at 14%, would you expect the latter to rise more than the former, or indeed either of them to rise at all?

    Jim Surowiecki: Your first question, unfortunately, can’t really be answered in the abstract. It’s perfectly possible for a business with high returns on capital to still be overvalued – that is, for its stock price to overestimate the cash flows it will generate over time. In that case, the fact that a company is generating high returns on capital won’t translate into an increase in its stock price. Microsoft’s average return on invested capital, for instance, is consistently good – above 25% — but its stock is just about where it was a decade ago.

    This speaks to your second question, which is really about expectations. If the market is accurately forecasting the returns on capital of the low-ROIC company and the high-ROIC company, you wouldn’t expect the latter’s stock price to dramatically outperform the former. But assuming both are fairly valued, the high-ROIC company will have a much higher valuation, meaning it will generate more income for shareholders going forward (in the form of dividends, buybacks, etc.)

    That’s why, all things being equal, you want to own shares of companies that generate high returns on capital rather than those of companies that don’t. This is, in a way, self-evident. If you put money into a company, you want it to use that money to generate high returns, higher than you could get elsewhere. That’s what companies that have high returns on capital do: Microsoft earns an additional twenty-five cents for every dollar it invests. By contrast, companies with low returns on capital create less value, and companies that earn returns that are lower than their cost of capital (as was true of Japanese companies between 1990 and the early part of this century) actually destroy value for their shareholders.

    Eddy Elfenbein: A company?s share price is the net present value of all future cash flows. A company?s return-on-equity is a measure of profits for the next year relative to present equity, so the two are connected. However, a high ROE does not translate to a rising share price, but a rising ROE should. Regarding your question, I would assume that the market has discounted both stocks? net present value which incorporates ROE. Therefore, I would only expect the stocks to rise at the pace of the risk-free rate plus the equity risk premium.

    This may help: ROE can be broken down into three parts; profit margin, asset turnover and leverage. It goes like this:

    Profit margin is earnings divided by sales. Asset turnover is sales divided by assets. Leverage is assets divided by equity.

    Earnings……….Sales…………..Assets
    —————X—————-X————–
    Sales…………….Assets………..Equity

    Note that the sales and assets cancel each other out to give you Earnings divided by Equity.

    David Merkel: The question can be answered in the abstract, with some noise.? With a few assumptions/limitations as disclosed in this article, Quantitative Analysis is not Trivial ? The Case of PB-ROE.? In most mature industries where capital constrains growth, there is a linear relationship between price-to-book and and ROE.??? This is a result of the dividend discount model, given the assumptions of the article that I cited.

    There is the inherent assumption that net worth is the limiting factor in doing new business.? If that is not the case, then the model does not work.? If sales is the limiting factors the equation becomes price-to-sales as a function of profit margins.

    FS: What’s the relationship between stock price, ROE, and risk-free rate of return? Would one expect ROEs in a country with a zero risk-free rate to be lower than ROEs in a country with a higher risk-free rate? How does that feed in to stock prices, if at all?

    JS: You would expect returns on invested capital to be lower in countries with lower risk-free rates (like Japan). Two reasons suggest themselves for this: first, the low risk-free rate may be indicative of lower growth prospects for the economy as a whole. But also, when the risk-free rate is low, the hurdle rate for corporate investments is also lower (because investors’ expectations of what counts as a reasonable return are also lower.) That may make companies more likely to invest in low-return projects. Both factors have something to do with why Japanese firms have underperformed over the last twenty years (and in particular in that 1990-2002 stretch). But I think the most important factors explaining the low ROIC of Japanese firms were their indifference to shareholder value and their willingness to invest in value-destroying projects.

    EE: Again, a company?s share price is the net present value of all future cash flows. ROE is the best measure of the growth of future cash flows. How do we discount that? We discount it by the cost of capital which is risk-free rate plus an equity-risk premium. That?s why a lower risk-free rate tends to boost equity prices.

    According to the Gordon Model, it should look something like this:

    Price = Earnings/(Risk Free Rate + Equity Risk Premium – ROE)

    DM: The risk free rate often has little to do with where corporations can source funds.? Eddy talks about the equity risk premium, but that varies over time.? At present that risk premium is high.? If the country in question is in a liquidity trap, like Japan, equity risk premiums are high.? In general, equity risk premiums are a free market, and disconnected from the “risk free rate” represented by short government bonds

    FS: How can a company with a positive ROE destroy economic value for shareholders?

    JS: The key to understanding how a company with a positive ROE can nonetheless destroy economic value is simply recognizing that equity is not free. It has a cost, just like debt does, a cost that reflects the return that investors demand as compensation for the risks and opportunity costs that owning equities entail. We can debate how to calculate that cost of equity (risk-free rate + market risk premium is a simple solution). But the basic principle is, as I said above, that a company is only creating economic value for its shareholders if it’s earning more than its cost of capital. Again, this is intuitive: if you were the part owner of a company that, on a risk-adjusted basis, was earning less than the yield you could get on a 30-year T-bill, you probably wouldn’t keep your money in that company, because you would effectively be losing money with every day that passed. Shareholders feel the same way, so the share prices of companies that earn less than their cost of capital are unlikely to rise over time. According to a study by the Japanese government, Japanese companies’ return on capital was below their cost of capital for roughly the entire decade of the 1990s through 2002. If you want to know why Japanese stock prices fell precipitously during that period, that’s the biggest reason why: the companies weren’t creating any value for shareholders. And what made it worse was that, as a result of the bubble, expectations were already inordinately high.

    One thing I should say, though: Japanese companies have significantly improved their performance in the past five years, and there’s a strong case to be made that, as in the U.S., the recent sell-off of the Nikkei has been massively overdone. In fact, if you think that the transformation of Japanese firms in recent years will be long-lasting (I’m agnostic on the question), then the Nikkei looks very undervalued right now – or at least it did before it rose something like 15% in the last week and a half.

    EE: All companies in all industries are in phantom competition with the cost of equity capital. Even though you can?t see it, you?re struggling against it every day. So even if a company manages to squeak out positive ROE, capital will not flow your way if you keep losing to everybody else.

    DM: No disagreement here.? Companies must earn more than their cost of capital in order to add value.? This helps explain why low positive ROEs trade at a discount to book value.

    =-=-=–==-=-=-=-=-=-=-=-=-=-

    That’s all, and spite of all the discussion here, I own shares of? Honda Motors and the SPDR Russell/Nomura Small Cap Japan ETF,

    Full disclosure: long JSC HMC

    Conducting Reverse Auctions for the US Treasury

    Conducting Reverse Auctions for the US Treasury

    Posted on by David Merkel

    I regularly read “A Dash of Insight,” and greatly appreciate the commentary of Dr. Jeff Miller.? What I write here is an effort to encourage what he wrote in this piece advising President-Elect Obama.? (I would have my own advice for the President, but there are so many vying for his ear now, that I sigh and say “Let the poor man get on with it.? He will be imprisoned for the next four years, and likely find less capability of doing what he wants than he imagined.”)

    How would one implement what Dr. Jeff suggests?? As a bond manager, I was pretty good at price discovery.? I would convene a committee of large holders of the illiquid instruments and ask them what are the largest classes of homogeneous structured securities that no longer have markets now.? Once they agree on the classes (probably the AAA portions of the senior-sub structured ABS, RMBS and CMBS deals), the agent for the Treasury picks a subset of the largest deals, and announces how much of each security (say 10% of each tranche) they will offer to buy.

    Market participants are then invited to submit binding offers to sell any amount of the securities up to the maximum.? The Treasury’s agent could require a minimum amount of bids in order for an auction to be valid (say 2-3x the purchase amount).

    One tweak I would put in would be to award the bonds to the winning bidders at the price offered by the bidder with the highest bid not receiving bonds.? I used this successfully for years in bond auctions, and though it makes the trader shake his head initially, when I would say, “I’m offering protection against regret in advance, besides, I want aggressive bids.” they would say, “Okay, I get it.”

    After the auctions, there would be benchmark prices, yields, and spreads for a wide number of securities, and then the modelers would apply those prices to the mezzanine and maybe the subordinate tranches, which are too small to hold auctions for.

    Similar securities might find trading levels as well, but if not, the Treasury could run another set of auctions, and repeat as necessary.? Given the most of the securities auctioned are AAA, at worst, the Fed might have an interest in the short-to-intermediate AAA paper.

    If the Treasury followed a procedure like this, it could unjam the securitized fixed income markets, and do so at prices where the taxpayer bears modest losses at best.? I am not as optimistic as Bill Gross or Warren Buffett on this matter.? The point of the auction is to get the sellers to compete against each other, not compete with the government’s agent.

    Now, price discovery is a two-edged sword.? FInding the market clearing price will make the markets start moving again, but it also might prove that some financial institutions are inverted (negative net worth), if not insolvent (can’t get enough cash to pay all immediate claims).? If we are willing to stomach the possible insolvencies that this will reveal, then I am game for Dr. Jeff’s proposal.

    And, maybe this will show the need for RTC II, successor to the old Resolution Trust Company.? Bad financial institutions need to be conserved/liquidated, so that leverage can be reduced in the financial system of the US.

    So, let something like this be tried, but be ready for adverse consequences if the pricing turns out to be worse than anticipated.

    Ten Points About the Markets

    Ten Points About the Markets

    Posted on by David Merkel

    1) It is a wonderful thing to be the world’s reserve currency; we can milk the rest of the world until things change.? There is some push from emerging markets to have a change, but the effectiveness of that push is questionable.? Someone has to give the US an ultimatum, and no one is there yet.

    2) With the decline in fixed income volatility, mortgage yields are falling.? Good for mortgages, but the real question is what happens when the Treasury starts borrowing like a maniac.

    3) Many hedge funds have raised the gates.? Capital cannot easily exit.? GIven the weak balance sheets that hedge funds have, this is normal for a bear market.? The only surprise is that investors did not anticipate the troubles.

    4) Perhaps the money to banks from the government is going only to relatively sound institutions.? That is consistent with the idea of making some institutions sound, and letting them buy up marginal banks.? Upshot: don’t expect an early increase in lending.

    5) Analyze those that are on the other side of the table.? If they have a reputation for being smart, be extra careful.? Many municipalities and other entities lost money dealing with investment banks.? No surprise.

    6) Many do not understand mark-to-market accounting.? First, GAAP is the least of the problems — collateral agreements require MTM.? Regulators can ignore MTM as they please. Second, MTM is misapplied by auditors; it does not mean “last trade,” but an estimate of where a liquid market would trade.

    7) Shut the barn door after the cow has escaped.? Yes, loan underwriting standards have tightened, in the middle of a credit bust.

    8 ) There is less cash flow to service; the financial sector should shrink.

    9) S&P 500 at 600?? Not impossible, and not likely, but if profit margins crush down, possible.

    10) where could longs make money in October 2008? Nowhere.? Real bear markets crush almost everyone.

    In closing, I am not concerned about the victory of Obama.? The new president will have little freedom, and will face significant unsolvable problems.

    The Biggest, Baddest Bubble of Them All

    The Biggest, Baddest Bubble of Them All

    Posted on by David Merkel

    It’s election day, and I may as well try to fuse economics and politics for a moment.? Personally on an economic basis, I don’t think this election means that much.? Consider this post at RealMoney from earlier this year:


    		 David Merkel
    Cultures are Bigger than Economies, Which are Bigger than Governments
    1/7/2008 1:19 PM EST

    To start this off, I don’t fit neatly on the political spectrum. I am an economic libertarian, socially a conservative, but utterly against the recent wars that we have pursued. I also think that we need to find a way to dismantle the two party system, but that will never happen. So now you have enough to disregard me if you like.

    I don’t think the primaries make any difference at all. The three leading Democrats are all very alike. It doesn’t matter which one wins the primary. The Democrats would have their best chance with Obama, because general elections tend to be won on (sadly) which candidate is more likeable.

    As for the Republicans, there are differences, but not to any great degree on likely economic policy. I say “likely economic policy” because none of their differential policies are likely to survive if one of them wins the general election. Any Republican win is unlikely to have that much of a mandate.

    There are differences between the Republicans and Democrats on economic policy, but this is where my headline comes into play: “Cultures are Bigger than Economies, Which are Bigger than Governments.” Given the mismanagement of our government, particularly with respect to entitlement programs, though also costly wars, future governments will have less wiggle room. Raise spending, cut taxes? Go ahead and try. No surprise that the US Dollar continues to fall. Outsiders will eventually tire of funding US deficits in US currency.

    The Republicans will leave the micro-economy more free than the Democrats, but aside from that, I don’t think the election matters much, at least as far as economics goes. There may be other reasons to vote for one side or the other, but pocketbook issues rank low for me, and in this election, the payoff from the differences will not be big.

    Now, cultural change, in the unlikely event that it would occur, is another matter. But American history has been replete with big shifts before, and the economy and politics get dragged along. Perhaps the question to ask is what will be the next big shift in American culture? I don’t have any read on that now, but then, when it happens, it is often fast.

    Position: none

    Our biggest bubble, which is still inflating, are the debts of the US Government, both explicit and those not accrued for.? We are going to have a difficult time borrowing in the present for all of these new bailout/stimulus/pork programs.? Our debts are getting deeper, not shallower.

    Consider this graph from this article at Clusterstock:

    We may have a slight breather from the increase in total debt recently (2006-7), but it is going up in the near term.? My view is that we need delevering, and that will be a big theme in coming years once the government tires of the new policy of shifting private debts onto the public balance sheet.

    Now, I’m still dubious that the bailout policy will work.? Reasons:

    When a foreign holder of Treasuries is willing to give up 40 basis points of yield on a 10-year T-note yielding 3.80%, so that they can get paid off in Euros if there is a repudiation of US Treasury obligations, there is significant uncertainty over the creditworthiness of the US Government.? (That’s just an example, there are other reasons to enter into such a CDS.)

    Now, the debt-to-GDP graph above doesn’t take into account pension and entitlement underfunding/non-funding.? From another comment at RealMoney:


    		 David Merkel
    Digging a Hole to China (So We Can Borrow Some More)
    10/28/03 08:26 AM?ET
    With a gracious assist from one of our readers at Economy.com, here is the link I promised yesterday. The report does not break out one final number — one has to look at the “balance sheet” on page 58, and the “Statements of Social Insurance” on page 65, which they count as an off balance sheet liability, and add them up. It looks like this (in USD):

  • Net Liability: $6.8 trillion
  • Soc Sec, Pen & Dis: $4.6 trillion
  • Medicare, part A: $5.1 trillion
  • Medicare, part B: $8.1 trillion
  • Total: $24.6 trillion

    • This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

    np

    That $24.6 trillion figure was from September 2002. As of September 2007, it would now be around $50 trillion. ( Here’s the link to the 2007 figures.? New figures out in two months.)? By the way, thanks Mr. Bush, for being such a reformer of Social Security and Medicare. You added on another $10 trillion of unfunded liabilities that future generations will have to fight over bear in your prescription drug program.? You have been the most damaging president on economics since Nixon.? (Sorry, I lost my cool. 🙁 )

    That $50 trillion does not count in state and corporate underfunding of pensions and benefits.? Oh, and with the fall in the markets, they want a bailout also.

    Who doesn’t want a bailout?? The US Government can just borrow some more to aid us on our way to prosperity.? Those debts and unfunded promises will have to be paid someday, either through taxes, inflation, or repudiation (total or external).? The economic mess at that point will be far worse than it is today for all those who rely on the US Dollar.

    Our problems in the US are larger than our politics.? It goes down to our very culture, borrowing from the future to take care of the present.? It is true for our Government, and many corporations and individuals.? The pain will come, the only question now is what form it will take.

    Time to Ditch the Style Box

    Time to Ditch the Style Box

    Posted on by David Merkel

    If you were trying to create a system for controlling investment risk in equity investing, how would you do it?? What I would do is look at the factors that are the least positively correlated in terms of return generation, and focus on them.

    But what do investment managements consultants do?? They divide the world up into managers that look at two factors: large/mid/small capitalization, and value/core/growth.? This has been popularized by the Morningstar “Style Box.”

    Looking over the last 15 years, the style box is very correlated with itself.? The lowest correlation is 75%, between largecap value and smallcap growth.? That is not a reason to categorize managers; the difference between the average largecap value and growth manger is teensy. It is even true between largecap value and smallcap growth.? And in more recent years, the correlations have been tightening to nearly 90% at worst.

    So, consider country allocations.? Over the last 15 years, the correlations in developed markets have been 45% at worst, with the average being near 70%.? Looking at the last few years, both figures are higher.? My opinion: the advent of naive quantitative investing has pushed all correlations higher.

    But now consider correlations across economic sectors.? Over the past 14 years, the correlations have been 32% at worst.? Across industries, which are more diverse than sectors, some of the correlations are negative, perhaps affording true diversification.

    My point here is that those that look at capitalization size and value/growth are missing the boat.? If you classify managers based on that, you are focusing on minor concerns that do not aid much in diversification.? Better to focus on the industries that a manager invests in, and/or the countries that those companies are located in — there is a real oportunity to limit risks through either of those two methods.

    Now, as for me, when I pick stocks, I start with the industry.? I ignore the factors in the style box.? I look for industries that are near the bottom of their pricing cycle, and buy the highest quality companies there.? For industries that are doing well, but are undervalued, I buy companies with undervalued growth prospects, with good quality balance sheets.

    I strongly believe that the investment consultant community has shortchanged its clients by focusing on the “style box.”? Very little of the risks of the market result from factors in the style box, while much resluts from industry selection, which is a richer model.

    So, as for me, if I have to be squeezed into the style box, call me midcap value with some style drift, buying companies larger and smaller, and outside the US, as conditions dictate.? I’m looking for the best value over the next three years, and I don’t like non-economic factors distracting me.? Why should that be such a crime, that the ignorant gatekeepers screen me out?

    The risk model for the investment consultants is broken.? Let them find one that better reflects the way that the market works.

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