March 2011 – The Aleph Blog

Regarding David Sokol, Redux

Posted on 31 March 2011 by David Merkel

I am republishing what I added to yesterday’s post, and adding onto it, because many readers would have missed it.

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In the cold light of morning, I have thought of one more issue? why is Buffett so loosey-goosey with things that ought to be mandatory disclosures for avoiding potential conflicts of interest?

Every firm I have worked for, and even now at the current small firm that I run, there were/are mandatory disclosure rules. My promise to clients is that I get the same results they do, win, lose or draw.

Regardless, it highlights a weakness in Buffett?s highly qualitative way of managing his company and managers. You not only have to avoid breaking the law; you have to avoid the appearance of breaking the law, or even the ?fairness code,? however defined. And, he has said as much to his managers in his biannual memo to them:

The priority is that all of us continue to zealously guard Berkshire?s reputation. We can?t be perfect but we can try to be. As I?ve said in these memos for more than 25 years: ?We can afford to lose money ? even a lot of money. But we can?t afford to lose reputation ? even a shred of reputation.? We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.

Sometimes your associates will say ?Everybody else is doing it.? This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can?t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.

If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it?s very likely that if a given course of action evokes such hesitation, it?s too close to the line and should be abandoned. There?s plenty of money to be made in the center of the court. If it?s questionable whether some action is close to the line, just assume it is outside and forget it.

And Buffett implicitly confirms such a view by accepting Sokol?s resignation, with no hint that he tried to argue him out of it, as he did twice before. Implicitly, Sokol?s unethical behavior led to him leaving Berkshire Hathaway ? one can try to dress is up otherwise, but it fails the smell test.

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There are other issues in play here.

1) Sokol received a list of possible takeovers from Citi.? He was acting as an employee of BRK at the time.? As such, BRK should get the first benefit of his insight.? Yes, BRK is an industrial/financial conglomerate, and not a mutual fund.? But the first duty of an employee is to use data given to you for the benefit of the firm, and use it for the benefit of the firm.? Citi was not offering data to David Sokol as a retail client.

I faced similar situations at a fund that I worked for, where I did not make my case well enough for the portfolio manager.? After he did not want to buy my idea, I asked for the freedom to buy it myself.? It was not granted, and I did not buy it.

2) Sokol sent an assistant to hand Buffett the resignation letter; he did not want to face Buffett.? I suspect he knows that he disappointed Warren, and did not want to face him.

3) Buffett comes off high-handed in that he deems his initial letter to be all the data anyone will get on the matter.? I’m sorry, Warren, but the SEC may have a lot to say here — they don’t know that all of the relevant data has been disclosed.? Maybe you don’t either.? Sokol withheld material information from you; might he have withheld even more data from you?

4) Look, give Buffett some credit here — after so many years of doing business and trusting his managers, he has one blowup from a fellow who is temperamentally hotter than most of his managers.? This incident does not characterize Berky, but it does point out a weakness.? If I were talking to Warren, I would say this:

Look, Warren, you can centralize your company now, under your terms, while you are still alive and thinking clearly, or the company will do so after you die, and you will have no influence in the matter.? The failure with Sokol is basic, and you should have admitted fault in not asking him the size of his position, since you have been informal in requiring disclosure of investments from high-ranking employees.? Start analyzing Berkshire now, as an integrated company, and ask what you want centralized, and what you leave to the subsidiaries.

5) Sokol did not follow BRK’s ethics rules:

All directors and executive officers of the Company, and the chief executive officers and chief financial officers of Berkshire Hathaway?s subsidiaries, shall disclose any material transaction or relationship that reasonably could be expected to give rise to such a conflict to the Chairman of the Company?s Audit Committee. No action may be taken with respect to such transaction or party unless and until such action has been approved by the Audit Committee.

and

Covered Parties are prohibited from taking for themselves opportunities that are discovered through the use of corporate property, information or position without the consent of the Board of Directors of the Company. No Covered Party may use corporate property, information or position for improper personal gain and no employee may compete with the Company directly or indirectly. Covered Parties owe a duty to the Company to advance its legitimate interests whenever possible.

Sokol had the idea of Lubrizol as a result of his position at BRK.? That data belonged to BRK, not Sokol, and he should not have used it for personal gain.

6) Is Buffett too trusting?? I would say no, but would add “Trust, but verify.”

7) As for Charlie buying shares of BYD, Charlie was not an employee of BRK, but a director, and as such, has a different standard of duty to BRK.? Sokol was an employee, and as such owed a duty to BRK to use data he received for the benefit of BRK first.

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I intend this as my last comment on Sokol, unless some amazing new data arrives.? Sokol and Buffett both blew it, but in different ways.? Sokol could have:

Left years ago.? Why wait to pursue a dream when you are already rich?
Told Buffett the full story voluntarily.? He had a lot of credibility inside Berky, so why not?
Donated all profits to charity.? (Weak, but mighta worked.)

Buffett could have:

Asked for the position size.
Asked him to sell as a condition of the merger.
Had better more regular disclosure of brokerage accounts from top employees.

What a mess.? Buffett should say more on this matter.? I believe he will be hurt if he says nothing more, without government coercion.

Regarding David Sokol

Posted on 30 March 201131 March 2011 by David Merkel

David Sokol knows how Buffett and Munger think. He knows what would be attractive to them.

So, even if the initial comments from Buffett were negative on the purchase of Lubrizol, Sokol, having more data, could be confident, because once the full data were available to Buffett and Munger, the deal would likely be done.

Sokol has been one of Buffett’s CEOs for awhile.? You think he can’t recognize another man who would be a good fit for Buffett?? I suspect he knows the pattern intuitively.? Buffett likes managers who think as he does; Sokol knows what sort of manager that is; once Buffett talked to the CEO of Lubrizol, the deal would be done.

With that as background, I fault Sokol for buying a lot of shares of Lubrizol, knowing that he would recommend the purchase to Warren, where the odds were in his favor that Warren would buy.? This also takes into account the goodwill that Sokol has with Buffett and Munger, given his management of MidAmerican, and his turnaround of NetJets.? Don’t think that that means nothing, even if Buffett says otherwise.

My view is that it was unethical, but not illegal, for Sokol to recommend the purchase of Lubrizol without disclosure of the size of his position in Lubrizol.? Mere mention of a position is not enough, unless it was a small position.

Yes, Sokol could not force the purchase, but he could have not brought it to Warren, in which case he would have made or lost money off of operations.? By buying, and then recommending the stock to Buffett, he raised his odds of a successful outcome.? That is a way of misusing your influence within the organization that you serve, which is unethical.

UPDATE 9:30 AM 3/31

Kid Dynamite did a post on this, and asked me to comment.? Here it is:

You have not misinterpreted me, KD. But in the cold light of morning, I have thought of one more issue… why is Buffett so loosey-goosey with things that ought to be mandatory disclosures for avoiding potential conflicts of interest?

Regardless, it highlights a weakness in Buffett’s highly qualitative way of managing his company and managers. You not only have to avoid breaking the law; you have to avoid the appearance of breaking the law, or even the “fairness code,” however defined. And, he has said as much to his managers in his biannual memo to them:

The priority is that all of us continue to zealously guard Berkshire?s reputation. We can?t be perfect but we can try to be. As I?ve said in these memos for more than 25 years: ?We can afford to lose money ? even a lot of money. But we can?t afford to lose reputation ? even a shred of reputation.? We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.

Sometimes your associates will say ?Everybody else is doing it.? This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can?t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.

If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it?s very likely that if a given course of action evokes such hesitation, it?s too close to the line and should be abandoned. There?s plenty of money to be made in the center of the court. If it?s questionable whether some action is close to the line, just assume it is outside and forget it.

And Buffett implicitly confirms such a view by accepting Sokol’s resignation, with no hint that he tried to argue him out of it, as he did twice before. Implicitly, Sokol’s unethical behavior led to him leaving Berkshire Hathaway — one can try to dress is up otherwise, but it fails the smell test.

Longer TIPS and Shorter Nominal Notes

Posted on 30 March 201130 March 2011 by David Merkel

This should be a short post.? QE2 — for the most part, the Fed has bought shorter nominal (non-inflation protected) Treasury notes.? Now, we knew from the beginning that the Federal Reserve would buy the grand majority (94%) of its nominal bonds 10-years and shorter.? Also, 97% of the bonds would be nominal, and only 3% TIPS.? That makes some sense, because the Treasury bond market has an average maturity of around 5 years, and the Fed’s intended purchases of nominal bonds work out a little longer than that, at 6.5 years.

With TIPS the Fed left itself free to do whatever it wanted with respect to maturity.? So far, the NY Fed has done ten purchases of TIPS — $16.1 billion worth, which would indicate they are 89.5% of the way to their (perhaps approximate) $18 billion dollar target.? Let me summarize in a graph the purchases of TIPS to date, together with the targets for nominal Treasury purchases:

Average maturity for TIPS purchases is 14 years, versus 6.5 for nominal bonds.? As you can see in the graph, below seven years, more nominals are bought than TIPS, and vice-versa above seven years.? TIPS purchases are also concentrated in on-the-run 10- and 30-year bonds, which constitute 37% of all TIPS purchased.? On-the-run bonds are the ones most recently issued, and more actively traded.? They may have a disproportionate effect on the market as a whole.

What are we to make of this?? It’s not as if the Fed is avoiding longer nominal bonds; their purchase profile is longer than that of the Treasury market as a whole.? But with TIPS, the Fed is buying a disproportionate amount of the long end.? Why?? Possible reasons:

1) Maybe the Fed is no brighter than the average schmo,? and can’t bring itself to buy many bonds with a negative yield versus the CPI.

2) Perhaps the Fed anticipates higher inflation in the distant future, and is purchasing a small hedge.

3) Maybe the Fed is trying to make long-term inflation expectations look high, for reasons that are not obvious to me.

I lean toward reason 2.? Reason 3 is dumb.? Reason 1 is too easy; the Fed has made so many errors in the past — but that doesn’t mean that will continue to do so.

The correct answer is not known with certainty; the main thing I want to highlight is that the Fed is disproportionately purchasing long TIPS.? If you can tell us why, please comment so that we all might benefit.

Avoid Investment Scams and Bad Advice, Web Edition

Posted on 29 March 2011 by David Merkel

I have had two prior posts on this topic, and I can tell you that Bonanza Goldfields and GTX Corp both cratered though they still live, sort of.? Bioneutral has done poorly, but has not cratered.

So today, while I was reading an article at Time.com, the liberal magazine, I clicked on a link but the page was not fully loaded, and I was transferred to this page.? As scams through postal mail die, so they must appear on the web.

As for today’s folly, let read a part of the disclaimer:

Compensation

AmericanEnergyReport.com has been retained by an unrelated third party to perform promotional and advertising services intended to increase investor awareness of UnionTown Energy Inc. (UTOG). To date, AmericanEnergyReport.com has received five hundred thousand USD from an unrelated third party for performing these services. The services performed have included profiling the company on the AmericanEnergyReport.com website and issuing opinions concerning UTOG in newsletters and press releases. In addition, AmericanEnergyReport.com expects to receive an additional two million USD cash in future compensation for the continuation of the marketing program for an additional 3 months and to cover marketing vendors to pay for the costs of creating and distributing this report online in an effort to build market awareness. AmericanEnergyReport.com will disclose any future compensation. Anyone viewing the AmericanEnergyReport.com website or its newsletters and press releases should assume the hiring party or affiliates of the hiring party own shares of UTOG, which they plan to liquidate. Further, it must be understood that the liquidation of those shares may or may not negatively impact the share price. AmericanEnergyReport.com has received this amount as a production budget for advertising efforts and will retain amounts over and above the cost of production, copywriting services, mailing and other distribution expenses as a fee for our services. As such, our opinion is neither unbiased nor independent, and you should consider that when evaluating our statements regarding UTOG.

Since AmericanEnergyReport.com receives compensation from, and its owners, operators and affiliates may hold stock in, the profiled companies, there is an inherent conflict of interest in AmericanEnergyReport.com statements and opinions and such statements and opinions cannot be considered independent. AmericanEnergyReport.com and its owners, operators and affiliates may benefit from any increase in the share prices of the profiled companies. AmericanEnergyReport.com services are often paid for using free-trading shares. AmericanEnergyReport.com and/or its owners, operators and affiliates may be selling shares of stock at the same time the profile (or other information) is being disseminated to potential investors; AmericanEnergyReport.com will not advise when it or its affiliates decide to sell. Investors must make all investment decisions based on their own judgment of the market and the particular securities.

So, the writers get paid a lot, and may be paid? in the stock of those they write about?? No way they have independent opinions, and no wonder the type is so tiny and at the far bottom of the page.

Much as I like the prospects for oil, I do not believe that “Oil prices can only go up!”? That’s the language of fools.? In almost every economic environment, there can be significant setbacks to? a long-term trend, or even reversals.

The advertising appeals to the naive view that because other companies have reach share prices in the 30s, so might this stock. One of those comparable companies in that group is Northern Oil & Gas (NOG), of which my friend John Hempton is skeptical.

Now, I am not going to do a complete teardown of UnionTown Energy Inc.? At present, I am busy, and I know that companies that seek? paid analysts are usually crooked.? Why?? Simple.? Small companies with something good going keep it quiet, so that management can buy more of the company.? Unless they need more capital to build up plant and equipment, they don’t need to seek coverage.? Those that seek paid analysts to sing their praises are seeking for strength to sell into.

That’s how simple it is, and I record the price of UnionTown here: $1.55.? Also please note that the advertising campaign has run out and the price is now falling.? Caveat emptor.

Compensation
AmericanEnergyReport.com has been retained by an unrelated third party to perform promotional and advertising services intended to increase investor awareness of UnionTown Energy Inc. (UTOG). To date, AmericanEnergyReport.com has received five hundred thousand USD from an unrelated third party for performing these services. The services performed have included profiling the company on the AmericanEnergyReport.com website and issuing opinions concerning UTOG in newsletters and press releases. In addition, AmericanEnergyReport.com expects to receive an additional two million USD cash in future compensation for the continuation of the marketing program for an additional 3 months and to cover marketing vendors to pay for the costs of creating and distributing this report online in an effort to build market awareness. AmericanEnergyReport.com will disclose any future compensation. Anyone viewing the AmericanEnergyReport.com website or its newsletters and press releases should assume the hiring party or affiliates of the hiring party own shares of UTOG, which they plan to liquidate. Further, it must be understood that the liquidation of those shares may or may not negatively impact the share price. AmericanEnergyReport.com has received this amount as a production budget for advertising efforts and will retain amounts over and above the cost of production, copywriting services, mailing and other distribution expenses as a fee for our services. As such, our opinion is neither unbiased nor independent, and you should consider that when evaluating our statements regarding UTOG.

Since AmericanEnergyReport.com receives compensation from, and its owners, operators and affiliates may hold stock in, the profiled companies, there is an inherent conflict of interest in AmericanEnergyReport.com statements and opinions and such statements and opinions cannot be considered independent. AmericanEnergyReport.com and its owners, operators and affiliates may benefit from any increase in the share prices of the profiled companies. AmericanEnergyReport.com services are often paid for using free-trading shares. AmericanEnergyReport.com and/or its owners, operators and affiliates may be selling shares of stock at the same time the profile (or other information) is being disseminated to potential investors; AmericanEnergyReport.com will not advise when it or its affiliates decide to sell. Investors must make all investment decisions based on their own judgment of the market and the particular securities.

Limits: Models, Governments, and Central Banks

Posted on 29 March 2011 by David Merkel

Imagine for a moment that the US Government decided to end all taxation in order to “stimulate” the economy. “Wait,” you might say, “The deficit is bad enough today, how can we let it get any worse?”? A US Treasury Department spokesman says, “Don’t worry.? As the? government, our commercial paper financing captive subsidiary [the Fed] can issue overnight CP at zero percent infinitely/indefinitely.”

But after a little while of doing this, printing money to cover deficits, interest rates rise enough such that a broad coalition of those that need to borrow complain loud enough that the policies get reduced or reversed.? A modern Paul Volcker shows up, blows cigar smoke in the faces of Senators, and refuses to fund the US Government through loose monetary policy.

But the Government is still determined to run huge deficits, and calls upon the Treasury to float US dollar-denominated debt. The market, unused to such large amounts of debt, steepens the yield curve, rapidly, as short rates fall because excess printing of money is over.

Now, people might be grateful that their taxes are gone, as well as the need to be an amateur accountant each April, but that does not mean that they would want to lend to the US Government, so long as they run the place in such a harebrained way.

Eventually, growth in interest payments in dollars would exceed GDP growth, leading lenders to believe that they will never be paid back.? At that point, a lenders strike would ensue, and rates would rise dramatically.? Private borrowers, who pay more than the government to borrow, would scream, and bring political pressure to bear on the government to curtail its borrowing, which crowds out private borrowers.

At that point, the government would have reached its rope limit.? Remember, you can’t get something for nothing — not even governments.? There is always a cost, even if forced onto third parties via monetary inflation, or crowding out in the credit markets, even if those costs appear with significant time delays.

We would be back to my triad of Default, Inflation, Higher Taxes ? Choose One.? There are limits to everything on this side of Heaven.? Governments are not omnipotent in regulating economies; indeed, their track record is pretty dim, as is the record of fiat currencies as providing a stable unit of account.

So, as we possibly draw closer to the end of superloose FOMC policy, and with no hint of any real budgetary normalcy in sight, be aware that we are in uncharted waters.? Beware of listening to what mere theoreticians say should happen based on their models.? Their models have never plied their trade in the rough waters we are currently in.

Far better to read This Time Is Different or curl up with your favorite selection of economic history books.? You might get some clues as to what may come, or you might not, but your odds will be better than listening to the mere theoreticians.? The world and national economies at their worst are always more volatile than what the models will say, and governments prove weak when matched against the folly of their failed policies.

Things are not as good as they look

Posted on 27 March 201127 March 2011 by David Merkel

Before I start this evening, anyone who can point me to people with little or no emotions, or Asperger’s disease, who are good investors, could you send me? a link?? I am not looking for Michael Burry stories.? I am looking for articles that are more general.

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I was chairing a pension board meeting for my denomination recently, when the representative from Morgan Stanley mentioned the positive change in the GDP figures.? I winced, and said to myself, “Doesn’t sound right.? How can the economy be doing well when energy and food are running up in price?”

So, when I got home, I looked at the 4Q “Final” GDP figures.? After a little while I realized that we are facing the same phenomenon as we did back in 2Q 2008, when I write the piece, Another Look at Preliminary Second Quarter GDP.? Let’s start with the definition of Gross Domestic Purchases, which I think more closely tracks the way average Americans feel than Gross Domestic Product does.

Gross domestic purchases

The market value of goods and services purchased by?U.S. residents, regardless of where those goods and services were produced. It is?gross domestic product (GDP) minus?net exports of goods and services. Equivalently, it is the sum of?personal consumption expenditures (PCE),?gross private domestic investment, and?government consumption expenditures and gross investment.

Source: U.S. Bureau of Economic Analysis

Pretty simple — GDP minus net exports equals Gross Domestic Purchases.? The trouble is that import price increases increase real GDP relative to real GD purchases.

Note well: IPD stands for implicit price deflator, which is a comprehensive measure of inflation.? Also, figures may not add due to rounding, timing differences, and errors in revisions.

In 4Q 2010 real GDP rose 3.1%, while real Gross Domestic Purchases fell 0.2%.? Why? Energy and other import costs rose which depressed the price indexes for GDP versus Gross Domestic Purchases.

Over the long haul, the two series are close to equal, but when they diverge, they tell a story.? The current story is that average consumers in the US are doing badly, while those benefiting from high corporate profits, and increasing exports are doing well.

In general, I am not impressed with statistics collected by our government, or how they use them.? But it’s useful to understand what they mean — to understand the limitations of the statistics, so that when naive/conniving politicians use them wrongly, one can see through the error.

Before I close for the evening, I’ll give one more example: the use of core CPI as a more reliable indicator of inflation than the unadjusted CPI.? From first principles, I already know something is wrong here, because if you want a more stable estimate of central tendency than mean, one can use a trimmed mean (Dallas Fed), or a median (Cleveland Fed) — you don’t toss out a whole class of data inside your calculation simply because it is more volatile on average.? and with respect to food and energy, yes, they are more volatile, but also over the last three, five, ten, and twenty years, inflation in food and energy has been higher than that of the core CPI.? For those who want to paint the inflation picture as happy, it is more convenient to paint that picture using the core CPI, which is a bogus concept.

We could go on with other intellectual weaknesses of the CPI — substitution effects, owners equivalent rent and hedonics, none of which are theoretically wrong, but which are applied wrongly, and lead to an underestimate of inflation.? If you have access to RealMoney, you can consult my article there.? Also, statistics vary by income level — those that are poorer spend a greater proportion of their income on food and energy, making the concept of the core CPI even worse for those less-well-off.? Or, as the guy shouted to William Dudley as Dudley misused the concept of hedonics — “I can’t eat an IPad!”? Statistics, even if properly done, reflecting the average income, will not necessarily represent the median person, much less the lowest quartile.

Just be wary with statistics, and those who use them.? Many have an axe to grind, including me, and will pick and choose their statistics at whim to suit their case.? I try to be fair — these are gripes that I have developed with the statistics over the last decade — my tune has not changed here.? They help to explain why goods and services price inflation has been restrained in the face of an exceedingly easy monetary policy.? Or, look at the asset inflation engendered, which does not enter into the Fed’s inflation lexicon.

Be wary.? Look at a broader range of statistics, and take apart the existing statistics.? Don’t just take the pronouncements of our government at face value.? They are experts in saying what is technically true, while implying what is false.? Be wary.

Book Review: Financial Jiu-Jitsu

Posted on 24 March 2011 by David Merkel

The genre of personal finance books is crowded.? I have read my share of good and bad books in this area, and the book that I am reviewing this evening falls in the good column.

It covers all of the main areas of personal finance adequately, and makes analogies from the world of martial arts.? Now, personally, to me that is an odd place to source analogies for investing.? I remember being in a meeting when I was a corporate bond manager, and the new head of credit research said to the credit analysts, “Credit analysis is war by another name.”? I rolled my eyes, and said to myself, “Oh, please, this is a business, and no more than a business.? Don’t make my analysts non-economically aggressive.”

This book is long on structuring your finances, and short on how one invests, as is common for most personal finance books.? The advice is simple and practical, and will benefit most individuals/families.

One of the many places where I agree with him is that you don’t have to have a budget.? Save first, and then survive on the remaining cash flow.? This is an excellent way of managing finances, but it takes discipline.? Not everyone can do this because they lack discipline on a month-to-month basis.? Those that don’t have that discipline should craft a budget.

I also found his approach to financial goals useful, because it asks the deeper questions on what the ultimate reasons for living are: not only ways in which we want to be served, but ways in which we want to serve.? Figure out the broad goals for life first, then figure out the financial means to serve those ends.

He also takes a conservative approach to how much money one needs in retirement, using a 4% withdrawal assumption, which in a low interest-rate and mid-to-high P/E environment like today is only reasonable.

It was a breezy read for me, getting through the 180 pages in 90 minutes or so.? Part of that is that it is a very familiar topic to me, but I suspect more of it is good structuring and chapter ends that repeat the main points in summary form, so that the main ideas are difficult to miss.

Everything important gets covered here for the life of an average person/family.? The reader faces the challenge of executing on the good advice, or finding a good adviser to guide him.

Quibbles

Though I was a wrestler in high school, I sometimes found the analogies to martial arts to be strained.? More importantly, I had a hard time following the logic in the appendix regarding investment performance.? I am no fan of Modern Portfolio Theory, but MPT does not require the concept of buy and hold.? Buy and hold stems from the idea that equities outperform equities and fixed income by a wide margin (the “equity premium”), so one can always win by holding onto equities, and not ever switching into safer asset classes.

The author’s concept of capital preservation investing does not get adequately defined.? Indeed, that could be a book in itself.? The idea? that there are seasons to take more risk and seasons to take less risk is obvious in hindsight, but implementing that idea is tough, and the author leaves us with not enough to do it.? That should not be too much of a surprise though, because if there were an easy solution here, we all would have adopted it years ago, and I would be opining to you from a life of leisure, rather than that of a working stiff.

As such, I don’t penalize the author too much, no one has the holy grail of market timing nailed down yet.

Who would benefit from this book: This is a basic book, and most suited for those that need to get their lives in order.? Personally, I suspect younger males would find the analogies between investing and martial arts most appealing.? I should try it out on my son who wants to be a police officer.

If you want to, you can buy it here: Financial Jiu-Jitsu: A Fighter’s Guide to Conquering Your Finances.

Full disclosure: The author sent this to me after asking me if I wanted it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Book Reviews: Three Views of the Future

Posted on 23 March 2011 by David Merkel

When you have 17 books read and ready for review, you take a step back and say, “Are there any common themes here?”? I have three books that attempt to predict the future, and I play them against themselves here.? They give three different views of the future.? My own view is an amalgam of all of them — optimist, inflationist, and deflationist.? It will be interesting to see which scenario happens, if any.

The Global Debt Trap

This is the inflationist scenario.? Two Austrian School economists, who previously had published only in German, were persuaded by Martin Weiss to publish their next book in English.? Their last book, Das Greenspan Dossier, was a bestseller in Germany.? That book critiqued the easy money policies of Alan Greenspan, and the asset bubbles he was creating.

In this book, they look at the subsequent policy which doubled down on Greenspan’s blunders, where the bubble in private and financial debt is replaced with public debt.? They argue that this is an environment that will eventually result in inflation, and that those that want to preserve their wealth will need to invest in gold and other commodities in order to prosper, assuming the government does not come after you and take your gold from you.? This book takes the view that governments will become dictatorial as they get more desperate.

Quibbles

I enjoyed this book more than the other two, but I found its conclusion and advice to be more severe than is likely to result.? Also, the subtitle of the book overpromises.? If they are right, you won’t make a fortune, you will only preserve purchasing power, which may be better than most.

Who would benefit from this book: Most investors would benefit from this book a little.? It has the best explanations of what went wrong in the past and why.

If you want to, you can buy it here: The Global Debt Trap: How to Escape the Danger and Build a Fortune.

Full disclosure: The publisher sent this to me after asking me if I wanted it.

The Age of Deleveraging

Dr. Gary Shilling was way ahead of most commentators in arguing for a deflationary environment.? Give the man credit, and the erudite folks at Hoisington Investments who are quietly the best bond investment managers over the past 30 years.

But the book is utterly self-congratulatory over past calls.? Other books point at good past calls, but less frequently.? I began to tire of it and entered uh-huh-uh-huh mode, where I scanned the book in two hours.? The book sounded like a compilation of research reports on a wide number of topics reflecting an economy with too many claims on it, so best to grab the claims that are certain to be funded/paid.

Quibbles

The weakest point of the book is arguing why the government would not inflate its way out of the crisis.? Yes, so far there has been deflation, backed by the US government, but why should the US government continue to pay particularly when the costs of Social Security and Medicare become steep?? The book has no answer for that.

Who would benefit from this book: Most investors would benefit from this book a little.? I can’t rule out the deflationary argument, after all, that is what happened in the Great Depression.? But will it happen when there is no link to gold in the currency at all?? I am dubious.

If you want to, you can buy it here: The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.

The Next Boom

Technology and free markets conquer all.? Don’t get me wrong, I love the free market, and wish we had more of it in the US.? This is one of those books that assumes that we will necessarily get progress if we let people pursue their visions for prosperity.

Nice, but what about the present difficulties that have to be worked through in financials companies and the US Government?? How do we work through Social Security and Medicare?? The book says that we will grow our way out of it.? I say that it is difficult to grow when the government is over-regulating, and consumers are still over-indebted.

Look, I can see his arguments in the long run, but in the intermediate term there are big issues to be dealt with that the author gives scant attention to.

I appreciate the long-term arguments.? Many economics books fail to appreciate the degree to which economies can self-heal through growth.? But it takes a lot of time, and there may be significant crises before the greater prosperity.

Quibbles

My quibbles have already been given.

Who would benefit from this book: Most investors would benefit from this book a little. Those that are pessimists would benefit more.? The pessimistic arguments always sell more books, and this book bravely takes up the reasons why technological improvement will better our lives in the future.? Good for all of us that htey wrote this, even if they ignore intermediate-term problems.

If you want to, you can buy it here: The Next Boom: What You Absolutely, Positively Have to Know About the World Between Now and 2025.

Full disclosure: The authors/publishers sent these books to me after asking me if I wanted them.

Closing

My heart is closest to the Global Debt Trap, but I have some sympathy for both of the other books.? Deflation is a major pressure, and we will have improvements in productivity even in the midst of trouble.? The question is what the US government will do to fund itself as its deficits ascend.? As I have said before, there are three answers: higher taxes, inflation, or default.? At least one of those will visit us in the intermediate-term.

Responding to a Bright Reader

Posted on 21 March 2011 by David Merkel

One of my readers made some good comments, and asked some good questions, so I am responding here.? From the article, Dave, What Should I Do? (3):

DM: Some of my friends want to invest with me, but I am not a total solution to anyone?s financial needs, because the only stuff I am managing is the risk capital.

Reader: Just curious, why did you choose to go this route instead of the “total solution” route.

Later in this post, you have very detailed bond fund recommendations, so why not just manage the total portfolio with the appropriate asset allocation across risk capital versus bonds?

I’m not seeing the advantage of just the risk capital approach. It seems like less AUM, and less fees, and the client still has to figure out what to do with the remainder of the investable capital.

Between your comments, and requests from clients and potential clients, that is what led me to start the fixed income strategy.? I am moving some of my family’s assets into that strategy so that I have “skin in the game.”? I always thought I would do this, but I thought it would come later.? Reality has intervened.

And, from the article, Managing Fixed Income for Equity Clients:

Given your background, I would think managing the bond portion would be almost a triviality. I would assume for bigger accounts you could do individual bonds effectively, and I understand for smaller accounts going the CEF/ETF route. I am genuinely curious why for smaller accounts you would totally avoid actively managed bond funds. This is what I currently do. I use Hussman Total Return and PIMCO Total Return for my bond allocation, but I have been thinking about further diversifying that. I?ve been thinking of adding Jeff Gundlach?s new fund now that he is on his own. My understanding is he is considered one of the top bond fund managers. I?ve also heard Dan Fuss from Loomis Sayles is really good. My thought with the bond allocation is to put it on auto-pilot as much as possible, and focus my efforts on generating alpha in the risk asset part of the portfolio.On a broader point, I think you are right about offering this, because I think most people are looking for a ?total solutions? provider. If one only manages the equity allocation, then I think you almost have to stress that to the client, and then they are still left to their own devices on what to do with the rest of the investable money. My thought is why give up that business and more importantly are you really helping that person by basically saying I only do A and you are on your own for the rest. In my view, managing the total portfolio is really win-win for both the advisor and client, and I am actually surprised at the number of advisors who only do stock-picking. My thought is they largely only do that because that is what they like.

Anyways, I hope this has been somewhat helpful, and I?d love your feedback on some of the funds I mentioned if you care to offer it.

I have respect for Dan Fuss, Jeff Gundlach, John Hussman, Vanguard and Pimco.? Pimco is misunderstood, because it is a quant shop, and uses a ton of fixed income derivatives.? Vanguard has the most durable advantage because of low expenses.

Why am I not using actively managed bond funds?? I would rather work with simple vehicles that allow me to express my macro views, and have low costs for clients.? I am the manager.? If I use actively managed funds, I am the manager of managers.? That is not what I want to be.? Eventually, if my fixed income assets get big enough, I will stop using funds and buy bonds directly.? And that will be a lot of fun, because when I managed a lot of bond assets, I was able to add a lot of value through clever trading.

And from the article Abandon All Hope All Ye Who Enter Here:

1.? What do you mean by “dual currency”?

2.? In your view, what are the investment/portfolio implications of what appears to be the inevitability of nothing meaningful getting done on fiscal policy until the crisis hits with full force.? Seems to me many, even highly intelligent people, believe we can put off adjustments for another day down the road.

http://oldprof.typepad.com/a_dash_of_insight/2011/03/constructive-postponement.html

Dual currency means that a nation has two currencies, one for domestic dealings, and one for international dealings.? I do not advocate it, but such a system can be used to favor domestic interests over international interests, or vice-versa.? It depends what the government wants to do.? Historically, there have been cases where a government under stress:

defaults on foreign obligations
defaults on domestic obligations
defaults on both

The dual currency helps with the first two options, because it allows the government to easily choose who to pay.

On the fiscal policy deadlock: the credit cycle is unpredictable in term of detailed timing.? How much more the credit cycle as applied to governments, which “never go broke.”? Things are great until they aren’t.? Who predicted that the PIIGS would erupt specifically in 2010?? Seeing the troubles is easy, naming the time is tough.

Delay merely makes the future solutions tougher, because the problem to solve is bigger.? The trouble is, we don’t know what actions our government will take.? I lean toward inflation, given the tendency of American history, but who can tell?

This is a tough time to be managing bonds, but what time isn’t?

Three Years from Now

Posted on 19 March 201120 March 2011 by David Merkel

With my portfolio management rules, one implicit idea is that I am not managing for the near future.? The near future is a crowded trade.? How is it crowded?

High frequency traders schnitzel away at the bid-ask.
Day traders and swing-traders play with chart patterns, and generally follow the trend, perhaps to some advantage on average, or not.
Quantitative equity managers turn their portfolios over rapidly.? What?s the average holding period, three months?
Mutual fund managers and many institutional equity managers turn their portfolios rapidly.? The average holding period may be in the vicinity of ten months.
Long-short equity hedge funds have short holding periods as well.
ETF trading tends to be rapid, but how much effect that has on the underlying is less certain.

The Buffetts of the world are rare, where the favored holding period is forever.? Marty Whitman also rarely sells.? Maybe my mother comes close, with holding periods around a decade, and she has done well over the years.

I set up my methods to get into a less crowded game.? When much money plays for the short-run, why not play for the intermediate-term?? You don?t have to play for the Buffett-like forever ? after all, he is playing a different game as he builds a conglomerate that can likely prosper after his death in most scenarios where the US survives.

Even Buffett did not play for forever when he had less capital; he would do some arbitrage, which was short term.? He would buy stocks that he would trade away a few years later.? Forever became the mantra as the assets to deploy grew large.

I manage money for a small but growing number of clients.? I don?t have the constraints that Buffett does.? But I would rather choose a less crowded area in which to compete.? Thus I aim for three years out.

Pimco and Value Line

There are others that institutionalize a longer view.? I will mention two of the better known in the retail community.? Value Line, for its data service does an economic projection 3-5 years out, assuming economic growth and no major wars going on.? I often think their projection is too bullish, but the point is to give a common set of factors off of which to base financial projections for the companies that they follow.

As an aside, Value Line as a service has hit hard times largely because the short-cycle aspects of the service that go into the Timeliness Rank are overanalyzed by the market ? price momentum, earnings momentum, and earnings surprise.? But that doesn?t mean that the data service is useless ? where else do you get so much data on a page?? Even Buffett uses it.

Pimco does a three-year projection to analyze where the various bond markets and economies will likely be.? That feeds into their overall asset allocation across the fixed income asset classes.

Mean-reversion?

My view is that we have to look past the present day, and ask what will things will be like three, maybe five years from now.? During times of crisis, ask whether there is a permanent change going on, or one that will likely be fixed.? Most problems will likely be fixed, so crises are times to add more cyclicality to the portfolio little by little.? Don?t be a barbarian and make bold moves.? You could be wrong.? But don?t be a ?fraidy cat and panic, lest you be the one that loses the most.

True structural shifts are rare.? Absent war on your home soil, plague, famine, rampant socialism (not seen in the US or Western Europe yet), most change tends to happen gradually, often due to social or technological change.? More often than not, the politicians and regulators are behind the curve, reacting slowly to a societal/business environment that has already changed.? This applies to emerging markets as well.

So, during a crisis, leg into investments that you think people and businesses will still need 3-5 years from now.? In fixed income, think of what cashflow streams might be in demand relative to inflation rates.? Think in terms of industry mean-reversion, while avoiding buggy whips like newspapers, bricks and mortar booksellers, fixed-line telephones, etc.? Most of the areas I avoid are areas where the internet is collapsing margins of offline businesses.

But when things are running well, think of taking a little off the table, particularly in areas where the economy is running hot.? Again, little-by-little ? the peak of the credit cycle is not a peak but a mesa, where it may take 2-4 years before the credit bust hits.? But, the longer we have been on the mesa, become more aggressively conservative.

Risk Control Done Up Front

Risk control is difficult to do on a spur-of-the-moment basis, when an event has happened, and your stock is down 10% or more.? And that?s not to say that I don?t experience events like that on single stocks every now and then.? The point is to think ahead now, and minimize the odds that your total portfolio will not be badly positioned for the next three years, taking account of what might go right or wrong, and the approximate odds thereof.

To manage a portfolio in this way is businesslike, like a flexible diversified company that invests in more promising business lines, while selling/reducing capital to business lines that are less promising.? It also gives ideas time to develop; mean reversion is typically a 3-5 year process, so allow time for this.? Patience in a good idea will be rewarded.