June 2011 – The Aleph Blog

Got Cash?

Posted on 29 June 2011 by David Merkel

Ecclesiastes 10:19 (NKJV)

A feast is made for laughter, And wine makes merry; But money answers everything.

There has been a small flurry of posts off of James Montier’s piece on the virtues of cash.? I wrote a piece like it recently (not as comprehensive, but possessing brevity): Chasing Your Tail Risk.

Like gold, cash is special because it doesn’t do anything.? Even money market funds do nothing, or almost nothing.? It just sits there, waiting.? It waits for the day when the Fed is forced to raise rates because inflation is running faster, even though the economy is still underemployed.? It waits for the day when bond yields rise and stock prices fall, where there are good opportunities to use the cash.

Having cash on hand allowed my church to buy a building cheaply in March 2009, and allowed me to help rescue a friends business, as well as buy some cheap stocks.? The same was true for me in October 2002, when I fully deployed my cash into stocks.

Cash is flexibility.

Cash says, “I don’t know.”

Cash says, “I don’t care.”

Cash says, “I’m ready.”

When opportunities are numerous, I am more than willing to part with my cash.? But when yields are low, and valuations are high if profit margins mean-revert, I would rather have more of a cash buffer.

For my account, and client accounts, I did buy some stock last week.? If the weakness had persisted, I would have bought more.

I still have an above average amount of cash (for me).? I am waiting for opportunities to get better before I deploy it.

Never Got Kodak

Posted on 29 June 2011 by David Merkel

I remember looking at Eastman Kodak a number of times over the last decade.? Often a few metrics would look cheap, but when I would look at the bevy of factors in the financials and consider the effects of technology, I could never get myself to be a buyer.? To me, it seemed to be the ultimate value trap — a modern buggy whip company.

That’s why the behavior of Bill Miller, a so-called value investor, was so surprising to me.? He had a saying, “lowest average cost wins,” but that implies that the stock will rise at some point.? For stocks that keep falling, the average cost does not matter.? And lest I seem to be boasting, I made the same mistake on Deerfield Capital.

But he did the same thing on Freddie Mac, though that was more dramatic.

The core idea of value investing is NOT “buy cheap,” (lowest average cost) but margin of safety.? My greatest mistakes in investing came from not seeking enough margin of safety.? Same for Bill Miller, though the effect on his track record was far greater.

Evaluating Six Investing Mistakes To Avoid

Posted on 25 June 2011 by David Merkel

I read this article today, and he invited comments.? Here are my comments (his words are in italic):

While no investment approach is successful all of the time, here are six common investing mistakes to avoid:

Inability to take a loss and move on.

This is a good point, subject to what I will mention later.? If you learn new data about a company, such that you conclude it is worth far less than your original estimates, yes, it is likely you should sell.

But often when investors sell after a disappointment, they sell too cheaply.? Bounces often come after disappointments.? The key question is to estimate the new value, and calculate a new implied return, and compare that against the implied returns of alternative stocks.? Are you holding the stocks with the best set of likely returns?

Not selling winners.

The stock may have been a winner, but that doesn?t mean it can?t win more.? Don?t look through the rear-view mirror.? Look through the windshield.? What is your estimate of value NOW?? It may be a lot more valuable than when you first purchased it.? If uncertain, sell a little bit of it ? it helps psychologically to do that, because taking a gain will make you more comfortable about the remainder of the position.

But if the stock is one of your leading ideas, even after a run-up, why sell any of it?? Again, rank the idea against the alternatives that you might reinvest in, and choose the idea that gives you the best likely returns, adjusted for risk.

In my opinion, too many people trim winners that have more to run.? Be bloodless, and evaluate the future prospects of the company versus those of alternatives.

Not setting price targets.

Fixed price targets are foolish.? Price targets should be dynamic, and shift with the estimated value of the firm.? Further, evaluate companies against alternative investments.? Only sell the stock of a company when you have a company significantly better in terms of implied returns to replace it with.

Trying to time the market.

I agree that it is difficult to time the market.? That doesn?t mean that it is not worth trying to do it on an intermediate-term basis.? Follow the credit cycle in the corporate bond market, and you will have a good idea of where stocks are likely to go.? When corporate lending falls apart, so do stocks.? Also, momentum tends to persist, so be more aggressive when stocks are above their 200-day moving average, and less aggressive when below the average.

Worrying too much about taxes.

In general, I agree.? Taxes are a secondary concern, particularly for those who use stocks for charitable giving.? Donating appreciated stock is a home-run strategy for those with long-term capital gains.

Not paying attention to your investments.

This is true.? If you can?t evaluate you own investments, you should get a professional to do so.? By professional, I mean someone trained to understand how investing works, because few truly get how it works.? They should at least hold a CFA Charter, and hopefully show some competence beyond that to show that they have transcended the training of one with a CFA Charter.

My main points to you are these:

Don?t look through the rearview mirror.? Look through the windshield, and pick the stocks that offer the best returns now.
Only buy a new stock when its implied returns are better than most stocks in your portfolio.
Only sell a stock in order to fund a new stock with better implied returns.
Good investing is a lot of work.? If you can?t do it, get a professional to do it for you.
Consider taxes to the degree that it makes sense, and donate appreciated stock when you can.

The author?s six investing errors have a modest amount of merit, but the intelligent investor is dynamic, and adjusts to changing market conditions.? Your assets should be managed by those who are similarly dynamic, if you can?t do it yourself.

I read this article today, and he invited comments. Here are my comments (his words are in italic):

While no investment approach is successful all of the time, here are six common investing mistakes to avoid:

Inability to take a loss and move on.

This is a good point, subject to what I will mention later. If you learn new data about a company, such that you conclude it is worth far less than your original estimates, yes, it is likely you should sell.

But often when investors sell after a disappointment, they sell too cheaply. Bounces often come after disappointments. The key question is to estimate the new value, and calculate a new implied return, and compare that against the implied returns of alternative stocks. Are you holding the stocks with the best set of likely returns?

Not selling winners.

The stock may have been a winner, but that doesn?t mean it can?t win more. Don?t look through the rear-view mirror. Look through the windshield. What is your estimate of value NOW? It may be a lot more valuable than when you first purchased it. If uncertain, sell a little bit of it ? it helps psychologically to do that, because taking a gain will make you more comfortable about the remainder of the position.

But if the stock is one of your leading ideas, even after a run-up, why sell any of it? Again, rank the idea against the alternatives that you might reinvest in, and choose the idea that gives you the best likely returns, adjusted for risk.

In my opinion, too many people trim winners that have more to run. Be bloodless, and evaluate the future prospects of the company versus those of alternatives.

Not setting price targets.

Fixed price targets are foolish. Price targets should be dynamic, and shift with the estimated value of the firm. Further, evaluate companies against alternative investments. Only sell the stock of a company when you have a company significantly better in terms of implied returns to replace it with.

Trying to time the market.

I agree that it is difficult to time the market. That doesn?t mean that it is not worth trying to do it on an intermediate-term basis. Follow the credit cycle in the corporate bond market, and you will have a good idea of where stocks are likely to go. When corporate lending falls apart, so do stocks. Also, momentum tends to persist, so be more aggressive when stocks are above their 200-day moving average, and less aggressive when below the average.

Worrying too much about taxes.

In general, I agree. Taxes are a secondary concern, particularly for those who use stocks for charitable giving. Donating appreciated stock is a home-run strategy for those with long-term capital gains.

Not paying attention to your investments.

This is true. If you can?t evaluate you own investments, you should get a professional to do so. By professional, I mean someone trained to understand how investing works, because few truly get how it works. They should at least hold a CFA Charter, and hopefully show some competence beyond that to show that they have transcended the training of one with a CFA Charter.

My main points to you are these:

1. Don?t look through the rearview mirror. Look through the windshield, and pick the stocks that offer the best returns now.

2. Only buy a new stock when its implied returns are better than most stocks in your portfolio.

3. Only sell a stock in order to fund a new stock with better implied returns.

4. Good investing is a lot of work. If you can?t do it, get a professional to do it for you.

5. Consider taxes to the degree that it makes sense, and donate appreciated stock when you can.

The author?s six investing errors have a modest amount of merit, but the intelligent investor is dynamic, and adjusts to changing market conditions. Your assets should be managed by those who are similarly dynamic, if you can?t do it yourself.

The War Against Savers

Posted on 24 June 2011 by David Merkel

Today, Charles Rotblut, CFA who is the AAII Journal Editor wrote:

Federal Reserve Chairman Ben Bernanke continues to be the enemy of savers. Yesterday, the Boston Red Sox fan reiterated his belief that interest rates should be kept at rock-bottom levels for an extended period of time. He views this as necessary in order to keep the economy growing.

When you run an investment group that is largely composed of retirees and near-retirees, it is reasonable to call Bernanke the enemy of savers, because he is the enemy of savers.? When one can’t earn anything over one year without risk, something is wrong.? Better that the economy grow more slowly, than that savers not get their due for not consuming.

Saving deserves a return.? Let the Fed raise the Fed funds rate by 1%, and they will see that there is no harm to the banks, and little harm to the economy.? Once you have 1% slope between twos and tens you have more than enough oomph to make the economy move.? What, does the AARP have to bring a age discrimination lawsuit against the Federal Reserve to make this happen?? The Fed is discriminating against the elderly.

But now consider another issue — money market funds.? I consider them to be superior to banks because their asset-liability mismatch is so small, and they have generated small losses relative to banks and other depositary institutions.

Prime money market funds in the US have been investing 50% of their assets in the Commercial Paper [CP] of Core Eurozone Banks.? Well guess what?? If the Greeks and other fringe members of the Eurozone default, and the core governments don’t bail the situation out, those holding? CP of core Eurozone banks may take a loss.? And this is at a time where French and German Banks are facing liquidity issues.? Take time to review your money market funds.

The problems of the US and China are significant, but the problems of the Eurozone are pressing.?? The endgame there will arrive more rapidly because the underlying structure is unstable.? One currency can’t serve multiple cultures.? Also, there should have been an Eurozone exit plan designed in from the beginning.? It was hubris to think it would never need that level of adjustment.

It seems like the ECB is becoming a repository of euro-fringe debt, and perhaps the IMF as well.? After all, it doesn’t cost the ECB anything to absorb those debts, but it indirectly spreads the risk to the euro-core nations if there is ever a default or unfavorable restructuring.? A central bank can’t go broke, but it can impose problems on those that use the currency if defending the central bank exacerbates other problems in the economy.? (E.g., printing money to cover over bad debts absorbed by the bank, while inflation rolls on.)

On a slightly different level, I’m not sure that the banking regulators in the US or Europe really got the main lesson from the crisis.? Risk management is liquidity management.? I still think that banks rely too much on short liabilities to finance illiquid, longer assets.? One advantage of mark-to-market accounting is that it can reveal those mismatches to investors, or perhaps, to regulators.?? Extra capital can help, but it is usually not enough when there is a run on short-term liquidity, particularly because capital is the excess of assets over liabilities.? If there are not enough liquid assets to meet the redemption of liquid liabilities, the result is insolvency.

“But that’s a liquidity problem, not a solvency problem — just give it time and the market will normalize, the assets are worth more than the liabilities anyway.”? But at such a time, no one wants to buy the longer, less liquid, lower quality assets.? If the bank could raise liquidity, it would.? It can’t, so it is not only illiquid, but insolvent.? It’s always cheaper to issue liquid liabilities, because those are attractive to savers and investors, but they a poison in a crisis.

My fear here is that there may be another call on liquidity that forces the Fed or the ECB to backstop banks.? Not sure what would cause it; it’s always hard to pick which straw will break the camel’s back.

Thus I say be cautious at present; have some safe assets available in case we have a panic that emanates out of Europe, and has second-order effects on the US.

On Insurance/Securities Company Lawyers

Posted on 23 June 201120 June 2017 by David Merkel

This will be an odd piece that some will want to skip.? My impression of lawyers has been shaped by the lawyers I came to interact with inside insurance companies.

At company A, everything was thin and entrepreneurial.? On one block of business that was clearly unprofitable, as actuaries, we thought the dividend scale should be reduced to zero.? The lawyer gave quick advice, saying that we could do so.? Later we find out it takes a board resolution to do so. Augh!

On a personal note, the in-house lawyer could be useful for personal advice, for which I was grateful.

At company B, the lawyers for the most part acted very professionally, but would hem and haw over advice.? More often than not, they would point me to the legal library.? Usually I did okay with that, but once I blew it looking over Florida’s annuity reserving regulations, where they seemingly allowed for a more lenient reserving table, only to find that the law defined the lenient table as the conservative table, without changing the name in the statute.

At company C, out of 7 lawyers, there was one really competent one, so competent that she had twins and took care of them and still got the work done.? When the competent one was recognized by the bigger lines of business, she was allocated to the biggest line of business.? The rest of the lawyers were a waste — again, I was pointed to the law library.

I needed to redraft the main set of contracts for our division.? They were over a decade old and flawed in the new environment.? We needed to be able to accommodate new products as well.? I was assigned to one lawyer whose social skills were outclassed by a clam.? I asked for help in drafting the contract.? He told me to do it myself.? I did it, and asked for a critique of what I had done.? I waited, and waited.? We needed to get this filed with the states.? I asked for a deadline, and I showed up on deadline day — he just told me it was fine.

I filed it with the states, and 47 of 49 accepted it — I knew New York would not approve.? But state approval is one thing… getting agreements to hold up in court is another.

In another incident, they deemed a derivative deal legal where there was no economic purpose to the deal… it just altered accounting and taxes.? In that situation, I was the only person in the room that understood all of the aspects of the deal, but made it known to all involved that I thought it was dishonest.? Five months later, FASB’s EITF validated that opinion, and the practice was ended.

At company D, the legal department was a lapdog to the management, but we drove a bill through the state legislature to modernize the state’s life insurance investment code.? Fifty years of improvement in one whack is something, especially when it is tweaked so serve the public interest.

During the dissolution, where our division was being sold off by the parent company, the head lawyer began talking to my employees on behalf of the acquirer.? I intervened, calling him, saying, “Why are you carrying water for E company?”? He blinked, and stopped.

At E, F, and G companies, I found securities company lawyers to be different.? They were much more concerned with compliance.? The lawyers at company F (Hovde) were particularly competent and businesslike, the others less so.

Hovde had a culture where inside information was not tolerated.? It happened to me twice, and I talked to the lawyers, and we refrained from trading in the names, which I heartily approved of.

My sense is that most of the company lawyers I dealt with were hacks, aside from the few entrepreneurial companies that I worked with, where they went the extra mile and then some.

But after all this, I know that my experience is limited.? Things could be very different for others than for me.

Redacted Version of the June 2011 FOMC Statement

Posted on 22 June 2011 by David Merkel

April 2011	June 2011	Comments
Information received since the Federal Open Market Committee met in March indicates that the economic recovery is proceeding at a moderate pace	Information received since the Federal Open Market Committee met in April indicates that the economic recovery is continuing at a moderate pace, though somewhat more slowly than the Committee had expected.	Shades down their view of GDP.? (finally!)
and overall conditions in the labor market are improving gradually.	Also, recent labor market indicators have been weaker than anticipated.? The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan.	Shades down their view of employment.? Wishful thinking regarding transitory factors? Japan does not have that big of an impact on US employment, nor do food and energy prices, which have been going up for some time.
Household spending and business investment in equipment and software continue to expand.	Household spending and business investment in equipment and software continue to expand.	No change.
However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.	However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.	No change.
Commodity prices have risen significantly since last summer, and concerns about global supplies of crude oil have contributed to a further increase in oil prices since the Committee met in March.		Sentence dropped, as have commodities dropped.
Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued.	Inflation has picked up in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions.? However, longer-term inflation expectations have remained stable.	Shades inflation view up a little, but argues that it is transitory.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.? The unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.? The unemployment rate remains elevated; however, the Committee expects the pace of recovery to pick up over coming quarters and the unemployment rate to resume its gradual decline toward levels that the Committee judges to be consistent with its dual mandate.	FOMC expresses additional optimism regarding recovery.? Every bad thing is transitory, every good thing is continuing, except housing.
	Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee’s dual mandate	New sentence.? Again, inflation transitory.
Increases in the prices of energy and other commodities have pushed up inflation in recent months.? The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations.	as the effects of past energy and other commodity price increases dissipate. ?However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.	Sees effect of rise in commodity prices fading.
The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.		Sentence dropped.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November.	To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.	Reemphasizes the Fed funds rate, brings it up higher in the document, now that QE2 is waning.
	The Committee continues to anticipate that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate for an extended period.	Moved up from below. ?exceptionally low levels for the federal funds rate for an extended period? means that the short end of the yield curve will stay flat as a pancake.
In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and will complete purchases of $600 billion of longer-term Treasury securities by the end of the current quarter.	The Committee will complete its purchases of $600 billion of longer-term Treasury securities by the end of this month and will maintain its existing policy of reinvesting principal payments from its securities holdings.	No real change. They will stealth-fund the US Government to the tune of $600 Billion.
The Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings as needed to best foster maximum employment and price stability.	The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.	They see the end of QE2 coming, and will manage their bloated balance sheet as best they can.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.		Moved higher in the document.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.	The Committee will monitor the economic outlook and financial developments and will act as needed to best foster maximum employment and price stability.	Little real change.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.	No dissent.? Where are the so-called hawks?

Comments

Given that the effects of QE2 are subsiding, the FOMC moves the Fed funds sentence up higher in the document and moves up the language that ?low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate for an extended period.? Means the front end of the yield curve will hug zero for some time, absent a crisis in inflation or credit.
In one sense, the FOMC is emphasizing what they can do in the future, not what is in the past.
The FOMC is a lot more bullish on the strength of the economy than the general public.? Aside from housing, every good thing is continuing, and every bad thing is transitory.
The Fed engages in wishful thinking regarding transitory employment factors? Japan does not have that big of an impact on US employment, nor do food and energy prices, which have been going up for some time.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
Where are the hawks?? This report does not give a fair rendering of the rising risks of inflation, driven by commodity, agriculture, and energy costs.
The Fed is not shrinking its balance sheet anytime soon.

Questions for Dr. Bernanke:

How big is the effect on employment from higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan?
Couldn?t increased unemployment be structural, after all, there is a lot more competition from labor in emerging markets?
Isn?t stagflation a possibility here?? I mean, no one expected it in the ?70s either.
Could we end up with another debt bubble from keeping short rates so low?
If the Fed ever does shrink its balance sheet, what effect will it have on the banks?
Could we have more economic historians on the FOMC, and fewer neoclassical economists?? Perhaps we could end the intellectual monoculture there?? (Even I wouldn’t ask this… I know the answer.)

Book Review: The Misbehavior of Markets

Posted on 22 June 201122 June 2011 by David Merkel

I met Benoit Mandelbrot at a conference at Columbia University back in early 2001.? It was a conference on the use of fractals in a wide number of subject areas, very few of which dealt with economics.? Mandelbrot was on of the few panelists to include anything on economics, though a few of the biologists gave me some ideas.

As far as I could tell there were only two economists at the conference, and we went out for Indian food together at lunch.? I met Dr. Mandelbrot at the wine reception where we discussed the state of the markets.? He and his friend, George Soros, both feared that Wall Street was mishedged, and that a crisis was coming.

Bright guy, though the eventual crisis was a liquidity crisis, and not a hedging crisis.? But the diversity of people in terms of field of study at the conference helps to explain what drove Mandelbrot intellectually.? He saw analogies across a wide number of phenomena, connected by one main idea — similar power laws.

The book points out the now-well-known fact that price changes are more volatile than the normal distribution will allow.? That has impacts on option pricing and portfolio management.

The book’s criticism of Modern Portfolio Theory, another idealistic creation of economists that neglects real world data is excellent.? From a misdefinition of risk as being equivalent to volatility springs the monstrosity of MPT.

The book shoes many ways where the received orthodoxy of MPT and the efficient markets hypothesis fails.? The only reason these idea hang around is that they are accepted uncritically, almost like a cult.? The chapter on the “Heresies of Finance” is particularly good, and poses problems for much of academic finance.

I liked the book a lot, and think that most academics and practitioners should read it.? It will broaden your horizons, even if you disagree after you have read it.

Quibbles

The main difficulty is this: just because A follows a similar power law to B, does not mean that A & B have something in common.? There are often spurious correlations.

Who would benefit from this book:

Most serious investors and academics could benefit from the book.? It will challenge your preconceptions.? That doesn’t mean that everything Mandelbrot writes is correct, but most of his criticisms of MPT are correct.? The question becomes what to replace MPT with?

If you want to, you can buy it here:?The Misbehavior of Markets: A Fractal View of Financial Turbulence.

Full disclosure: I bought the book with my own money.

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.

What I Think Technical Analysis Is

Posted on 21 June 2011 by David Merkel

I have internally debated about writing this for years.? I hold the following? with weak conviction, and invite correction.

If I want to describe fundamental investing, I will use a model of free cash flows.? Now, few value investors invest that way, but most approximate it.? There is one theory behind fundamental investing — the real returns of businesses drive stock prices.

But for technical analysis I see it this way: 80% of the time, follow trends.? 20% of the time, when trends move to extreme levels, resist trends.? None of this involves chart-reading, which to me seems arbitrary.

The way that I view momentum here is in accord with behavioral finance.? But testing this would require a global theory of technical analysis — something that could be mechanized so that the theory, rather than the practitioner could be tested.? Looking at the audited values of accounts of a subset of managers is not valid — we would need to look at all accounts following the same theory, and unsuccessful accounts don’t line up to be identified.

I am still looking for a global theory of technical analysis.? Every chart should be able to have the same analysis applied.? Someone give me the expert system that applies to all situations.

But as for now, I think most of technical analysis is just following price momentum.

What is Liquidity (V)

Posted on 18 June 201119 June 2011 by David Merkel

I am sure that I will write more on this topic, should I live so long.? My contentions are:

Securitization does not create liquidity, it only redirects it.

The Fed does not create liquidity, it only redirects it.

The Treasury does not create liquidity, it only redirects it.

When I wrote this, one reader asked me to expand on this.? Let’s start with the simple one, securitization.? Take a bunch of loans.? How easy is it to trade them?? Not that easy.? The buyer will want to re-underwrite the whole thing.? It will take time, and time is the opposite of liquidity.

But when you securitize, the last loss pieces are very liquid.? After all, they are AAA/Aaa.? But that comes at a cost.? The lower-rated pieces are less liquid for two reasons.? 1) the tranches are small. 2) in a bad situation, the principal could be wiped out in entire.

Securitization does not improve liquidity in aggregate, but it shifts liquidity to the AAA securities.

But what of the Fed and the Treasury?

They don’t create liquidity, as much as steal liquidity from savers.? The Fed creates liquidity through low interest rates, redirecting economic value from savers to debtors.? it is even more transparent in liquidity facilities they create and in quantitative easing, where they put the solvency of the central bank at risk.

Practically, the Treasury and Fed are a unit — think of the Fed as the commercial paper issuing arm of the treasury, though their commercial paper bears no interest, and is redeemable instantly.? We call them dollar bills.

The Fed and Treasury can redirect liquidity to their favorites, but it leaves the rest of the market starved.? The market will heal over time, but it is no credit to the Fed or Treasury.? The market finds ways to heal in spite of the actions of governments.

Wait to Buy Berkshire Hathaway

Posted on 18 June 2011 by David Merkel

Catastrophes come in clumps.? Part of that is the correlatedness of weather.? When disasters are occurring, it may pay to wait until the season is near its end to buy reinsurers.? Who can tell what additional losses will arise in a year where losses are shaping up to be bad?

When there have been many tornadoes, and powerful ones, there are often many hurricanes, and powerful ones.? Wait to see if the hurricane season has some punch, and if it does, wait until October to buy BRK or other reinsurers.

If the season doesn’t have punch, start buying a little in late August or early September, and complete the job in October.

Don’t get me wrong, I like BRK, and would buy it at book value, or near it.? There are many other pure play reinsurers I might buy instead, if they survive the hurricane season.? They would have much more upside.? But in a really bad scenario, after the damage, BRK would be a low risk bet.? In 2005 as the last hurricanes were hitting, I urged my boss to buy BRK — they would be the last man standing in reinsurance.? And indeed BRK moved steadily up from there, without us.

BRK is much more than a reinsurer, but reinsurance will be the main focus for the next four months, so be aware…