June 2011 – Page 2 – The Aleph Blog

Chasing Your Tail Risk

Posted on 18 June 2011 by David Merkel

There are many people out there following aggressive investment strategies, but they want to be covered if things go wrong.? Why not sell down the positions a little and buy some high quality short-to-intermediate-term bonds?

What!?! Give up the upside?!? They would rather buy some insurance — something that will pay off big if things go bad.

But think of the other side of the trade.? What does the one offering you insurance have to do?? It depends if they are scrupulous or unscrupulous.

Scrupulous: Set aside money or high quality assets in reserve, and treat the premiums as part of the the return on a high-yield money market fund, albeit with the possibility of a severe loss.

Unscrupulous: Don’t set anything aside.? Write as many contracts as you can.? It’s free money because there won’t be any crash.? And if there is a crash, declare bankruptcy.? After all, many others will be doing the same thing — you will have company.

Even if the contracts in question are exchange-traded, with margin posted, still the one writing the contracts and taking the risk should be ready to pay the whole wad in the disaster scenario.? Maybe the exchange will make up a few small defaults, but even exchanges can go broke if the situation is severe enough.

In order for tail risk to be mitigated fairly, someone must keep a supply of slack high quality assets.? Rather than the insurer doing that, why not have the investor do so?? The insurer brings along his own cost structure.? Why not self insure and bring down the risk level directly.? Someone has to hold high-quality assets to mitigate risk; let the investor be that party; embracing simplicity and enjoying reduced risk without the possibility of counterparty failure.

Quaint, huh?? And it doesn’t involve a single disgusting derivative, unlike those that would create a “Black Swan” ETF.

Topple the King

Posted on 17 June 201117 June 2011 by David Merkel

In Chess, it is good etiquette to topple your king when the position is hopeless.? Why prolong the agony?

Now, I am only a casual player of chess.? I play maybe? one to three games per year since I turned 25.? I’ll tell you two quick stories.? I played chess on Yahoo! six years ago, and was unrated.? After engaging a game with a “Class C” player, he found himself in a bad position after 20 moves, and said,”You may be unrated, but you are clearly not a beginner.”? I won shortly after that, with him resigning before checkmate.

Then when I was 22, my suitemate at the grad dorm invited me to his father’s 50th birthday party. (Being 50 now, it makes me think.)? A fellow asked me if I would like to play chess.? I said yes, and in a long, closed, ugly game, he crushed me.? I toppled my king, so as not to prolong the agony.? He grinned at me and said, “Good game.? I’m a rated chess Expert.? Want to play again?”

The grin got me, so I said yes though I knew I could not beat an Expert.? I was a Class C player at best.? I was White this time.? I played an aggressive open game and somehow forced a checkmate on move seventeen with his king in the center of the board.? The look on his face was precious to say the least.? Then the surprise came.? An old guy watching behind me said, “You have talent with combinations in open games.? Do not play closed games.? I am a Chess Master.”? He then proceeded to play the Expert, and trounced him solidly.? I did not dare play him, though there was no opportunity.

My personal history in Chess is only here to describe when one should give up.? My view is that the EU should give up on the Euro, and plan now for its demise, going back to individual currencies for each nation.? The experiment has failed.? Topple the King.

If all Eurozone nations collectively give up on the Euro, and it ceases to exist, after a period where national currencies float against the Euro to determine breakup value, that would be a good thing.? We all have known that it is impossible for monetary union to exist without political union, unless a small nation be a slave to a larger one (US-Panama).

Is Greece having a liquidity problem or a solvency problem?? I think it is the latter.? Extensions and additional loans to a country that has structural solvency problems will not solve the problem, but merely extend the problems.

If you are in Germany, France, or the Netherlands, rather than bailing out Greece, take the cheaper route — bail out your banks for losses on Greek debt, and be prepared to do it for other weak Eurozone nations.? Prepare for the dissolution of the Eurozone; it is coming.? Topple the King.

Or , be more aggressive, end the Eurozone entirely because it is flawed in entire, and let national currencies re-emerge.? It will be better for all nations involved.? Germans won’t? have to subsidize others, and Greeks will be able do devalue and survive, as in the past.

To the Eurozone, I say, “Topple the King.”? You should have done it long ago for the good of all.? Free trade is a good thing, but a common monetary policy is not.? Give up before you are checkmated by the global bond markets.? It may come slowly or quickly, but it will come.

PS — to this day, I don’t play closed Chess games.? My winning percentage has gone up.

Book Review: Reckless Endangerment

Posted on 16 June 2011 by David Merkel

This book on the crisis is different for two reasons:

1) It focuses on the causes of the financial failure, and the history behind them.? It spends relatively little time on the failure in 2008.

2) It spends almost all of its time on the GSEs, Fannie Mae and Freddie Mac.? They were big contributors to the crisis, but they weren’t the majority of the crisis.

This book chronicles the growth of the housing bubble, which was a financing bubble, as most bubbles are.? How did financing for housing get so cheap?

Low interest rates from the Fed.
Lower underwriting standards from Fannie, Freddie, and independent lenders.
Trickery from lenders offering a low initial rate.
Pressure from Congress to make more loans to low-income borrowers who should have been renters.
A mistaken idea that more housing owned by residents was good social policy.

It also describes many of the people who disproportionate benefited from the bubble, and what their motives were for helping to expand the bubble.? It also mentions many who tried to fight the bubble unsuccessfully.? It does *not* mention the “Fannie Fraud Patrol,” who helped to uncover Fannie Mae’s errors in 2003-2004.? It was a loose group of analysts who found inconsistencies in Fannie’s financial statements… we fed OFHEO.? I was one of them, and I have the T-shirt to prove it, even though my contributions were the least of the group.

One? more note: consider Walker Todd, reprimanded by the Fed in 1993 for suggesting that the Fed should not be allowed to bail out non-banks.? Prescient guy, punished of course.? He was one of many who took the chance and fought the Fed or the GSEs.? Almost no one comes out the better for that effort.

Quibbles

The authors blame the rating agencies rather than the regulators that demanded that ratings be used, even if the agencies were less than certain about their models.? Real bond investors never look at the ratings, except as investment policy constraints.

Who would benefit from this book:

It’s an easy read.? This book benefits from having a good writer, and someone who actually knows that markets.? Great combination.? Most people would benefit from this book, because it would disabuse them of the notion that the actions of the government are for the good of the nation.? Special interests won, and many average people lost.

If you want to, you can buy it here: Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon.

Full disclosure: The publisher asked me if I wanted the book and I said “yes.”

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.

Correction: How to Make More Returns on REITs

Posted on 15 June 201115 June 2011 by David Merkel

I want to thank Geoffrey Ching for spotting an error in my post How to Make More Returns on REITs.? He even came up with what I did wrong; my signal was off by one month, producing returns way too good to be true.? So is the strategy wrong?

No.? It’s still a good strategy, just not astounding.? Here’s the double quintile for mortgage REITs:

And for equity REITs:

Here’s the return graph for equity REITs:

And that for mortgage REITs:

It feels intuitively right that Mortgage REITs don’t beat equity REITs, even with a better strategy for both.? The momentum strategy boosts? the returns on mortgage REITs from 5.1% to 11.1%.? For Equity REITs it moves from 12.0% to 14.0%.

I don’t wonder at this result.? Indeed, my shame is that I didn’t probe the last result more.? This is still useful for those who would pursue momentum, just not as useful as the first article.? And with that, I apologize to my readers for my prior error.? It is my policy to correct errors once I am convinced of them.

Plan Your Giving

Posted on 15 June 2011 by David Merkel

During hard economic times, fundraisers for charities get desperate.? Their endowment, if any, has shrunk, former less-well off patrons are less certain of their wage incomes, and are less prone to give; well-off patrons have fewer appreciated assets to offer.

I’ve been getting a spate of such calls recently.? I tell them that I plan my giving each year, and do not give to anyone else, no matter how worthy.? If they want to be considered for next year, send data to me via postal mail.

They never send it, at least not yet.? They only want the money now, not in one year.? If that ‘s the attitude, I don’t want to give.? For years I have wanted to give money to the local volunteer firefighters, and I talked to the chief, and said that I would give, but for my charitable giving trust, I needed their tax ID number.? He said that he would certainly get it to me.? He never did.

We all have different goals for charitable giving.? I’m not telling you where to give.? But analyze how much is spent on the mission in question versus supporting organizational infrastructure.? You want to see a high ratio there.

I only give to organizations where I know those that run the place; sometimes I help out.? But when I trust an organization entirely, my gift goes to? “where most needed.”? Why? Because someone has to support the internals of the organization in order for the mission aspects of the organization to operate.? If you know that the leaders are minimizing costs, acting honestly, and dead-set on pursuing the mission, give without restrictions.

And that brings up another aspect of my giving.? Give big to a few, and nothing to others.? The few that you support you should know well, to the degree that you might not only give money but time.? Charitable giving should be an expression of what you value most in society.? And by focusing, you will only support worthy causes, rather than “a little here and a little there,” where you lack of oversight allows charities to misspend money.

Final notes: by planning your giving, you eliminate those that make emotional appeals, and give rationally to what you would like to see prosper.? At worst, leave a small percentage of total giving for unexpected appeals. ? One value of this is that it starves the paid fundraisers that eat up a large part of the money given, who are not a charity at all, and charities should be discouraged from using them.

In the end this will reward the best charities, and starve the worst, which is a win-win.

Learning to Like Lumpiness

Posted on 11 June 201114 June 2011 by David Merkel

Simplistic financial plans assume a smooth return that the client will earn.? Why?? No nefarious reason, but planners don’t know the future, so they either:

1) Assume an average rate as a baseline for calculations, or

2) Display the average, median, or some? percentiles from a series of randomly estimated possible futures.

But life isn’t that way.? Markets are lumpy.? High and low returns happen more frequently than average returns.? What’s worse, returns tend to streak over years and decades.? So much for the Efficient Markets Hypothesis.

So what to do?? Better to be like the great moral philosopher Linus van Pelt, who carried a candle at night, and his sister Lucy asked him why he was doing so.? Linus replied, “It is better to light a single candle than to curse the darkness.”? After Linus left, Lucy mused for a moment, and shouted, “YOU STUPID DARKNESS!”

Volatility is a fact of life, and even the volatility is volatile, with regions of seeming stability, and regions of extreme booms and busts.

My “single candle” is simple — it is an adjustment of expectations, which involves reasoning that when things have been horrible, after some amount of time, it is time to take risk again, before it is perfectly obvious to do so.? Same thing when things are great, it may be time to take risk off the table.? I would add that delay in doing so is not a failure — lumpiness means that trends run further than would be reasonable.? But when the momentum wanes it is time to change.

I’ve been in the situation multiple times, but it is really difficult to get permabulls or permabears to recognize that something has shifted.? I wrote about this a number of times in my series “The Education of a Corporate Bond Manager.”? I was constantly fighting those who were hanging onto the old trend too long.

And at another firm, I could not convince my boss to go long once the nadir of the credit crisis had passed.? He expected more trouble to come, while I looked at the bond market and found an absence of distressed credits.

The lesson of both cases is that opportunities to earn total returns or preserve capital are lumpy.? If the market is longing for safety now, it will likely do so for a while, and the same is true for bull markets.

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Many retirees say “I just need a certain reliable income of X%/year. Please get that for me.”? We may as well tell these people to buy a CD or annuity, except that Fed policy makes the rates inadequate for their needs.? And yes, this is a deliberate policy of the Fed, picking on the elderly and the conservative in order to fund marginal lending that might? result in some tiny increment of growth.

It is far better to ask three questions:

1) Where are we now in the credit risk cycle? Rising, Peak, Falling, or Trough?

2) Where are yields on high-grade corporate bonds now?

3) Can you afford to spread your yield needs over five years?

Bond investors need to realize that most returns of the bond market are earned at three times: first, after the nadir of the credit cycle, credit-sensitive bonds soar.? Second, during deflationary times, buying long-dated Treasuries.? Third, when inflation is running, rolling over short-dated fixed income claims.? Beyond that, one can clip bond coupons during abnormal times of stability.

By asking the above first two questions, we can ascertain whether it is a favorable time to take risk or not, and what sort of risks to take.? The last question is more of a reasonableness check on the client.? If he has to have the return every year without fail, tell him to seek it at a bank or insurer, and see if he is pleased with the results.

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But now take it one step further.? When will our stupid economists and politicians get it through their heads that lumpy economic growth is normal, and even that it is desirable that growth is not smooth?? Effort to produce a smooth economy led to a debt build-up, which ultimately sabotaged growth.? Far better to let small recessions do their work, and leave the Fed funds rate high until marginal investments are repriced, with the attendant bankruptcies.

The US economy grew more rapidly when there were no efforts at stimulus.? Yes, there were severe recessions, but the booms thereafter more than made up for it.? Though it would hurt a lot in the short-run, far better to end the deficits of the US government, and the pitiful efforts of the Fed, giving greater certainty to the private sector, that businessmen could make long-term decisions without worries that taxes, regulations, or interest rates might change dramatically.

Like it or lump it, some say.? Why choose?? Learn to like the lumpiness of the asset markets and the economy in general, and many things will go more easily for you.

On Redistricting

Posted on 11 June 201120 June 2017 by David Merkel

Given all the brouhaha that exists over redistricting, I thought I would give one simple idea that would free our nation and states from tyranny. ;)? Turn the job over to a computer.? Yes, take the blood and politics out of it, and let computers make fair districts.

How do we do that?? Simple.? You need a computerized map of the political entity being divided, and the locations of the voters.? You give the computer a simple instruction: minimize the length of the internal boundary lines within the political entity, subject to the districts being roughly the same population.

No one can argue that such a method is not fair.? It produces compact, convex districts that look? fair, and no one needs to say a word — just accept the output of the computer.

What would be the benefit?? Districts would be a lot less polar, and seats would not be as safe for incumbents.? And when the new census comes out — boom! Many politicians would find themselves fighting for their lives in new districts that don’t fit them.

This could herald the return of the citizen-lawmaker, because it would be difficult to maintain a seat for a long time.? Perhaps with some help, such as permanently disallowing politicians from being lobbyists, it could make a genuine change in the way our government works.

PS — In my life, I have been approached by others to use my math skills to gerrymander a large state in the US.? I refused (at age 29), though I knew how it could be done.

Book Review: Enchantment

Posted on 11 June 2011 by David Merkel

How do you get people to like you?? Love you?? Be insanely passionate over you, and what you do, sell, etc?

If the book “Enchantment” is correct, it means you have to become the person that inspires people in what ever you are pursuing.? It means that you have to be:

Likeable
Trustworthy
Prepared
A risk-taker who produces
A salesman (in a good sense — you are out to persuade in a good cause.)
Persistent, and make persuasion stick.

But that must extend to customers, employees, and all influencers.? If you are not your own boss, you must manage up and learn to influence the boss as well.

Beyond that, learn to use both push and pull technologies to make people want to know what you are about.

Finally, as with all marketing texts, the reader becomes educated on techniques.? It helps to inoculate you against others who try to use such techniques on you, particularly those that have nothing to offer.

I enjoyed the book and would recommend it to others.? Guy has a gift for making the complex simple.

Quibbles

I may come off as a prude in saying this, but there is never a? good time to use crude language.? It is a substitution of negative emotion in place of thought.? I have never yet found a situation where one could not use clean words to express the same idea that profanity aims for.? Also, workplaces where profanity is common among leaders spawn it among followers.? Everyone is worse off, and your company will come of as rude or lower-class.

Who would benefit from this book:

Many would benefit from this book.? It has a lot of good ideas that would aid your marketing.

If you want to, you can buy it here: Enchantment: The Art of Changing Hearts, Minds, and Actions.

Full disclosure: I asked the author for the book and he sent it to me, apologizing for the delay.? Guy, thanks for sending it, delay or not.

Industry Ranks June 2011

Posted on 10 June 201110 June 2011 by David Merkel

I?m working on my quarterly reshaping ? where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted??? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I?m not saying to change if things are working well.? I?m saying don?t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and to a lesser extent Reinsurance, particularly those that are strongly capitalized.? I?m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word about reinsurance: I suspect this year will have yet more property catastrophes, particularly from hurricanes.? A lot of flexible capital has rolled into Bermuda over the last few months, so I would be disinclined to play too heavily there until late in the year.? There’s too many financial players that think there is easy money to be made in reinsurance after the recent spate of catastrophes, but that added capital is eliminating any hard pricing environment that might have emerged.? Maybe if they take losses later this year, capital won’t flow so freely for a while… I can dream.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.? The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I?m looking for undervalued and stable industries.? I?m not saying that there is always a bull market out there, and I will find it for you.? But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.? I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.? The red zone is pretty cyclical at present.? I will be very happy hanging out in dull stocks for a while.

That?s why I?m not digging through any red zone stocks this time.? I don?t see the value, especially if we have a slowdown globally, and/or in the US.? I don?t trust this economy.

Simplify Corporate Taxes

Posted on 8 June 20118 June 2011 by David Merkel

Longtime readers know that I favor a simplification of the tax code, for both individuals and corporations.? Working as an actuary inside life insurance companies, I saw the complexity of accounting with up to seven accounting bases running at the same time.

Let me suggest one very simple modification to the tax code — let the IRS tax corporations on their illustrated income, with GAAP income as a minimum.? All other tax preferences are abolished.? The idea is this: corporations want to show shareholders how successful they are.? The basis that they choose to use? to show how successful they are is directly applied to taxes.

This would have one of two effects: either companies would stop illustrating income greater than GAAP, and GAAP would become more conservative, or companies would start paying more taxes.

As for private equity, they could not disclose changes in unrealized capital gains as part of their returns without being taxed on it.? Alternatively, we could consider a 15% of book value as imputed income tax, with a true-up when the fund is liquidated.

As for Buffett, let him retract his statements about increase in book value, lest BRK be taxed on it.

And mutual funds and hedge funds, they are corporations also — tax them on total returns.? Illiquid investments should be assumed to earn 15%.

The idea here is to strip away all tax deferral, and force everyone to pay taxes each year — this will work a lot better than the Alternative Minimum Tax.