Month: November 2012

Don’t be a Fool

Don’t be a Fool

Posted on by David Merkel

When I wrote for RealMoney, I would often write things critical of others, but not identify my target.? Why?

  • I didn’t want to get kicked out, or have a fight that would discredit RealMoney.
  • But I did want to teach general principles.

I maintain that practice to this day.? Typically, I don’t name names.? Again, two reasons:

  • I don’t want to get sued.
  • But I do want my readers to understand what are shoddy practices, so they can avoid them.

Recently, a large investment website has been loosening up their standards for who they will allow to advertise via e-mail.? Here is one redacted advertisement:

A New Strategy With Startling Results

Dear Investor,

A small group of XXX clients are making 20% to 40% in trading profits…PER DAY.

They call it ?Exploiting the Banker?s Market.?

Their trading methodology is unlike anything you?ll find in today?s financial marketplace.

And best of all, their newsletter is totally free.

Honestly, this is the only investing newsletter worth your time.

?Sign up for free now. [link removed for your protection]

Sincerely,

XXX Investing Team

P.S. By exploiting the banker?s market, they just hit winners on 19 out of 22 trades, including gains of 45%, 48%, 56%, and 78%.

Prior to this, they took gains on 30 out of 33 trades. You can achieve these same returns. It’s simple.

As long as the bankers remain in control of the markets (and now that Obama got re-elected, you know they will), this unique trading methodology offers you a safe and consistent way to profit.

If you?re interested in profiting day after day ? even if the bankers and the Fed are working against you ? then do not miss these unique trading strategies.

It?s all revealed to you in this free newsletter. [link removed for your protection]

YYY
30 Forest Ave
Naperville, IL 60540

Note that YYY is a penny stock promoter.? XXX may be decent enough, aside from their willingness to employ YYY.? Investing in options is a ticket to the poor house for most, because the market is not very liquid.? It is very hard to make money trading options.? Most lose money doing so.

But here is another from the same e-mail list:

Dear Investor,

Where were you on August 13, 2012, when tech-stock guru WWW gave the green light on EZchip Semiconductor (EZCH), then trading at $28.36?

Well, maybe it doesn?t matter because very few investors had ever even heard of this red-hot networking chip company.

But on November 8, EZchip reported a huge earnings beat and rallied an incredible 15% to $34.80 in one day, delivering a 23% gain for ZZZ subscribers [link removed for your protection] who bought alongside Sean at the $28 level.

So we?ll ask you some simple questions?

  • Do you want to make money off of hot technology trends that have nothing to do with how the US Fiscal Cliff and European drama play out?
  • Would you like to get in on the hot storage play at which Facebook (FB) and Apple (AAPL) are throwing money?
  • Or the semiconductor producer that is printing money on the global transition to 4G/LTE smartphones?
  • How about the left-for-dead social-media play that is about to rise like a phoenix?

If you answered yes, then we’ve got an offer for you.

We?re giving you an exclusive 30% discount on an annual subscription to ZZZ [link removed for your protection] , WWW?s exclusive money-making tech stock newsletter that will help you do all of the above and more.

For just $447 (a savings of nearly $200!), you?ll receive:

? ? ? ? ?
? ? ? Exclusive access to WWW?s hand-picked portfolio of technology stocks ?
? ? ? ? ?
? ? ? Instant e-mail updates whenever WWW makes a trade or initiates new coverage ?
? ? ? ? ?
? ? ? Expert analysis of the most important tech-industry news ?
? ? ? ? ?
? ? ? Access to quarterly webcasts, where WWW delivers in-depth analysis of the technology industry ?
? ? ? ? ?
? ? ? WWW?s special report: 5 Stocks That Will Gain 50% From Apple TV ?
? ? ? ? ?

But most importantly, with a ZZZ subscription, you will get direct access to Sean, who stands by ready to answer any and all reader questions through our regular mailbag feature.

Sean?s goal is simple: to have your ZZZ subscription pay for itself many times over through winning trades while keeping you up to date on everything that?s hot in tech.

So, do you want in? [link removed for your protection]

Advertisements like this appeal to dopes.? There is no easy money in the market.? Anyone can cherry-pick a record of risky calls and show a bunch of wins.? What of the losses? How many and how severe were they?? Why don’t you show the results of an audited real money portfolio that you managed?? What, you didn’t put any real money behind? these calls?

Look, when advertised results are too high, they usually aren’t real.? Get smart.? Avoid websites that propagate such nonsense.? Anyone willing to sully their reputation for a bunch of cheap advertising revenues is not worth your time.? I get about 10 advertising proposals per week, and I turn almost all of them down.

If it seems too good to be true, it is false.? Avoid reaching for the rare exception, and you will be much better off.

The Rules, Part XXXV

The Rules, Part XXXV

Posted on by David Merkel

Stability only comes to markets in a self-reinforcing mode, from buy and hold (and sell and sit on cash) investors who act at the turning points.

Beyond the vicissitudes of the markets, there are businessmen.? They have a sense of what their capital costs.? They reason regarding acquisitions and selling off their own holdings/subsidiaries.? They ask themselves how permanent current financing conditions are likely to be.

They don’t play momentum; they just look for when buying or selling businesses makes sense.? The market, on the other hand, has many that only want to buy what is rising, and sell what is falling, to a first approximation.

The market is about business, not stock trading.? Businesses are primal, trading markets are secondary. When businessmen find a publicly-traded business trading at an attractive value, they buy it, particularly if there are synergies between the businesses.? Thus during the bust phase of equity and credit markets, M&A often consists of cash-rich firms buying out firms that are in distress.

The same is true in boom times.? Companies sell themselves, or subsidiaries to leveraged players who think the game will go on much longer than reality will bear.? The sellers sit on the cash; the buyers enjoy the losses when the bust comes.

Volatile markets favor those with strong balance sheets — those that can wait for a better day, or, those that can wait for better opportunities. In either case, they can wait; they do not have to buy or sell now.? They are experiencing no cash flows forcing them to action.

Those with strong balance sheets focus on return on book capital, and avoid leverage.? They look to grow the book value (“net worth”) of their company, and ignore secondary goals.? They are shareholder-oriented.? They take advantage of both sides of the boom-bust cycle — selling near peaks when return on capital is lousy, and buying near troughs when return on unlevered capital is fat.

This is simple stuff, but hard to execute, because the fear/greed cycle interferes with rational calculation.? Regardless, absolute valuation investors put in the tops and bottoms of markets by their selling and buying.? To the degree that technical analysis works, it is because they trace the bread crumbs of large valuation oriented investors.

That’s all for now.? Thoughts?? Give it to me in the comments.

 

Sorted Weekly Tweets

Sorted Weekly Tweets

Posted on by David Merkel

 

Politics

 

  • California Democrats seize super majorities in both houses of Legislature http://t.co/Wp2cVYTF CA businesses plan exit strategies $$ Nov 08, 2012
  • Harsher energy regulations coming in Obama’s second term http://t.co/JHDKAhok Fracking, chemical emissions, & more $$ -losing green energy Nov 08, 2012
  • US crop insurance a post-election target, farm bill elusive http://t.co/9OdbRVjy W/Ag doing so well over last 5 yrs, this should b ez, not Nov 08, 2012
  • Ethanol Going Ugly Turns Bush Plan Into Obama Test http://t.co/Pe6ixxc1 Should b a no-brainer, but Congress ag state politics r ugly $$ Nov 08, 2012
  • Could This Be End of Evil Filibuster? http://t.co/t72aR3OR Limit filibusters to actual votes & require physical presence on the floor $$ Nov 08, 2012
  • Obama Win Means Health Overhaul to Move Ahead in States http://t.co/ybXggsLt Destroy health care 2 replace it w/single-payer system $$ Nov 08, 2012
  • Yep, There Have Been Problems With Email Voting in New Jersey http://t.co/lZjzVNrG In general, probability of fraud in voting is rising $$ Nov 07, 2012
  • Defense Fund Rockets to Four-Year High: Romney Rally? http://t.co/3fzUDRTH Discounting Obama’s change of heart after election $$ 😉 Nov 06, 2012
  • Romney Threatens Pimco?s Gross With Bernanke-Dumping Plan http://t.co/xO6Tm0aF 2 many links in the chain of reasoning; low prob correct $$ Nov 06, 2012
  • Southfield Twp. voter appears to die, then asks ‘Did I vote?’ http://t.co/2ZwRgotp I found his words to his wife 2b touching in many ways $$ Nov 06, 2012
  • Tuesday Is Election Night, Be Careful What You Tweet http://t.co/UdPPMYiJ Measure twice, cut once, tweeps. & bring a dose of skepticism $$ Nov 05, 2012
  • Three Men Make a Tiger http://t.co/eX1PziJK John Mauldin predicts Romney as victor; piece is mostly about eliminating confirmation bias $$ Nov 05, 2012

 

China

 

  • China: Worse Than You Ever Imagined http://t.co/Kp69IC1n 40MM+ people were killed during the “Great Leap Forward.” Mao deserves derision $$ Nov 08, 2012
  • China’s leadership challenge in new era: douse “inequality volcano” http://t.co/pJiAksUl Widespread poverty in China scares Communist Party Nov 08, 2012
  • A Cheerleader for Mao’s Cultural Revolution http://t.co/d3RhdV95 Lied about Cultural Revolution & The Great Leap Forward. Millions died. Nov 08, 2012
  • The Chinese Credit Bubble – Full Frontal http://t.co/MDZn1jCs As I have argued for some time, total debt in China is quite high $$ #danger Nov 07, 2012

 

Companies

 

  • Peltz Takes Stake in Danone http://t.co/P1AdRe9G Danone $DANOY is a French firm, will be difficult to encourage change $$ Nov 08, 2012
  • Prudential Records $618 Million Loss on Derivatives http://t.co/6ZQK1Uk5 I worry about life industry; the acctg 4 secondary gtees: yuck $$ Nov 08, 2012
  • Nucor Galvanizes Gas Hopes http://t.co/NmfZ9fmJ $NUE provides capital 4 development of gas resources of $ECA -Gets 50% stake in wells $$ Nov 08, 2012
  • Office Depot-OfficeMax Deal Seen Rescuing Value http://t.co/bNsFKuJU The failure of office retailers as the non-profit $AMZN undercuts $$ Nov 07, 2012
  • SapuraKencana Agrees 2 Buy Seadrill Tender Rigs http://t.co/XXrAsjFj Interesting deal, clever investor; expands Malaysia exposure $SDRL $$ Nov 05, 2012
  • Sharp blunted, and it?s not alone http://t.co/5jTHzKuN Argues that Japanese electronics mfg & exports r getting killed by strong yen $$ Nov 04, 2012

 

Federal Reserve

 

  • Inflation, QE and forcing the banks to lend http://t.co/XuPgRPJm I’ve subscribed 2 The Economist for 25 years; they r getting dumber $$ Nov 04, 2012
  • Casting Dual Roles, at Treasury & the Fed http://t.co/kIwpAzZ3 Bernanke’s Last Supper & The Return Of Larry Summershttp://bit.ly/Sp9PBZ $$ Nov 04, 2012
  • Off of the last tweet, it would be nice 2c Bernanke retire; he really may b tired of the abuse. His prob was he thought he knew what 2 do $$ Nov 04, 2012
  • & as a result, could not c that Neoclassical macro does not work with an overindebted economy. We need fewer economists at the Fed & Tsy $$ Nov 04, 2012
  • Wrong: Seth Klarman Goes Nuts On The Fed In His Latest Investor Letter http://t.co/G6gAkMfU Y I think value investors should run the Fed $$ Nov 04, 2012
  • Seth Klarman, like most value investors, is farsighted & not just thinking about how to goose GDP for the next year. Klarman 4 Fed chair $$ Nov 04, 2012

 

Eurozone

 

  • Convergence between the core and the periphery economies in the Eurozone http://t.co/2oD2exeV Drowning PIIGS pull Germany & France under $$ Nov 08, 2012
  • ECB & Fed: Worlds Apart http://t.co/zZuaFiXU Axel Merk praises the ECB & disses the Fed. Argues that ECB has not gone fiscal as the Fed has Nov 08, 2012
  • Unsteady Greek Coalition Faces More Strikes http://t.co/dxQJYzmw Suspect they make it through; Greeks don’t want 2 leave Eurozone yet $$ Nov 05, 2012
  • The peripheral threat to France http://t.co/0atOAKZq Many of the PIIGS r getting more competitive relative 2 France. No E-zone w/o France Nov 04, 2012

 

Rest of the World

 

  • Old People Versus Babies, In One Graph http://t.co/Erk2Mu8z Global demographic crisis in one very easy to manipulate graphic $$ Nov 08, 2012
  • Iceland Sees Mortgage Bubble Threat From Foreign Cash http://t.co/djtYZDxw The problems of capital controls start to bite $$ #nofreelunch Nov 06, 2012
  • Turning Trash Into Tidy Profit http://t.co/FvM32C3a Optimistic story on turning trash into durable building materials in Senegal $$ Nov 05, 2012

 

Sandy and Disaster

 

  • Frederick County teen wins regional science competition http://t.co/F72thGx3 The software can read a picture & tell where it is. $$ Nov 08, 2012
  • Sandy’s Aftermath: Samuel Pritt Develops Geolocation Software http://t.co/InnwZaGe Young friend won Siemens US Science Competition $$ Nov 08, 2012
  • Insurance divides haves from have-nots after Sandy http://t.co/NngZdchm Insurance is for catastrophes; scrimp on frequency, not severity $$ Nov 04, 2012
  • Reserved Buoyancy, Down-Flooding, and Living Off the Grid http://t.co/TXxn9f6e The value of slack in physical systems, especially boats $$ Nov 03, 2012

 

Market Dynamics

 

  • FIRE IN THE DISCO! http://t.co/YComOnGA @reformedbroker warns us that a recession is coming, & talks about a decline in corporate profits $$ Nov 08, 2012
  • Even 6.75% is too high. Looking at the Q-ratio, CAPE10, & long high quality bond yields would make 4% more realistic http://t.co/vjP0X7y1 $$ Nov 06, 2012
  • Lightening the Pension Load http://t.co/bi2j6cdJ Never thought I’d c terminal funding return; can b bad 4 annuitants if insurer fails $$ Nov 06, 2012
  • Fitting Factors Into the Formula http://t.co/35speWwR Bob Arnott& Cliff Asness discuss quantitative investing; long article worth reading $$ Nov 06, 2012
  • TAGP expiration will put downward pressure on short-term yields http://t.co/YgwmR2bu Once guarantee goes, much S-T $$ will look 4a home $$ Nov 06, 2012
  • Cash as Trash, Cash as King, and Cash as a Weapon http://t.co/fWS1TOTl In different environments & hands, cash has different properties $$ Nov 06, 2012
  • Wrong: Is Your Manager Skillful?or Just Lucky? http://t.co/vJu2tTrd Bill Miller neglected “margin of safety” & reaped bad results $$ Nov 05, 2012
  • http://t.co/VRj1k4Vg They didn’t read paper closely. Performance of anomalies diminished, not destroyed, by publishing academic research $$ Nov 05, 2012
  • For John Maynard Keynes, Economic Theory Was a Sideline http://t.co/IVdB6Gyc He was a better investor than he was an economist $$ Nov 05, 2012
  • It?s the Earnings, Stupid: ?Atrocious? Q3 Turns Josh Brown Cautious http://t.co/a2ChJKTL Time 2b cautious says @reformedbroker. Calendar? Nov 05, 2012
  • “All I know: The next bankruptcy cycle, whether in 2 or 3 or 4 years, is going to be one for the ages. Count on it.” http://t.co/xtHy7lqj $$ Nov 03, 2012

 

Policy

 

  • A New Idea of How to Fix the Ratings Agencies http://t.co/fTEECPUP by @carney | My response: http://t.co/3dWFo2Pv $$ Nov 06, 2012
  • Investors won?t read the fine print http://t.co/t2W8Nrk9 Even many institutional investors become overworked, lazy, etc. & don’t read $$ Nov 06, 2012
  • Hero of the day, CPDO edition http://t.co/wIxyPo2T I remember 2006 when @alea_ @interfluidity & I (@ Realmoney) were criticizing CPDOs $$ Nov 05, 2012
  • Health-Care Law Spurs Shift to Part-Time Workers http://t.co/0ui2LGvm Law of unintended consequences: How 29-hr workweek got created $$ Nov 05, 2012
  • 10 things walk-in clinics won?t tell you http://t.co/qKPj3D3R Major factor is the loss of continuity u have w/doctor who knows u $$ Nov 05, 2012
  • After Bailout, Giants Allowed to Dominate the Mortgage Business http://t.co/K9HZZWDu “Is this what we saved [the financial system] for?” $$ Nov 04, 2012

 

Retweets

  • Can say that again RT @bespokeinvest: Wow, big selloff in the last couple minutes of trading. Dow down 430 points since Tuesday’s close. $$ Nov 08, 2012
  • Some gift RT @pdacosta: Gift that keeps on taking: France, Belgium agree to pump 5.5B euros into bailed-out Dexia http://t.co/qgq8PI6R Nov 08, 2012
  • RT @ReformedBroker: This Greek austerity bill is the equivalent of slapping a Kick Me sign on the Troika’s back. Gives us one day’s peac … Nov 07, 2012
  • Rupert goes back to sleep $$ RT @felixsalmon: RT @dansabbagh: Pearson says FT is not for sale. “This particular Bloomberg story is wrong. ” Nov 06, 2012
  • RT @SimoneFoxman: you’ve got to be kidding me. — Southfield Twp. voter appears to die, then asks ?Did I vote?? http://t.co/2ZwRgotp Nov 06, 2012
  • First of many 2 come RT @FrancesDenmark: Indiana is the first state to drop its pension return expectations below 7.0% http://t.co/ir8anqN4 Nov 06, 2012
  • Murdoch would b interested $$ RT @ReformedBroker: The Financial Slides RT @TheStalwart: Who will buy the FT? Maybe BI in a reverse merger? Nov 06, 2012
  • Bite your tongue 🙂 Janet Yellen has exceeded the Peter Principle $$ RT @fundmyfund: precious metals say = janet yellen here we come Nov 06, 2012
  • Easy 2 talk tough, hard 2 not repay $$ RT @munilass: So much for cities standing up to Calpers http://t.co/xWIciI4C Nov 06, 2012
  • marriage changes u $$ RT @moorehn Surprising: single & married women are further apart politically than men & women r http://t.co/b4adY1pc Nov 06, 2012
  • Probably priced in $$ RT @kyles09: isn’t the exp of TAG a negative for the big bank stocks or do you think it is already priced in? Nov 06, 2012
  • I was just looking forward to the end of the political season, sigh RT @jfahmy: Hillary Clinton listed as current 2016 favorite (6:1 odds). Nov 05, 2012
  • Dog bites man RT @TheStalwart: National Review endorses Mitt Romney http://t.co/ZBAptg8Q Nov 05, 2012
  • Wow $$ RT @businessinsider: New York Magazine’s Breathtaking Cover Shows Manhattan From Up In The Sky by @KimBhasin http://t.co/FaTgCqA1 Nov 03, 2012

 

Replies

  • @valuewalk Thanks. $DANOY might do what they can to improve margins, but might play badly in France. Has mgmt been s/h-friendly in past? $$ Nov 08, 2012
  • @Frank_McG Very cool. We homeschool — only 4 left, 1 senior, 2 freshmen & a 5th grader. My wife is having a blast. $$ Nov 08, 2012
  • @TheOneDave You’re welcome — you do some great stuff Nov 07, 2012
  • @TheOneDave Hey, Dave, don’t see where we can get the Chart… Nov 07, 2012
  • @amacker Floating NAV, hehe Nov 07, 2012
  • @TheStalwart My friend and former boss Eric Hovde would have beaten Baldwin, and handily… Nov 07, 2012
  • @kyles09 My actuarial conservatism, and knowing that God can do whatever he wants with me Nov 07, 2012
  • @carney I hear you: I’m going to write a piece where I take my “eliminate the rating agencies model” and clarify it http://t.co/x4WsWaj3 $$ Nov 06, 2012
  • @PragCapitalist Thanks, Cullen. I applied that idea to corporate board elections when writing 4 Realmoney, Shame it didn’t get traction $$ Nov 06, 2012
  • @michaelroston Yes, but there is a lot of $$ on both sides, and the phones ring. WV & PA gambling firms & Christians vs MD gambling firms Nov 06, 2012
  • @michaelroston However, if you live in MD all u hear about is 7, the ballot measure expanding gambling. Other measures: <crickets> $$ Nov 06, 2012
  • @BradErvin1 That’s what I am saying — they r taking consensus risks $$ Nov 05, 2012
  • @BradErvin1 But my point about the balanced funds is this: in the selection he could invest in, they r all taking the same broad risks Nov 05, 2012
  • @BradErvin1 57, Married, one kid at home, significant assets good job, wife w/good health, 52, he not so healthy, has saved aggressively Nov 05, 2012
  • @FriedrichHayek I knew that Keynes got bailed out once (or was it twice?), but he learned from his losses, & was far better at the end $$ Nov 05, 2012
  • @MarketIntegrity @CFAInstitute @CFAcareers @CFAevents You might want to get different logos; it makes you look like u r RT-ing yourself $$ Nov 05, 2012
  • @japhychron Bingo. You got it. Nov 04, 2012
  • @TeamHeadwaters Forgot about that.. those are some of the best limestone deposits in the world, in an area ideal 4 potato farming, right? Nov 04, 2012
  • @nelson3748 That seems correct, but doesn’t S. Korea have the same issues w/the Chaebol, & they r functioning ok, seemingly… Nov 04, 2012
  • @munilass Thanks. I put it on my wish list. We discussed mishedging in the finance markets, Soros, &c. Nice of him 2 spend time w/little me. Nov 03, 2012
  • @munilass What’s the title of the book? I spent about ten minutes talking with him in early 2000 at a Complexity Theory conf @ Columbia U Nov 03, 2012

 

Comments

  • I suspect that Obama ends up winning the popular vote as well, and maybe surpasses 50%, fwiw, which isn’t much… $$ Nov 07, 2012
  • Best thing about elections: they’re over. Second best: gridlock continues. Worst: Four more years of Bush-clone Obama. $$ Nov 07, 2012
  • “Stocks aren’t GDP futures, so its not a lock that they immediately fall during the recession?” ? David_Merkel http://t.co/CdH1CNuP Nov 08, 2012
  • Last pres election, took oldest child 2 vote. This time, took child #5 2 vote. If I live, next time will be kids 6 & 7. Time after, kid 8 $$ Nov 06, 2012
  • “Josh, the article is worth a read, but the Chronicle of Higher Education misreported on it. The?” ? David_Merkel http://t.co/BFGqCw04 $$ Nov 06, 2012
  • “People easily forget that the stocks of commodity producers are very different than buying the?” ? David_Merkel http://t.co/dDlMNxIY $$ Nov 05, 2012
  • Helping a client w/his 401(k). Common balanced fund risk factors chosen: Low Duration, Medium credit quality, Large Cap Blend Equities $$ Nov 05, 2012
  • The benchmark changes added jobs that were created at an unknown earlier point in time. If they were… http://t.co/TmRLG1vg Nov 03, 2012

 

Eliminating the Rating Agencies, Part 3

Eliminating the Rating Agencies, Part 3

Posted on by David Merkel

There’s one thing that is a little odd about me: occasionally as I am waking in the morning, something that I have been thinking about comes crashing in on me, and I get a moment of clarity where everything seems obvious for a complex question.

So to begin, I would like to say that I was utterly wrong in part 1 and part 2 of this series.? It won’t work.? Here’s why:

When is it safest to buy high yield bonds — when spreads are tight, or when spreads are wide?? Of course, when spreads are wide.? When spreads are tight, it is risky to buy corporates.? But my method for allocating capital would do the reverse: it would force a lot of capital to be allocated when spreads are high, and little when spreads are low.? That’s the wrong way to do it.

Second, most bond defaults occur because the borrower chokes on an interest payment, not a principal payment.? If you can make the interest payments, under normal circumstances, you can refinance the principal.? That indicates that the risk of a bond will grow less than linearly with maturity.? It may even be flat.

The upshot of this, is that you would want to assign capital counter-cyclically if you could, but no one would go for that, it doesn’t fit human nature.? So maybe a compromise works where there is a fixed amount of capital assigned across the cycle, and not varying by maturity.? So how do you make adjustments for variable riskiness?

For corporate bonds that have a public stock trading, a contingent claims model can yield good results.? Egan-Jones does that, though many of the major raters have similar models, that they watch as a check on their fundamental reasoning.

But many bonds have no publicly traded equity to give them estimates of value and volatility.? Whether private corporates or securitized debts, there is no way to accurately estimate risks, unless you have a cash flow database of the underlying properties/assets, and aside from CMBS, that would be hard to get.

That brings us back to the rating agencies.? Much as they failed on rating novel types of debt that the regulators should not have allowed regulated entities to invest in, the rating agencies did a good job in rating seasoned corporate bonds, both private and public, incorporating private data to sharpen their estimates of creditworthiness.

I know that Dodd-Frank has required Federal Regulations to eliminate the use of credit ratings.? What have they substituted? Management judgement, simplistic statistical tests, nothing, and the ability to use quantitative rating schemes.? My view is this: there will be a series of scandals out of this, and there will be a return to the rating agencies, where human judgment takes in the factors that can’t be crunched into an equation.

Thus I return to my opinions expressed in: In Defense of the Rating Agencies ? V (summary, and hopefully final). You can’t live with them, but you can’t live without them.

Eliminating the Rating Agencies, Part 2

Eliminating the Rating Agencies, Part 2

Posted on by David Merkel

After writing Eliminating the Rating Agencies, I felt there was room for improvement.? Part of that stems from reading critiques of the rating agencies that really don’t understand why ratings exist.? Ratings don’t exist to help average people, they exist to allow regulators to evaluate the credit risks of financial institutions.

The beauty of my prior proposal is that it can be applied to any credit instrument, even private placements for which there is no market.? Let me give an example.? In mid-2002 with the ten-year Treasury yielding 4.5% an investment banker approached me with a private bond deal — $50 million in total to finance the owner of real estate where the US Government had old computers that would be difficult to do away with.? The yield offered was 8% for 10 years, and S&P shadow-rated it “A.”? We bought 20% of the deal.? We were the biggest holder at $10 million.

Following my procedure in the prior article, the amount of capital that would have to be put up would be almost $2.2 million.? Now, that is likely too severe, but maybe the regulators would choose a percentage of that amount as the right amount for all fixed income securities.? Other securities that are not hedges would be considered deductions from capital.

Is the bond illiquid?? More spread -> more capital required.? The beauty of this system is that it does not care where the excess spread is coming from.? It just measures the present value of the uncertain spread, and realizes that it is a very good proxy for credit risk.? It can be applied to any bond, preferred stock, etc. fairly easily.

There would have to an additional analysis for asset-liability mismatch, but existing methods for measuring that are adequate.? In any case, the rating agencies would no longer be needed for measuring credit risk.? Regulators would simply review the calculations of the actuaries/quants, as they file their annual/quarterly statements.? The value of the uncertain portion of the fixed income assets would be the proxy for the total credit risk of the firm.? No rating agency needed to calculate that.

Industry Ranks November 2012

Industry Ranks November 2012

Posted on by David Merkel

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, 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.

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 said, dull is hard to find these days.? Where will demand remain strong, or where will demand rebound are tough questions.

The Red Zone has a Lot of Noncyclicals

What I find fascinating about the red momentum zone now, is that it is laden with noncyclical companies.? That said, it has been recently noted in a few places how cyclicals are trading at a discount to noncyclicals at present.

So, as I considered the green and red zones, I chose areas that I thought would be interesting.? In the red zone, I picked IT services and beverages.? Stable industries.

In the green zone, I picked most of the industries.? If the companies are sufficiently well-capitalized, and the valuation is low, it can still be an rewarding place to do due diligence.

That said, it is tough when noncyclical companies are relatively expensive to cyclicals in a weak economy. Choose your poison: high valuations, or growth that may disappoint.

But what would the model suggest?

Ah, there I have something for you, and so long as Value Line does not object, I will provide that for you.? I looked for companies in the? industries listed, but in the top 4 of 9 financial strength categories, an with returns estimated over 15%/year over the next 3-5 years.? The latter category does the value/growth tradeoff automatically.? I don?t care if returns come from mean reversion or growth.

But anyway, as a bonus here are the names that are candidates for purchase given this screen.? Remember, this is a launching pad for due diligence.

Full disclosure: long for me and clients: HPQ, VLO, TOT, TEL, INTC, CSCO, VOD

An Actuarial Question

An Actuarial Question

Posted on by David Merkel

Here is a question from a reader:

Hi Mr. Merkel,

?My name is XXXXXXX and I rcently started my ASA modules. I am considering pursuing a Chartered Enterprise Risk Analyst designation from the SOA. I was curious if, based on your experience in both the financial and actuarial world, you had any thoughts on the CERA designation? I have

2.5 years of experience and work for a pension consulting firm, but would like to broaden my skill set. I really enjoy The Aleph Blog, especially the book reviews. Keep up the good work.

?Thanks,

?XXXX

My response:

Dear XXXX,

I don’t have an opinion on the CERA designation.? In my opinion, the SOA is in the midst of an existential crisis.? How do they survive, prosper, and maybe even grow the SOA?? Outside of their core industries, insurance and employee benefits, they have strong competition.? Many organizations that do something like them are larger than the SOA.

Ideas:

1) Put a gun to the head of the CAS by offering a casualty track.

2) CERA competing against other risk management credentials

3) Make an effort to create new “actuarial” tracks off of the experiences of nontraditional actuaries, most of whom are a lot more entrepreneurial than other actuaries.? Investing, big data, etc.? Look for all the things that involve the intersection of the Law of large numbers and durational discount…

4) Try to cooperate with the CFA Institute — how that will work, I have no idea, and I am reminded of the limerick about the young lady from Niger.

http://allpoetry.com/poem/8518887-Limerick_There_was_a_Young_Lady_of_Niger-by-William_Cosmo_Monkhouse

5) Attempt to merge all actuarial organizations in the US & Canada into one organization — try to go global, like the CFA Institute.? (The rewards of being global are far smaller than imagined.)

Think hard about what you want to do, and analyze which credential will get you there.? Then pursue it with all your strength, and pick up adjacent/tangential skills to differentiate yourself.? That last part is important, and it is what has made my career very different than most actuaries.

It’s kind of like violating the semi-strong form efficient markets hypothesis — in order to do better than the market, you need an edge.? Find that edge, because regardless of what credential you get, you will need to know more than that to excel.

Best wishes,

David

And his response:

Hi David,

Thank you very much for the thoughtful response. I had not considered the size of the SOA in relation to other competing organizations. As you said, I will have to do some hard thinking about what I want to do and pursue the my designations accordingly.

Thanks again,

XXXX

Thee is an article waiting to be written about credentialing in investments, and how the credentials are not worth much.? It is a lot harder to get an FSA from the Society of Actuaries than it is to get a CFA credential from the CFA Institute.? But the CFA offers a lot more with respect to investing than an FSA does.

Now, those are two strong credentials that are worthy of trust.? There are many more credentials out there, and most are not worthy of trust.? Be careful.? Many put initials after their names, and they aren’t worth a lot.? Be careful.

NOTA Bene

NOTA Bene

Posted on by David Merkel

Like my friend Cody Willard, I believe that one of the most important things that could happen politically would be to break the stranglehold that the Republican/Democrat duopoly has on the political process.? This evening, I am here to offer a simple way that this could be achieved without creating a third party.

(Wait a minute: could we bring “restraint of trade” charges against the Republicans and Democrats for their suppression of third parties?? After all, politics is a business, albeit a twisted one…)

NOTA: None of the above.? Whether by law or by constitutional amendment, all elections should allow for “None of the above” to be a choice.? If “none of the above” wins the election, the candidates are thrown out, and a new election would be held two months later, with none of the prior candidates participating.? Existing officeholders would continue until a new officeholder is elected.

My opinion is that if “None of the above” were an option in the current Presidential race, it would win handily.? Also, as far as the Republicans are concerned, it would have won their nomination, and the convention would have been old-style, where a compromise candidate would have arisen, far more amenable to average voters than Mr. Romney.

We need a brake on the system to arrest the power of the two parties, and give them real competition.? “None of the above,” helps provide that, so that when you have two lousy polar opposite candidates, they will be forced toward the center, or be eliminated by “None of the above.”

NOTA worked to destroy the politics of the Soviet Union; maybe it can help us as well.? If you’re tired of the polarized opinions of the Republicans and Democrats, then I would suggest pushing for legislation or Constitutional amendments that require the ability for all elections to have “None of the above” as a choice.

This Election Will Solve Nothing

This Election Will Solve Nothing

Posted on by David Merkel

When I look at the present choice between the two main parties, I am struck with how we are forced to choose between two fantasy worlds.? Romney thinks he can cut taxes further while we have record deficits.? I would be in favor of radically simplifying the tax code.? Bring back Reagan’s TRA ’86 — it was so simple that it starved those that made their living by gaming the tax code.? (Accountants, Actuaries, Attorneys — what is it with these “A” professions?)

Over the last 10 months, I have mentioned Romney in significant ways three times (aside from compilations of my Tweets):

Romney does not factor much into my thinking because:

  • I don’t know what he really believes.? His views have shifted a lot across many years, and in convenient ways.
  • His promises are not self-consistent.
  • Mormons are unusual, and most have distinct views on Israel and the US that make them rigid in their views.
  • If I worry about how a Catholic might respect the Pope, I worry more about how a Mormon respects the hierarchy in Salt Lake City.

But we know Obama, and his actions are at variance with his rhetoric.? He’s had only two significant piece of legislation passed during his term, and neither were good for the US:

  • Dodd-Frank: introduced? the bad concept of legislation via study.? Congress, dumb as it is, is supposed to analyze ideas for themselves, and not outsource analysis.
  • PPACA: Increases health care costs, destroys the ability to control costs.? Really dumb legislation could that only be passed because the rules of the Congress were ignored.

Neither bill was critical to what Americans wanted.? These were the actions of an ideologue that pursued his own misbegotten agenda.? I wrote four significant pieces regarding Obama, here they are:

Barack Obama is a rigid ideologue whose views are well known.? He also does not possess a lot of courage to push his views, aside from two pet projects.? I am genuinely surprised that no Democrats decided to oppose him in the primaries.

So, who do you vote for, the guy who has dumb ideas that are well-known, or the guy who you have no idea as to what he believes?? I say neither.? We need to create a third party to break the duopoly that is strangling US politics.? That is my main message to readers.

 

 

On Time Horizons

On Time Horizons

Posted on by David Merkel

Why are time horizons important?? Because people have future goals that they want to meet.? We typically invest money today because we have some need that we are trying to meet in the future, whether that is college expenses, retirement, or some other less common need.? Institutionally, that could be funding a charitable endowment, a pension plan, or the liabilities of a life insurer (or other insurer, but life liabilities are long).

Most retail investment advice is short-term in nature: the analyst has determined that something good or bad will happen in the short-run, so buy or go short now, respectively.? In general, such investment advice has not worked out well.? Why?? For the most part, it is very difficult to time corporate events.? It is better to try to gauge longer-term prospects, and invest accordingly — but that means you have to have no need for the assets in the short-run.? As is said in many places, you are only investing what you can afford to lose.

Few invest that way, because it is in our nature to be jumpy.? We look for short-term gains when we should be patient.? Many stocks are like crops that may take years to mature.? Yes, if you get the timing right, you can do far better, assuming you have better places to reinvest.? Making a clever move is one thing, but a series of clever moves is tough.? Investing is easy, but changing horses, and selling and buying to make a big kill is tough.

Now bonds offer more precision on time horizons.? Invest today, and barring default, your principal comes back at maturity. With equities, we rely on arguments that over the long run equities don’t lose money.? There is nothing structural to support this; ask the Japanese if they agree.? (I could comment on equity markets that have gone out of existence for a time, but I refrain.)

At present, the CAPE10 and Q-ratio indicate that stocks are not likely to return a lot over the next 10 years.? The same is true of most high-quality bond investments.? Also, true of most high-yield investments when expected losses are netted out.

In an over-indebted world, the marginal efficiency of capital is low — we need a certain amount of bad businesses to fail, so that capital can be reallocated to ventures that are more promising.? No one likes failure in the short-run, but it yields good results in the long-run — more promising ideas get capital.

We don’t need more houses, banks, autos, etc.? The bailouts were a failure because they perpetuated a part of the economy that was in oversupply.? Thus we have had a weak recovery.

Back to time horizon.? I am not crazy about buying bonds here.? The risk-reward is awkward, but the same is true of stocks.? That said, the variability on stocks is greater normally, but with rates so low, it may be similar.

If this does not sound optimistic, you understand me well.? Perhaps that means that cash, gold, or foreign currency bonds might be better, though I have my doubts on foreign bonds.

I’m going to keep doing what I always do.? I buy cheap, well-capitalized stocks, in industries that are out of favor.? I manage money with a view to holding stocks for 3-5 years.? Though it has not worked well for me recently, it has worked well in the past, and I will pursue my opportunities there.

 

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