David Merkel – Page 259 – The Aleph Blog

Book Review: The Wall Street Waltz

Posted on 13 June 200813 June 2008 by David Merkel

I’ve mentioned this before at RealMoney, but in early 2000, I was doing some serious thinking about investing. I decided to e-mail Ken Fisher a question that he had touched on in one of his Forbes pieces. That began an e-mail dialog that forced me to ask hard questions about how I did value investing. Personally, I was surprised how much time he was willing to waste on me, but I had read the three books that he had written up to that time, Super Stocks, 100 Minds that Made the Market, and The Wall Street Waltz. I had a good idea of how he approached investing.

He challenged me to throw away the CFA Syllabus and think independently — to focus on my own competitive advantage. That led me to analyze what had worked and failed in my prior efforts in value investing, and that led to what would become the Eight Rules. I did well in the prior era, but much better after my discussion with Ken Fisher.

One more note before I begin the book review. He told me that if something is known, it is not valuable for investing. I have modified that rule to be, “If something true is relied upon by many investors, it is not valuable for smart investors. If something false is relied upon by many investors, it is valuable for smart investors to bet against that.”

The Wall Street Waltz takes you on a graphic tour of economic and financial history. Using beautiful old charts created by multiple sources, he uses them to describe market action in the past, and what they might imply for the present. The original version, of which I have a copy, was written in 1987. The new edition updates Ken’s comments to 2007.

The charts provide a springboard for Fisher to explain a wide number of concepts:

Why preferred stocks are suboptimal investments. (Chart 31 — learned that first hand a a little kid as I saw my Litton convertible preferred crater.)
How economically linked Canada is to the US (Chart 15)
The value of P/E ratios for the market (Charts 1&2)
Why you shouldn’t panic over bad political/disaster news. (Chart 24)
How inflation is correlated internationally (Chart 49)
Gold preserves purchasing power in the long run, but that is about it. (Chart 57)
Stocks create value in the long run, despite short/intermediate-term fluctuations. (Chart 88)

I could go on. I chose those pages randomly. There is a wealth of knowledge here. I would like to close with a timely page that I targeted, Chart 64 — Unemployment and the 1 Percent Rule. The stock market tends to rally after the unemployment rate rises 1%, though the challenge is timing when to sell, and I don’t know what the rule should be for that. After the last unemployment report, the rate is more than 1% over the recent low. If correct, it is time to be a buyer, though what is true on average is not always true in specific.

Most investors don’t benefit from an understanding of economic history, which gives a broader skill set for analyzing current problems. This book is an aid in gaining understanding of economic history.

Full disclosure: If anyone enters Amazon through my site and buys something, I get a small commission. Your costs are not increased. This is my equivalent of the “tip jar” and so, if you like what I write, and need to buy through Amazon, please enter Amazon through links on my site.

If You Want to Do Well, Study Math, Science, or Business, and Work Hard

Posted on 13 June 200813 June 2008 by David Merkel

I read the coverage of this academic paper with some amusement. Something not mentioned by the reviewers is that the data set came from just one college. Should that then be applicable everywhere? I don’t know.

Also, the idea of correcting for brightness of students strikes me as misguided. Smart students know to apply themselves to majors that will pay off. Also, the concept that high-paying careers require more hours is also misguided. Most of the graduates in lower earning professions can’t work more hours, even if they want to; there is no demand for that.

The paper was written to deal with how one statistically deals with non-responses in surveying. That it deals with education is a happy accident. I would be careful generalizing from this paper. To me, it is another example of advanced research that is highly intelligent, but may lack common sense.

As The Yield Curve Moves

Posted on 13 June 2008 by David Merkel

My, but haven’t we had interesting times in the short end of the yield curve lately. Have a look at this graph:

This covers the period from the final aggressive 75 basis point move by the FOMC, where there were expectations of a 1% fed funds rate by year end 2008, to now, where the rate at year end is between 2.5-3.0%.? Now look at this chart, which summarizes the yield curve moves:

The graphs and numbers tell a story.? My four datapoints represent:

3/17 – The sharpest point in the loosening cycle, prior to going to 2.25%.
4/25 – Anticipation of the end of the loosening cycle.
6/6 – FOMC jawboning that we must support the dollar and fight inflation.
6/12 – Now.

Let’s describe the moves, period by period.? In Period 1, the transition was from maximum FOMC accomodation to the end of the loosening cycle.? What happened?? Investors required more yield to invest for two years versus cash instruments, because they concluded that short rates would not go near record low levels.? The long end of the curve flattened, because inflation expectations were under control.

In period 2, things were quiet.? Three month rates rose to reflect the new consensus that the FOMC was on hold after the 4/30 meeting for the foreseeable future.? The rest of the curve did nothing.

In period 3, members of the FOMC began beating the inflation drum, particularly the hawks, including Plosser, Lacker, Fisher, and Bernanke.? The belly of the curve (twos to fives) rises the most, anticipating tightening moves by the FOMC, leading the long end to flatten, and the short end to steepen.? This implies that inflation will remain under control in the long run, an idea borne out by the TIPS market, where you can buy 20+ year inflation protection at a real yield of 2.3% — a pretty good bargain for investors that must own Treasuries and other high quality debt.

I’ll give the FOMC this.? In the last four trading days, they helped create the biggest move in the 2-year note yield that we have seen in a long time.? They managed to push up 30-year mortgage yields around 35 basis points, close to the move in the 10-year note.

Now, (to the FOMC) is that what you wanted?? Go ahead.? Start tightening monetary policy in August or September.? See what that does to the investment and commercial banks.? See how that affects weakening employment.? Do it during an election year, when politicians in 2009 might say, “Central bank independence hasn’t helped the nation.? Let’s clip the wings of the Fed.”

I see the FOMC tightening, and then abandoning the tightening early, and reverting to a weak policy, accepting more inflation for the sake of growth in the real economy, and leniency to banks that are facing tough market conditions.

Monoline Malaise

Posted on 12 June 200812 June 2008 by David Merkel

Yves Smith at Naked Capitalism had a good post on the financial guarantors. It dealt with MBIA’s new refusal to make a capital contribution to its subsidiaries. Here’s the company’s take on the matter. And here was my comment at her (Yves’) blog:

David Merkel said…: Were I Dinallo, I would refuse to allow them to set up a new monoline. He has that authority for his own state. I might also take the existing companies into conservation. Then, let MBIA take their spare capital and try to set up a monoline in another state.The commissioners of the other states should refuse them as well, because they mismanaged an insurance company already. They are supposed to check these things when new insurance companies are formed.

Finally, I’m not sure how much good $1.1 billion will do them — If you look at the 2007 10K (page 161), and wipe out their investment in subsidiaries, and take the first quarter $2.4 Billion loss out… let them have the $1.1 Billion, their net worth is still negative.

Now, maybe the loss is at the subsidiaries, so their net worth at the holding company would be near zero. That would still cause them to violate the minimum net worth covenant on their bank debt, if they lost control of their subsidiaries.

The banks could force repayment, and if I were a leading bondholder (calling the major life insurers), I would have one of my lawyers make a courtesy call to MBIA’s lawyers, and suggest that any payment of bonuses could be viewed as fraudulent conveyance.

MBIA is in a bad enough spot, that I don’t see what good keeping the $1.1 billion does them in the long run. Thus, it has to be a short-term gambit.

June 11, 2008 5:56 PM

No, they didn’t promise to shareholders or bondholders that they would do it. It was only their intent.
But, they probably did make promises to the rating agencies and NY State insurance Commisioner Dinallo.

If I were in the shoes of the ratings agencies, not downstreaming the capital is worth at least another two notches in terms of downgrades. Can the management be trusted? Probably not, which calls into question all the non-verifiable data that they have from MBIA.

If I were in the shoes of Dinallo, I would not allow MBIA to support just one of its insurance companies. I would ask for the $1.1 billion to be contributed so that risk based capital ratios at the subsidiaries would be close to even.

Now, another analyst suggested that MBIA and Ambac should be junk rated. The idea here is that once a financial guarantor goes bad, it is likely that things are even worse. That is supported by the past behavior of the rating agencies and Moody’s own implied ratings as well.

Now, things could be worse. They are worse for Security Capital Assurance, which could not wriggle off the hook of their obligations to Merrill Lynch. This has negative implications on similar efforts of other insurers to not pay as promised. Even XL Capital, which owns a large portion of SCA, and has guarantees on parts of SCA’s business that was not part of the Merrill suit, fell. It fell because:

the value of their SCA stake fell
The value of their guarantees to SCA rose; harder to repudiate.
General malaise across all financial guarantors.

As a final note, the leverage that MBIA and Ambac had with respect to their market shares has evaporated with the regulators and the rating agencies. Who knows, maybe even with their GAAP auditors… The need to support MBIA and Ambac was greater when the alternatives were fewer, but when you have Berky, Assured Guaranty (give ACE some credit for discipline here), Dexia/FSA, and maybe other new entrants, you can turn your back on everyone else as a regulator. You don’t care about the exotic coverages, and you’re glad they are going away — you just have to clean up the mess. As for the rating agencies, they have reconciled themselves to the idea that all but the municipal enhancement business is dead. So, say goodbye to MBIA and Ambac writing new business. That is over.

Blog Notes

Posted on 12 June 200814 June 2008 by David Merkel

The following is going to sound a little sloppy, so please take it in stride. When I started this blog, I allowed a large number of entities to syndicate my content. I was a neophyte, so I did not keep a list. As of this post, no one, except Seeking Alpha and my employer, is allowed to republish my posts, whether taken via RSS or through a direct scrape of my blog.

Of course, fair use is permitted. Quote me if you like, but add value to my material through your commentary. I try to make my posts over 90% mine, perhaps you should as well. Linking is encouraged. I do that for a lot of sites, particularly those on my blogroll.

If you have registered at my site but never commented, and you are a legitimate reader of my site, e-mail me. I am going to delete a number of registrees who are simply likely spammers. They get caught by Akismet, but I want to tighten things up a bit.

Also, I try to be fair to readers, but any comment at my site can be deleted by me for any reason. I have not done this once yet, except for spam. I have edited a comment or two, but that’s all. Still, I reserve the right.

Finally, thanks for reading me. Your time is valuable, and there are many good blogs out there. Thanks also to those that link to me, and have me on their blogrolls.

Rebalancing Buy

Posted on 11 June 200822 June 2017 by David Merkel

Nothing big here, I’m just making a point of reporting my portfolio moves here. Yesterday, near the close, I did a rebalancing buy of Group 1 Automotive. I had a rebalancing sell on GPI recently, so this is part of selling high and buying low.

I still think that the auto dealers are more immune to recession than most players in the auto business. In addition to selling new cars, they sell used cars, and provide service. The latter two services are recession-resistant.

Also, in this environment, I have been deploying my excess cash slowly, and the allocation to Group 1 is a means of taking advantage of a swing down in its stock price.

Full disclosure: long GPI

FHA: Faulty Housing Assumptions?

Posted on 11 June 200822 June 2017 by David Merkel

As I get older, I still have a sense of wonder at the degree to which the US Government is a major lending institution. Today’s poster child is the Federal Housing Administration. What is the FHA?

“The Federal Housing Administration, generally known as “FHA”, is the largest government insurer of mortgages in the world, insuring over 35 million properties since its inception in 1934. A part of the United States Department of Housing and Urban Development (HUD), FHA provides mortgage insurance on single-family, multifamily, manufactured homes and hospital loans made by FHA-approved lenders throughout the United States and its territories.”

How is the FHA funded?

“FHA operates entirely from self-generated income and costs the taxpayers nothing. The proceeds from the mortgage insurance paid by the homeowners are captured in an account that is used to operate the program entirely. FHA provides a huge economic stimulation to the country in the form of home and community development, which trickles down to local communities in the form of jobs, building suppliers, tax bases, schools, and other forms of revenue.”

Well, good that it costs taxpayers nothing, if that is sustainable. The risk in the present environment is twofold. First, FHA is providing a lot of the loans that are getting done tight now. The backup plan is almost the primary plan now in a few places. Here’s an example:

‘David H. Stevens, president of Long & Foster’s affiliated businesses, said his real estate brokerage now holds regular FHA training sessions for its agents and the loan officers at its in-house lender, Prosperity Mortgage.

“Our FHA business in the Washington area went from virtually nothing at the end of 2007 to about 30 percent today,” Stevens said. “In some spots, FHA makes up 50 percent of all our loans.”‘

Now the percentage is much lower across the whole country. As the article points out, the loans have become more common in areas where housing prices are high, and the borrowers can’t come up with a down payment for a conforming loan.

As the number of mortgages originated/insured goes up, it FHA needs more capital to back those loans, all other things equal. The second problem is defaults. (Hat tip: Calculated Risk) Thery are one of the few places providing loans to lesser quality borrowers, so it is no surprise that their loss rate should be up considerably. Here’s the quote that caught my attention:

?Let me repeat: F.H.A. is solvent,? Mr. Montgomery said on Monday in a speech at the National Press Club. ?However, no insurance company can sustain that amount of additional costs year after year and still survive. Unless we take action to mitigate these losses, F.H.A. will soon either have to shut down or rely on appropriations to operate.?

Hmm… it looks like the US Government does not directly stand behind the liabilities of the FHA. Contrary to the original quotation from their website, it seems that in a pinch, they can ask Congress for funds, or, go out of business. (As an aside, I could not find out who regulates the solvency of the FHA. Thoughts?)

Well, not surprising. Our politicians like cheap solutions, which makes them lean on the GSEs and things like the GSEs, in order to get cheaper mortgage financing with dinging taxpayers. That works for a time, but the gambit comes to an end when the solvency of these quasi-public, quasi-private entities becomes threatened.

We’re not done with the fall in residential housing prices yet, and the difficulties at FHA are just another demonstration of that.

Hearing from the Proxy Solicitor

Posted on 10 June 200810 June 2008 by David Merkel

To whom it may concern: please send your agent soliciting my proxy to charm school. I don’t like being pushed to give my vote over the phone. I don’t regard it as secure as the internet or paper balloting.

Yesterday was a funny day, I received three communications (in this order) on National Atlantic.

The paper proxy and ballot.
An e-mail from some dear friends pointing out our former employer’s SC 13D/A, declaring their opposition to the deal.
The call from the proxy solicitor.

As I said to my friends: “I suspect that by this time, Gorman [the CEO] plus the arbs hold more than 50% of the shares. I will be voting my 0.15% against the deal, for what good that will do.

There are no appraisal rights, and I think the only possible remedy would be lawsuit alleging fraud, with a temporary restraining order on the deal. I don’t think that a lawsuit would succeed, but the laws of NJ, and the regulators are management-friendly.”

I have already admitted defeat on this one. Should the merger vote fail, I would expect the stock to drop considerably, because without replacing the current management team, there are no good options.

Full disclosure: long NAHC

Declaring Victory Too Soon

Posted on 10 June 200810 June 2008 by David Merkel

The last few months have seen a change in expectations of FOMC policy. The next expected move is a tightening, while some incremental loosening was expected 2-3 months ago.

One of the reasons for this is that the Fed has managed to calm the short term lending markets. They have also managed to defuse a possible crisis among derivative books by bailing out Bear Stearns with the aid of JP Morgan. Also, GDP growth hasn’t gone negative yet, at least the way the Government calculates it. As a result, Ben Bernanke feels that the risk of a substantial downturn has receded, and so, the next focus of the FOMC will be inflation.

Now, I don’t think the answer for the Fed is that simple. That said, there are many that would welcome a tighter FOMC policy.

China is importing our lax monetary policy, and they are unsuccessfully trying to fight the implications of the policy, because they won’t raise their exchange rate. They will have to eventually, perhaps after the Olympics, but a tighter US monetary policy relieves some of their stress.
Europe would welcome a tighter US monetary policy, because it would relieve pressure on the rising Euro. As it is, the ECB with its single mandate is moving to fight inflation. Even the Bank of England is not loosening aggressively, and their housing problems may be proportionately greater than those in the US.
The Gulf States would like a stronger US Dollar to help arrest the inflation that they are importing.
Savers in the US might like higher rates.

But the trouble is that there are still weak spots that might cause the Fed, which has a dual/triple mandate to not tighten monetary policy. (Dual — inflation and unemployment. Triple — financial system solvency, inflation and unemployment.)

The Fed is not out of the woods yet on real estate related credit. I commented many times at RealMoney that Home Equity Lending would be a big problem, back in 2006. I also warned on option ARMs. Well, both are looming problems now.
This will lead to problems in the regional banks. Many of them are exposed.
I still expect residential real estate prices to fall further.
The correction in commercial real estate prices has only begun.
Also, investment banks are still delevering and taking writeoffs. Lehman is the most recent poster child there, but other investment banks could still be affected.
Beyond that, we have defaults rising in speculative grade credit, which will do damage directly, and through the CDOs that they are in.
Places like the Philippines may be canaries in the coal mine — they may be experiencing outflows of hot money at present.

I think the Fed has less freedom to act than is commonly believed. As Yves Smith has commented at his blog, the Fed may have painted itself into a corner. I think the risks from inflation, unemployment, and financial system weakness are fairly well balanced. As it stands, the Fed has adopted the following policy:

Don’t let the monetary base grow. Sterilize all new lending programs.
Allow the banks freedom to expand their lendings; informally relax regulations for now.
Bail out any significant systemic risks.
Work out kinks in the short term lending markets through new programs.

The Fed may make some of those new programs permanent, but then they will need to find a new policy equilibrium involving greater tightness elsewhere in their policy tools. They will also need to decide what to do regarding investment bank leverage, both direct and synthetic. They will also have to figure out what comes first if there is a broader banking solvency crisis, and/or significant shrinkage of real GDP with a rise in unemployment.

It is my guess that Dr. Bernanke is talking a good game today, but that the Fed’s policies will be loose toward inflation, should systemic risk or unemployment prove to be more difficult problems than currently advertised today. They are not out of the woods yet.

Of Value to Value Investors

Posted on 7 June 200822 June 2017 by David Merkel

As value investors go, I am an inclusive kind of guy.? I’m not doctrinaire about what measures constitute value.? What is the correct model?? Well, if you could gather all of the data successfully, it would be something akin to the model Mike Mauboussin’s Expectations Investing.? The easy shortcuts of value investing are stripped-down versions of this (possibly impossible) model.? Oh, shortcuts?? Here are a few:

Price/Earnings
Price/Book
Price/Tangible Book
Price/Sales
Dividend Yield
PEG ratio (Growth at a reasonable price)

The shortcuts are usable, with some discipline.? I’m not sure about the theory itself: I’m sure it is correct; I’m just not sure it can be implemented.? (Hey, maybe Legg Mason has tried to implement it.? Wonder how they have done with it? 🙁 )

More usable are several speeches from noted value investors.? They won’t tell you what stock to buy, but they will teach you how to think about the equity markets.? So, here are three speeches I ran across recently, from:

From my time writing for RealMoney, I know what motivates most investors is the next hot idea.? Sadly, that does not produce value for investors.? Here and at RealMoney, though I will willingly talk about the stocks that I own, I would rather talk about how to think about portfolio management — thinking rationally about what assets will build the most value in the intermediate-term.? That will give readers much more; they will be able to think independently, and create value on their own, using experts as guides, but not being slaves to any other investor, including me.