David Merkel – Page 267 – The Aleph Blog

The US Dollar and the Limits of Irresponsibility

Posted on 19 April 200820 April 2008 by David Merkel

Promises, promises.? How many ways can the politicians dream up to spend money that they don’t have?? Perhaps it’s easy when you are the world’s reserve currency, and few argue with taking down IOUs denominated in US Dollars, at least for now.

But there are limits.? When looking at the US Dollar today the markets have kind of a benchmark that they use as their default scenario:

Fed funds will not drop below 1.5% at the bottom of this cycle.
CPI inflation will not rise above 5% for this cycle.
Nominal GDP growth will not drop below 4% for this cycle.
The US current account deficit will improve, albeit fitfully.
?Total Federal Debt will not grow faster than $600 billion per year.? (you didn’t know it was growing that fast, now did you? 😉 )

Of course, this is just my view, and I could be wrong.? But the US Dollar has gotten trashed, and in order for it to get hit further, the powers that be will have to exceed the current “Limits of Irresponsibility.”? As for the default scenario that I have laid out above, those are key parameters that I think are baked into the current low level of the US Dollar.? Violate those levels, get a lower Dollar.?? Get further away from those levels, and dollar could rally.

When I gave my talk to the Society of Actuaries, one of my recurring themes was, “It is wonderful to be the world’s reserve currency.”? Consider especially slide 32, where the weak dollar combined with strong overseas equity markets flattens out the net foreign assets to GDP ratio at near -20%.? We ship our losses overseas, and that isn’t counting all of the subordinated structured product that they bought… yet.

I am not a doom-and-gloomer by nature.? I try to recognize what is wrong, analyze what could be done to ameliorate the situation, and consider what could go right.? I am not an optimist on the US Dollar, though I don’t see how it falls much further from here.? There is room for the US Dollar to rally, if only a few things go less wrong.

In the long run, though, there are imbalances that the US needs to change, and the long run path of the Dollar will rely on those changes.? I believe that the markets embed an improvement in US policies long run; if that fails, we will continue to see the Dollar deteriorate.

Why I like TIPS

Posted on 18 April 2008 by David Merkel

I have received a little criticism regarding my liking for TIPS.? Much of it falls along the lines of James Grant’s criticisms of the securities, given that the government controls the definition of inflation, it can discriminate against TIPS holders.

Inflation as it pertains to TIPS has been running at a rate of 4% year-over-year.? I think that level will rise from here.? For those that are not constrained to fixed income investing, you can speculate in a variety of commodities and similar investments.? Have fun.? But for those that have to invest in fixed income, TIPS should be attractive, given the low rates on nominal Treasury Notes.

I? realize this involves speculation on future inflation and interest rates, but the margin of safety versus a 2-2.5% yield in short Treasury Notes makes TIPS compelling to me.

It’s That Season, Again

Posted on 18 April 2008 by David Merkel

I don’t celebrate Easter or Passover, though it is intriguing how far apart the two days are this year.? The season that I am talking about is annual reports and proxies.? This is just a friendly reminder to say that voting your proxies is something that helps keep capitalism legitimate.? Granted, I think that board elections should always be contested, and that access to the proxy should be available to anyone with more than 1% of outstanding shares, but my view is that both amateur and professional investors should take the time to evaluate proxies, vote accordingly for their interests, and not blindly side with management.

I vote down:

All directors at firms that have lost money for me.? (And the auditor!)
Most options and supplemental pay plans.? Pay people cash, not contingent stock that dilutes me.? And, most of the officers earn enough already.? If you don’t do your job because you love it, you’re not the right person for the job.
Shareholder proposals limiting executive pay, environmental issues, and other liberal folderol.

I vote up:

Proposals for greater shareholder democracy.
Plans to de-classify boards, and eliminate poison pills.
Proposals to split the Chairman and CEO positions.

If we’re going to be capitalists, let’s exercise our responsibilities, and have our companies act fairly and ethically.?? When we do that, it helps give capitalism a good name, and maximizesw the benefits in the long run to shareholders.

The Source of Most Economic Prediction Errors at Present

Posted on 18 April 2008 by David Merkel

This should be regarded as a small “opinion piece” of mine.? My big gripe with economic predictions over the past five years, is that forecasters use the old closed economy simplifications that worked when the US was a unique capitalist economy, and international trade flows did not affect the total picture much.

Today, I don’t try to analyze the US economy as a whole.? I look at its sectors and try to analyze them in a global context.? Even if the domestic US economy is in a funk, it is possible for sectors that serve other countries that are growing to do well.

So, I don’t make much of those who assume a recession will restrain inflation.? Perhaps a global recession will do so, but a US recession will not.? We need to look more closely at how the US is devaluing its currency versus other countries, and that might give us better clues regarding future inflation.

It is much richer to look at the sectors of the US economy, and look at them separately.? They have varying exposure to the US and Global economies.? That difference is critical now for investment decisions.

Not Concerned About Reinsurance Group of America

Posted on 18 April 200818 April 2008 by David Merkel

So Reinsurance Group of America missed estimates. Big deal; they’ve had good-to-excellent earnings for the last ten quarters; they have a bad quarter now and then when the “law of small numbers” catches up with them. Look at 2Q05 and 4Q01 for examples. The law of small numbers means that every now and then, you get a random gaggle of deaths with high face amounts, and the quarter is bad. This is often a good buying opportunity, because Wall Street, which only understands that the earnings missed, without understanding the underlying model, assumes that the miss will persist into the future. That has not been true of RGA.

I have met the CEO and CFO of RGA, and I think they know what they are doing, more than all of the other companies that do life reinsurance. They are the quality name in the space, including their more complex European competitors.

The stock price is currently way above my lower rebalance point, but I would be a buyer on weakness if I did not have a position. This is one of those stocks that you tuck away for 5-7 years, and you find that it doubles. The current oligopolistic nature of life reinsurance may shorten that timespan.

Full disclosure: long RGA

Ten Things To Be Concerned About

Posted on 17 April 2008 by David Merkel

1)? Picking up on some comments from last night’s post, why I am I not concerned about counterparty exposure?? Because Wall Street has always been very good at cutting off overleveraged clients in the past.? LTCM was an exception there, and only because Wall Street gave in to their request for secrecy.? Wall Street grabs collateral first, and then lets the client argue to get it back.? The investment banks require a significant margin, and when there is significant concern about getting paid, the lines get pulled.

The real worry here is that the investment banks don’t have good enough risk controls for each other.? Note that Bear’s crisis started when other banks stopped extending credit to Bear, and the fear fed on itself.

I liken the investment banks to long-tail commercial casualty insurers.? No one knows whether the reserves are right.? No one can.? Confidence is a necessary part of the game, which is made easier at lower levels of leverage.? But high leverage and opaqueness are a recipe for disaster when volatility rises.

2) Should you worry about Fed policy?? Yes.? The Fed is steering away from the Scylla of a compromised financial sector, and into the Charybdis of inflation.? As I will point out later, that is already having impacts on the rest of the world.? As for now, there are a few ill-informed writers who say that a negative TIPS yield on the short end is a reason not to buy TIPS.? That might be correct if inflation mean-reverts.? Given the short-term resource scarcity building in our world, I don’t think that is likely.

3) Should you worry about the US Government budget deficit?? A little — oh, and worry about the real deficit, one that puts the wars and other emergency appropriations on-budget, and takes out the excess cash flow from Social Security.? In a macro sense, for the nation as a whole, the impact isn’t that great… but it sends a message to foreign creditors who wonder what the value of the dollars will be when they get paid back.? When they see the Fed running an aggressive monetary policy in the face of rising inflation and a weak dollar, it makes their heads spin, as they contemplate the hard choices the weak dollar forces on them.

4) Could the falling dollar cause a crisis in China?? Maybe.? China is levered to US growth, which is slowing, and their export competitiveness versus the US declines as the dollar declines.? And what will they do with all of those dollar reserves?? Beats me.? After a certain point, additional reserves are useless — it is akin to lending more to an entity that you know is insolvent.? My guess is that the yuan will get revalued after the Olympics, and then the real slowdown will hit China.

5)? What of foreign food riots; are they a worry?? (More, and more.)? A little.? They are a canary in the coal mine.? They point to the short-term scarcity of total resources in our world, which only becomes obvious as a large part of the world tries to develop.? But, one practical thing that it implies is that energy and food prices will remain high for some time.? We are one global market at present, and energy and food prices are interlinked through the energy and fertilizer costs of farmers, and through stupid ideas like corn-based ethanol.

6) What of flat crude oil? production?? Yes, worry.? As I have said before, the government oil companies of OPEC countries control most of the supply, but they don’t always manage their resources as well as a capitalistic oil company.? Mexico, Venezuela, and Russia have declining production, to name a few.? The Saudis may not want to produce more, because they don’t know what to do with all the US dollar reserves that they have today.? Or maybe they can’t…

7) Worry about falling housing prices?? Yes.? The problems in the housing market stem from overbuilding.? There are too many houses chasing too few solvent borrowers.? This will eventually affect prime mortgages, because declines of 15-20% in housing prices mean that many prime loans would be underwater in a sale.? Remember, an underwater loan becomes a default after a negative life event — unemployment, death, disability, divorce, and uninsured disaster.

Before all of this is done, one of the major mortgage insurers should fail.? We aren’t there yet.

8 ) What of falling residential real estate prices in foreign countries? Yes, worry.? For Europe, it could lead to the end of the Euro, as countries needing looser monetary policies get tempted to abandon the Euro.? If the Euro’s existence becomes questioned, it will be a systemic risk to the world.

9) What of credit card delinquencies?? Yes, worry.? It shows that total financial stress on the consumer is high, particularly when added to the problems in mortgage and home equity loans.

10) Should you worry about bank solvency?? A little.? All of these previously described stresses have some bearing on the ability of the banking system to make good on their obligations.? Be aware that the FDIC was designed to handle sporadic losses, not systemic crises.? The odds of these problems affecting the depositary financials is still low, but the protective measures will not be capable of dealing with the worst case scenario, should it arise.

Perhaps I have more to worry about.? As I close up here, I haven’t mentioned the PBGC, Medicare, and a variety of other problems.? But, I have to call it a night, and symmetry with last night’s piece is worth a little to me.

Ten Things Not To Worry About

Posted on 16 April 2008 by David Merkel

There are many that cover the markets that try to get you to worry about things that aren’t real problems.? Here’s a sampling for the evening:

1) Changes in accounting standards, or ineffective/opaque accounting standards.? Take Goldman Sachs and level 3 assets as an example.? The accounting standard is fine, so long as you understand it.? In general, the higher the level of level 3 assets, the more opaque the valuation of assets is, and a valuation haircut gets assigned to the stock.? This is proper, because it happens to all companies with high or cloudy accrual figures.? It makes it hard to estimate free cash flow.

Should we move from US GAAP to IFRS, it should not affect the valuations of stocks on average, though it will make it a little harder to do financial analysis.? What does not change is free cash flow, which is not subject to accounting rules.? The money that can be withdrawn from a business without harming its current prospects (free cash flow) is the key metric for understanding business value.

2) Counterparty risk.? In derivatives, for every loser, there is a winner.? So long as the appropriate margin levels are maintained at the main brokerages, and the main brokers don’t experience conditions that dramatically change their credit quality, counterparty risk is not a problem.? (Or maybe, I should say, worry about the brokers, not the other counterparties.)

3)? Investors moving to cash.? Money rarely leaves the market.? When funds raise cash (and here), others buy their shares at a discount.? Typically, they are stronger holders than those that sold.? I wouldn’t be too bullish over stories of investors moving to cash, but I certainly would not be bearish.

4)? Rating agency downgrades, unless they trigger a debt covenant.? For the most part, market spreads and yields are set independently of debt ratings.? Sophisticated investors dominate the market, not the rating agencies.? As an example, suppose the US were downgraded to Aa1/AA+/AA+.? After a week, I doubt yields would change much at all, because the fundamental view of the US would not be changed by a change in its rating.

5) High credit spreads.? Those are a reason to be optimistic, because it means pain has been taken already.? Spreads can’t get higher than a certain level, or companies start delevering, because it is profitable to do so.? So when you see spreads near record highs, that is a buying signal, at least for the debt.

6) Retailers in trouble.? Some retailers are always in trouble during hard economic times.? It’s a tough business model, so expect some defaults; it is normal and healthy for the economy as a whole.

7) Collapse of a large portion of the auction rate securities market. ? Most borrowers will refinance.? In the interim, speculators are driving down the rates that get paid.

8) Downgrades of the major financial guarantors.? The market has priced it in, and perhaps we just run off MBIA and Ambac.

9) Tranche warfare in CDOs.? Read your prospectus with care, but when the seniors grab hold of a deal after and event of default, that is a step toward normalizing the market, though the mezzanine holders may ineffectively object as they end up getting nothing.

10) The ABX indexes, etc.? I’ve written about this before, but the various synthetic indexes — ABX, CMBX, LCDX, etc., are very hard to arbitrage against the cash market bonds that they represent.? The indexes should not be used for pricing as a result.? Whenever the synthetic market gets too much bigger than the cash market, it becomes a bettors market, and becomes incapable of delivering pricing signals to the underlying cash markets.

There are enough real things to worry about.? Perhaps I will write about those tomorrow.

Second Quarter 2008 Portfolio Changes

Posted on 16 April 2008 by David Merkel

For this quarter, I sold two my two placeholder assets, the Industrial and Technology SPDRs, and Arkansas Best, which had richened enough for me to trade out of it.

I had two rebalancing buys, Charlotte Russe and Avnet.? On Charlotte Russe, the rebalancing buy occurred because I tendered all my stock @ $18 in the Dutch Tender, and 45% of it got bought.? On Avnet, things aren’t as bad as the market thought on 4/15, in my opinion.? I had one rebalancing sell, Helmerich and Payne.? Just taking some off the table for risk reduction purposes.

Here is my final comparison file that was based off of data at the close of business on Monday.? To comply with the Bloomberg data license, all numeric fields remaining are ones that I calculated.? The columns of the file rank the 290 stocks on the following metrics (lower better unless noted):

52-week RSI
Trailing P/E
P/Book (2)
P/Sales (2)
P/2008E
P/2009E
Dividend Yield (higher better)
Net Operating Accruals (2)
Implied Volatility
Neglect (higher better)

The grand rank sums up the ranks giving double weights to P/B, P/S, and NOA.? My current stocks are highlighted in yellow, except for the two middle ones, which are in orange.? Candidates for sale come from the lower half (high grand ranks), candidates to buy from the upper half.

Here were my purchases (P/2008E):

International Rectifier — 9.5x
Group 1 Automotive — 7.1x
OfficeMax — 9.3x
Universal American Financial — 5.8x

Cheap names all (and could get cheaper?).? If you asked me what my concerns might be over this group of names, I would say that credit quality is adequate but not stellar.? I would also confess a little doubt on Universal American.? It looks cheap, and lines of business they are in are stable lines.? They lost money on mezzanine subprime mortgage ABS.? I looked at the writedowns, and they seem adequate.? If you send the security vintages 2006-2007 to zero, this stock is still cheap, in my opinion.?? What I can’t evaluate is whether they could have operational problems in their senior health insurance business.? It’s a good business, if managed properly.

As for International Rectifier and Group 1, I have owned them before.? With IRF, I like industrial technology — stuff that is harder to obsolete.? On Group 1, I looked at all of the small cap auto retailers, and picked this one.? I liked its business mix, and what seemed to be a clean balance sheet, with few immediate needs for liquidity.? The group as a whole has been smashed, and is discounting very unfavorable conditions.? I don’t think things are that bad, and besides, a lot of the revenues come from repairs and sales of used cars.

With OfficeMax, I think prospects are less cyclical than the market seems to believe.? Office supplies get purchased during bad economic times as well, and the current price already discounts? a lot of pain.

Well, those are my purchases.? Let’s see how they fare over the coming years.

Full disclosure: long HP CHIC AVT GPI UAM OMX IRF

Five Notes: What Can the Fed Do?

Posted on 15 April 2008 by David Merkel

1) There have been a number of recent articles questioning/explaining what the Fed can do in this present environment. Here are some examples:

My own view is that the Fed has used up a lot of firepower on the asset side, but still has a lot to work with. That said, the Fed should be careful not to complicate its balance sheet with a lot of off-balance-sheet agreements. Policy flexibility for a central bank is a real plus, so complicated agreements that make formerly liquid assets illiquid are to be avoided, particularly in a crisis.

Regarding Fed funds, it looks like they will cut 25 basis points on 4/30, but make noises that they are getting close to being done. Perhaps 1.75% will be the low for the cycle.

2) I already miss Alea. Before jck went on hiatus, he commented that the TAF was not effective at lowering rates, and that the TSLF was a success, though by success, he means that it’s not in hot demand. Tony Crescenzi speaks similarly. Perhaps the existence of the PDCF reduces the need.

3) Perhaps Lehman is an example of that, moving buyout loans off of their books, and getting financing for the AAA portion from the PDCF. Given the imitative culture of Wall Street, I would expect to see this repeated by other investment banks.

4) Volcker-mania. In one sense, it’s weird to see him speaking out now, given that he was silent for Greenspan, save for a little at the end. I agree with almost all of what he has been saying; it reads like my writings over the past five years. For a sampling of opinion:

Greenspan ate sour grapes, and Bernanke’s teeth have been set on edge. Bernanke inherited Greenspan’s ignored problems. At this point he and the Fed are puzzled — seeing rising inflation, but fearing what higher rates could do to the banking system. With a similar view that the Fed has few good options, consult Tim Duy.

5)? Finally, if we turn off the microphones, and shut down the cameras, will Alan Greenspan cease to exist?? His defensiveness toward his record undermines his record.? Better he should stop talking publicly, particularly if he follish enough to suggest that the housing market will bottom in 2008.

The US Dollar and the Five Stages of Grieving, Revisited

Posted on 12 April 200813 April 2008 by David Merkel

I recently received an e-mail from a reader regarding the post, The Problem with Hoarding, or, Don?t Play a Game with Someone Who Can Change the Rules. Here it is:

Why pick the year 2020 for a max? I like the previous post about the US Dollar and the 5 stages of grieving

That previous post was the one that first got me hooked on Aleph. Google found it for me when I was searching for some answers on what the heck was going on in the world.

Let me clarify. By 2020, I don’t think the US Dollar will be the world’s reserve currency. It may happen sooner than that. As for the five stages of grieving, that applies to the intermediate-term, and maybe the short-term. It certainly sounds like the G-7 is entering the stage of bargaining. If they decide to do a currency intervention, I hope they remember The Four Rules of Currency Intervention. It would save them money, whatever money is nowadays.

We are getting close to an inflection point here.? The pips are beginning to squeak.? Be ready for an intervention; and be prepared for it not to work, unless they follow the four rules.