David Merkel – Page 287 – The Aleph Blog

The Rising Disconnect between FOMC Policy and LIBOR

Posted on 26 November 2007 by David Merkel

The FOMC can loosen interest rate policy, but how much will unsecured interbank lending rates like LIBOR respond?? As it stands right now, the Treasury-Eurodollar spread [TED spread], is at 180 basis points, up from 96 basis points (or so — don’t have access to a Bloomberg Terminal).? 17 basis points of that rise is a rise in LIBOR.? Not the usual response that you expect to loosening monetary policy, but these are unusual times, when credit spreads dominate over monetary policy, even on high quality lending and short term.

It feels like the major global banks don’t trust each other enough to lend to each other short term.? This has impacts on mortgage markets as well, such as the ability to refinance mortgages, and resetting mortgage payment rates even on prime mortgages.

Typically the TED spread does not stay this high for long.? If the FOMC cut the Fed funds rate to 3%, that might normalize things, but for now they will be content with half measures like temporary injections of liquidity.? Now, a 3% Fed funds rate will produce other problems (inflation, lower dollar), and it won’t really solve the overall mortgage credit problems in the short-run, but it is what the market expects by mid-2008.? It might help out in problems with the banks that are on the cusp of creditworthiness, and that is what may drive the FOMC to act.

More later.

What I am Thankful for

Posted on 23 November 200722 June 2017 by David Merkel

With all of my family and guests gone or asleep after a big Thanksgiving Day at my house (17 people), I reflect on what I am thankful for.

My relationship with my God, Jesus Christ.
My wife of 21 years (today).? What a good woman, and what a help she has been to me.? Among many other things, she helps me focus on what is truly important in our short mortal lives.? At the church that I met her at, she was regarded as the “prize” of all the young women there.? I can tell you that their opinions were right.
My eight children.? Some do better, some do worse, but in aggregate, they are all doing well.
My congregation; good friends all, and they are a real support.
My friends, including the readers of my blog.? We all need friends.

Now for the broader stuff:

Though our civil liberties have been degraded by the misguided “War on Terror,” we still have significant liberties in the personal, political, religious and economic spheres.
Our economy still prospers, even amid bad monetary and fiscal policy.
Development in the developing world is screaming ahead.? As (classical) liberal economic economic policies are embraced across the globe, poverty is being reduced globally, which is something dear to me.
I haven’t made a lot on investments this year, but I’m still doing adequately.
I have several possibilities for how I will work as I labor to support my family.? (Perhaps an announcement coming soon…)
I’m grateful that my views of the Fed, residential real estate, and the debt markets have largely proven correct.
I’m even grateful for my losses; they keep me humble, and teach me a lot about investing.

That’s what I am thankful for; I hope you have it as good, or better, than me.

Why Did I Name This Site “The Aleph Blog?”

Posted on 22 November 2007 by David Merkel

I’ve been asked about the website name a number of times lately, so I want to explain the reasons behind the name.? Now, two of the reasons were listed on my first post:

Thanks for coming to the Aleph Blog. This is a work in progress, and suggestions are solicited for both style and content.

The Aleph Blog derives its name in two ways: first, Aleph is the Hebrew equivalent of the Greek Alpha. Alpha is what is desired out of investment managers ? outperformance versus a client?s benchmark. I have my methods for doing so that I have described over at RealMoney, and will continue here at my blog. Second is that the Hebrew letter Aleph corresponds to the word for ?Ox.? Well, what?s more bullish than an Ox?

I look forward to communicating with my readers, and building this site into something that a lot of people can learn from and enjoy.

Sincerely,

David

That was nine months ago.? The blog has come a long way since then.? There were several other reasons why I chose the name.? In the mid-90s, I wrote out a business plan for a fund that I called the Aleph Fund.? My goal was to create a Value investment shop called Aleph Investment Advisors, or something like that.? Why Aleph, though?? Why not Alpha?

Aside from the fact that “alpha” has been grabbed by others, I’m a little quirky.? Friends of mine call them “Merk Quirks.”? Because “alpha” is overused as an investment word, but the concept has validity, I decided to adopt the Hebrew version (aleph) in place of the Greek version.? My rationale involves my view of Western culture.? Given the influence that the Bible has had on Western culture, I view the Jewish impact to be as great as the Greek impact, but the Jewish part is underappreciated.? To most Christians, the part of the Bible written in Hebrew (Old Testament, Tenach) is more opaque than the part written in Greek (New Testament).

I’m a Reformed Presbyterian.? We view the Bible as a whole, and our pastors learn Hebrew (admittedly rudimentary), and Koine Greek.?? It’s important that those who lead us be able to understand the original languages as best they can.? For me, I pick up on a bit here and there.? If it wasn’t enough for me to see an “aleph” as the beginning of Psalm 119, it might have been enough for me to see the mathematical “aleph-null” when I was a kid — an expression for the total number of integers.? Aleph is big, very big.

That’s why I called this “The Aleph Blog.”? It dovetails into my personality, and it sets my investment blog apart from blogs that have more conventional names.

With that, I wish you a happy Thanksgiving.

Sincerely,

David

Musings on the Fed and Yesterday’s Article

Posted on 21 November 2007 by David Merkel

From Tuesday’s Columnist Conversation over at RealMoney.com:

		David Merkel
		Thinking About the Fed
		11/20/2007 1:51 PM EST

One of my maxims of the Fed is that it is better to watch what they do, and pay less attention to what they say. The markets are saying that they expect Fed funds at 3% sometime in 2008. The Fed governors see that also, and are being dragged there, kicking and screaming. They don’t want to do it; there is real risk to the US Dollar, and there are inflation risks as well. As they measure it, the economy is growing adequately, and labor employment is fairly full. But as Cramer and others point out, the financial system is under stress, manifesting most sharply in mortgage lenders and insurers. Secondary stress is in the investment banks and financial guarantors.

But what exactly has the Fed done so far? Most of the monetary easing has not come through growth in the monetary base, but from continued relaxation of reserve requirements. Given that the Fed is loosening, I would have expected a permanent injection of liquidity by now. As it is, the last one was May 3rd, when there was no hint of the loosenings coming.

So what then for future FOMC policy? The banks are increasingly incapable of levering up more. The monetary base will have to grow. With the Treasury-Eurodollar spread at over 170 basis points, the big banks don’t trust each other. Again, this measure points to 3.00-3.25% Fed funds sometime in 2008.

I see them getting dragged to cuts, kicking and screaming, until a combination of inflation and the dollar force them to change. Then the real fun begins.

Fed minutes out soon. Watch them make a fool out of me.

Okay, the FOMC minutes did not make a fool out of me.? Neither did the market action.? I’m in the weird spot of thinking that nominal economic activity is higher than expected, on both an inflation and real GDP basis.? I don’t like the mortgage and depositary financial sectors at present, two areas that are dear to the FOMC.? That’s where I stand.

One reader asked, what do you mean by, “Then the real fun begins.”?? Maybe I have to do a book review on James Grant’s, “The Trouble with Prosperity.”? James Grant is very often correct, but usually way too early, which is why it is hard to make money off of his insights.? The “real fun” is watching FOMC policymakers squirm as they balance off costs of inflation and economic growth on the negative side, as it was in the late 70s and early 80s.? It is also the fun of watching policymakers at the Treasury Department squirm as they realize that the the fiscal wind is in their face and not at their backs anymore, as the demographic winds spin 180 degrees.

Other readers e-mailed, asking the practical question of how to invest in such an environment.? First, don’t overdo it.? Invest for a normal market scenario, and then tweak it to add more short bonds, TIPS, Commodities, Foreign bonds, and stocks with good inflation pass-through.

I got a few questions asking me to justify my bearish view on the US Dollar.? On, a purchasing power parity basis, the US Dollar is fairly valued now.? (What goods can the Dollar buy versus other currencies?) Unfortunately, currencies react more to forward covered interest parity in the short run. (What will I be able to earn by investing my money in dollar denominated debt, instead of another currency?)? Low intermediate term interest rates in the US portend bad returns from investing in US Dollar denominated debt, so the US Dollar declines.? The rest of the world seems to be bracing for more inflation and more growth.? Because US policy is headed the other way, the US Dollar is weakening.

As for my longer-run negative view on US Bonds, US government policies are designed to undermine bonds.? They have made more future promises than they can keep.? Who will they renege on their promises?? Bond investors are the easiest target; they don’t vote in large numbers.? It will be harder to turn their backs to those receiving social insurance payments, at least in nominal terms.? They have a lot of votes.

That’s all for now.? More tomorrow.

The US Dollar and the Five Stages of Grieving

Posted on 20 November 2007 by David Merkel

Recently I had dinner with a college friend of my oldest son.? It surprised me, but he was interested in how the US dollar was doing.? I likened the current situation to the five stages of grieving.

The first stage is denial.? As it respects the US Dollar, in the initial phases in the decline of the US Dollar, most foreign? finance ministers and central bankers are pretty happy.? After all, foreign exchange reserves are at an all time high.? Export industries are booming.? The government loves the exchange rate policy that keep the US Dollar artificially rich against the foreign currency.? The banks are flush, credit is booming… what could be better?? After all, you can’t have too much in the way of US Dollar reserves, can you?? (They never have to worry about a currency crisis again!)? The government is happy with them, especially since they are supported by the exporters.

Anger is the second stage.? The dollar reserves are worth less and less on a relative basis, and they keep coming in.? The wisdom of having a fixed rate, crawling peg, or dirty float against the dollar is questioned.? Goods inflation is rising in the foreign market, and credit creation is getting out of control.? The finance minister or central banker face the hard choice of revaluing the currency up versus the US Dollar, which slows the economy, particularly exports, or let the situation continue, and build up more US Dollar reserves.? (“What will we ever use all these Dollar reserves for?” they might ask in a moment of lucidity. “What if the US Dollar fell a lot further?? That would reduce the value backing our currency…? Why is the Fed loosening so much?? Don’t they care about the Dollar?”)

So, some of them revalue their currency upward versus the US Dollar, some reduce the basket weight of the Dollar, some let the peg crawl faster, and some do nothing… and the US Dollar predominantly falls in value.? Some finance ministers complain about the Dollar, and net exports to the US begin to decline.? This is where we are now, and I don’t know how long it will take to get to the next stage.

The third stage is bargaining.? The foreign finance ministers and central bankers are stuck.? They are getting pressure to lower the value of the currency against the dollar from exporters, and the politicians that they support.? They wonder if an intervention on the foreign exchange market might do it.? They call their opposite numbers around the globe, proposing an intervention to raise the value of the dollar.? Enough agree to do it, and the coalition of the willing does what they don’t want to do.? They sell their own foreign currencies, and buy more dollars.? The surprise works!? They caught the FX traders leaning the wrong way, on a day when economic news was going their way, they cooperated, and they did it BIG!? The US Dollar rises a full five percent. (“See you at the party tonight!”)

Only one problem, which is clear the next day to Finance ministers, Central bankers and FX traders alike.? (“What are we going to do with all the new US Dollar reserves that we bought?? We already have too much of that…”)? The FX traders pounce, and take the opposite side of the trade, and push the US Dollar lower.

Stage four is depression.? (“There’s no way out, and we got snookered by the neo-mercantilist exporters who got us to keep the currency too low versus the US Dollar.”)? The US Dollar is below the earlier intervention level, and there have been a few additional failed interventions, where the FX traders ate the central banks for lunch.? The US Dollar continues to fall.

Finally, stage five, acceptance.? The foreign currencies rise to sustainable levels versus the US dollar.? Inflation and real economic activity decline in the foreign countries.? They begin buying more goods and services from the US, and dollar claims are redeemed.? Inflation and interest rates rise in the US, as we have to produce more to pay off the dollar reserves now being redeemed by foreigners.? (Send us goods and it will pay off your debts!? Amazing how the US got good terms on both sides of the transaction.”)

Well, maybe.? It will take a while before all major trading parties in the world float/adjust their currencies to fair levels.? At? the time that happens, though, it will be obvious that the US is less important to the global economy.? The relative value of all US assets will be a smaller proportion of global assets, though it will still likely be the largest share in the world.? My view is this process to get to stage five will take no more than 10 years.? By that point, the hopelessness of Federal social insurance programs like Social Security and Medicare, plus underfunded Federal and state retirement plans, will force benefit reductions and tax increases on the US, and crimp borrowing capacity, unless they borrow in a currency other than dollars.? There are five stages of grieving for US social welfare programs as well, but I am afraid we are only in the first stage now, denial.

That is a topic for another day, and not one that I am excited to talk about.

Seven Observations From Barron’s

Posted on 17 November 200718 November 2007 by David Merkel

Kinda weird, and it makes you wonder, but on the WSJ main page, I could not find a link to Barron’s. I know I’ve seen a link to Barron’s in the past there; I have used it, which is why I noticed its absence today.
I found it amusing that the mutual fund that Barron’s would mention on their Blackrock interview, underperformed the Lehman Aggregate over 1, 3 and 5 years. Don’t get me wrong, Blackrock is a great shop, and I would work there if they offered me employment that didn’t change my location. Why did Barron’s pick that fund?
I’m not worried about the effect of a financial guarantor downgrade on the creditworthiness of the muni market. Munis rarely fail. Most of those that do fail lacked a real economic purpose. What would be lost in a guarantor downgrade is liquidity. Muni bond insurance is a substitute for analysis. “AAA insured, I’ll buy that.” Truth, an index fund of uninsured munis would beat an index of insured munis, because default rates are so low. But the presence of insurance makes the bonds a lot more liquid, which makes portfolio management easier.
I’ve been a US dollar bear for the last five years, and most of the last fifteen years. Though we have had a little bounce recently, the dollar has of late been at record lows against currencies that trade freely against the dollar. I expect the current bounce to persist in the short term and fail in the intermediate term. The path of the dollar is lower, unless the Fed decides to not loosen more. Balance needs to be restored in the global economy, such that the rest of the world purchases more goods and services, and fewer assets from the US.
I don’t talk about it often, but when it comes up, I have to mention that municipal pensions in the US are generally in horrid shape. The Barron’s article focuses on teachers, but other municipal worker groups are equally bad off. The article comments on perverse incentives in teacher retirement, which leads older teachers to retire when it is feasible to do so. For older teachers, I would not begrudge them; they weren’t paid that well at the start, and the pension is their reward. Younger teachers have been paid pretty well. I would not expect them to get the same pension promises.
I like Japan. I own shares in the Japan Smaller Capitalization Fund [JOF]; it’s my second-largest position.

Japan is cheap, and small cap Japan is even cheaper. I would expect a modest bounce on Monday.
We still need a 15-20% decline in housing prices to bring the system back to normal. There might be an undershoot in price from the sales that forced sellers must do. Hopefully it doesn’t turn into a self-reinforcing decline, but who can be sure about that? At that level of housing prices, man recent conforming loans will be in trouble, much less non-conforming loans.

Full disclosure: long JOF

Book Review: What Works on Wall Street

Posted on 17 November 200712 February 2011 by David Merkel

This book was really popular in 1996, when it was published. James O’Shaughnessy gained access to the S&P Compustat database, and tested a wide variety of investment strategies to see which ones worked the best over a 43-year period. Unlike most books I will review at my site, this one does not get wholehearted approval from me. My background in econometrics makes me skeptical of some of the conclusions drawn by the book. There are several valuable things to learn from the book, which I will mention later; whether they justify purchase of the book is up to the reader.

My first problem is the title of the book. It should have been titled “What Has Worked on Wall Street.” Many analyses of history suffer from the time period analyzed. The author only had access to data from a fairly bullish period. Had he been able to analyze a full cycle that included the Great Depression, he might have come to different conclusions.

My second problem is that he tests a number of strategies that should yield similar results. One of them will end up the best — the one that happened to fit the curiosities of history that are unlikely to repeat. (That’s one reason why I use a blend of value metrics when I do stock selection. I can’t tell which one will work the best.) The one that works the best just happens to be the victor of a large data-mining exercise. Also, when you test so many strategies, and possibly some that did not make it into the book, the odds that the best strategy was best due to a fluke of history rises.
Now, what I liked about the book:

Combining growth and value strategies produced the best risk-adjusted returns. The growth and value strategies that did the best embedded a little value inside growth, and a little growth inside value.
Avoiding risk pays off in the long run, for the most part. If nothing else, one can maintain the strategy after bad years.
Value and Momentum both work as strategies. They work best together.
He did try to be statistically fair, avoiding look-ahead bias, diversifiying into 50 stocks, avoiding small stocks, and rebalancing annually.

Now, two mutual funds based on his “cornerstone growth” and “cornerstone value” strategies have run since the publication of the book. The value strategy has not worked, while the growth strategy has worked. Go figure, and it may reverse over the next ten years.

Now for those that like data-mining, and don’t want to pay anything, review Tweedy, Browne’s What Has Worked in Investing. This goes through the main factors that have worked also. Theirs are:

Low P/B
Low P/E
Net Insider Buying
Significant Declines in the Stock Price (anti-momentum)
Small Market Capitalization

Either way, pay attention to value factors, and if you trade often, use momentum. If you don’t trade often, avoid momentum.

Book Review: Triumph of the Optimists

Posted on 16 November 200722 June 2017 by David Merkel

Good investors are typically skeptical. They don’t buy every idea that comes their way, but they test and probe to find ideas with compelling value that are misunderstood by others. That said, the best investors are prudent risk-takers. They continue to search for good investments even in environments that seem to have a negative investing climate.

Skepticism can degenerate to permanent pessimism, particularly because most news coverage tends toward the negative. How does an investor remain bullish in the face of news flow that is predominantly negative? By looking at the broader tendencies of equity markets to flourish in the face of troubles over the long run. One good book for that is Triumph of the Optimists. [TOTO]
TOTO points out a number of things that should bias investors toward risk-bearing in the equity markets:

Over the period 1900-2000, equities beat bonds, which beat cash in returns. (Note: time weighted returns. If the study had been done with dollar-weighted returns, the order would be the same, but the differences would not be so big.)
This was true regardless of what presently developed nation you looked at. (Note: survivor bias… what of all the developing markets that looked bigger in 1900, like Russia and India, that amounted to little?)
Relative importance of industries shifts, but the aggregate market tended to do well regardless. (Note: some industries are manias when they are new)
Returns were higher globally in the last quarter of the 20th century.
Downdrafts can be severe. Consider the US 1939-1932, UK 1973-74, Germany 1945-48, or Japan 1944-47. Amazing what losing a war on your home soil can do, or, even a severe recession.
Real cash returns tend to be positive but small.
Long bonds returned more than short bonds, but with a lot more risk. High grade corporate bonds returned more on average, but again, with some severe downdrafts.
Purchasing power parity seems to work for currencies in the long run. (Note: estimates of forward interest rates work in the short run, but they are noisy.)
International diversification may give risk reduction. During times of global stress, such as wartime, it may not diversify much. Global markets are more correlated now than before, reducing diversification benefits.
Small caps may or may not outperform large caps on average.
Value tends to beat growth over the long run.
Higher dividends tend to beat lower dividends.
Forward-looking equity risk premia are lower than most estimates stemming from historical results. (Note: I agree, and the low returns of the 2000s so far in the US are a partial demonstration of that. My estimates are a little lower, even…)
Stocks will beat bonds over the long run, but in the short run, having some bonds makes sense.
Returns in the latter part of the 20th century were artificially high.

The statistical chapters on the 16 developed markets are amazing, but now almost seven years dated. Still, you can glean a lot from them.

This is an expensive book, and one that may not be for everyone. A cheaper book that covers many of the same issues is Stocks for the Long Run, by Jeremy Siegel. Now going into its fourth edition (I have a signed first edition), it covers many of the same issues, but with more of a US-centric approach, and going back another 100 years (with spotty data).

As I like to say, stocks do well, absent war on your home soil, out-of-control socialism, and severe recession/depression. These books will help you stay in the market even when times are hard. After all, who can tell when the market will turn up? Or down?

Dimson, Marsh and Staunton

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Jeremy Siegel

Full disclosure: I get a small commission from any book sales through these links.

Brief Note on Homebuilder Valuations

Posted on 16 November 200722 June 2017 by David Merkel

I have not been tempted to nibble at homebuilders yet. Take one look at the chart of TOUSA, and you can see why:

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TOUSA always looked cheap, but the level of leverage was way too high. Falling housing prices would have a larger negative effect on them.? Now they are staring at bankruptcy.

As it is, housing prices probably have another 10-15% to fall on average before this cycle ends.? There will be more bankruptcies among homebuilders before all of this is done.? When the cycle is done, there will be a few signs amidst the wreckage:

Surviving builders trade at 50-75% of written-down book value.
Earnings are negative, but no longer getting worse.
Early value investors will have given up on the sector.
Bond managers will reinstate the “no homebuilder bonds” rule.
Leverage will be similar to today, but on smaller companies.
Financial magazines will run articles on how smart MDC Holdings was during the “bad old days” of 2004-2006.
Old standards will return for loan underwriting.? Financial magazines will talk about prudence in borrowing against residential real estate, and how it is not a “one way ticket” to riches.
Inventory levels decline 20% from their peak levels.

Anyway, that’s what I expect.? At that time, or slightly before, I would probably buy two of the best capitalized homebuilders.? That’s what I try to do in investing… arrive slightly before the point of maximum pessimism.

Book Review: The Intelligent Investor

Posted on 15 November 200715 November 2007 by David Merkel

Fifteen years ago, my mom gave me a book that would change my life: The Intelligent Investor, by Benjamin Graham. Prior to that time, I was primarily investing in mutual funds, and did not have a coherent investment philosophy. The Intelligent Investor provided me with that philosophy.

What are the main lessons of this book?

Don’t overinvest in equities. Markets wash out occasionally, and it’s good to have some bonds around.
Don’t underinvest in equities. Bonds can only do so much for you, and it is good to deploy capital into equities when they are out of favor.
Stocks provide modest compensation against inflation risks.
Avoid callable bonds. Avoid preferred stocks.
Be conservative in bond investing. Read the prospectus carefully. Often a bond is less safe than one would expect, and occasionally, it offers more value than one would expect.
Purchase bargain issues on a net asset value basis when you can find them, but be careful of quality issues.
Volatility of stock prices can be your friend if you understand the underlying value of a well-financed corporation.
Having a longer-term investment horizon is valuable, because one can take advantage of short-term fluctuations in price.
Growth is worth paying up for, but be disciplined. Don’t overpay.
Be wary of mutual funds.
Be wary of experts.
Pay attention to the balance sheet; don’t invest in companies that are inadequately financed.
Review average earnings of cyclical companies.
Buy them safe and cheap. Don’t overpay for growth and trendiness.
Avoid highly acquisitive companies.
Watch cash flow, and question unusual accounting treatments.
Be careful with unseasoned (new) companies.
Strong dividend policies, in companies that can support the dividends, are an indicator of value.
Aim for a margin of safety in all investing.

That’s my quick synopsis of the book. Though I am not a strict Graham-and-Dodd investor (who is?), I apply the basic principles to most of what I do. This is still a relevant book today because the principles are timeless. If you want the updated version with writing from Jason Zweig, that’s fine. You gain in current relevance, and lose a little in nuance. Graham was a very bright guy. I give Zweig credit for trying, but aside from Buffett or Munger, who would really be adequate to revise The Intelligent Investor? I don’t think I would be adequate to the task….
Classic:

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As Revised by Jason Zweig:

Full disclosure: I get a small payment on the sale of the books, but if you are buying from Amazon anyway, it won’t increase your costs.